For better or for worse, the prime minister has set out her priorities for the UK’s exit from the European Union and the single market, but what does this mean for investors looking to allocate to commercial property?
Once again our industry is looking to history for help in understanding the relationship between inflation rates, interest rates and the impact on property yields.
Indeed, a recent meeting of RICS in London revealed that opinion is divided between the generations. Contrast the experiences of managers in their fifties who lived through the high-inflation period of 1970-79 with a younger generation of managers in their thirties or forties, accustomed to today’s bond rate regime and low rental yields.
In an effort to rationalise this behavioural bias, we recently took a closer look at inflation rates across the UK and Europe over the past 30 years. We found that for Central Europe the post-financial crisis “new normal” low-inflation-rate environment was more of a “not-so-new norm”. In this region, which includes France and Germany, average inflation rates have been well below 2% for the past 30 years.
While this period of low inflation might be attributed to strong euro discipline and the adoption of the Exchange Rate Mechanism, a look at history and the new-found relative strength of the European Central Bank indicate that Central Europe may be in for a continued period of low inflation and low growth. Both are good reasons for the ECB to maintain low interest rates, although some upward creep shadowing US rates is to be expected.
Against this backdrop, we expect that core rental yields of around 4% in Paris and the top seven German cities are here to stay, which should remain attractive to traditional institutional investors looking for long-term liability-matching returns from their European commercial real estate allocations.
What though for the UK? The 30-year norm argument falls out of bed in a post-Brexit UK. Let’s not forget that the UK entered the post-Lehman period with one of the OECD’s largest national debts and current account deficits in relation to GDP. The bold fiscal reform intentions of the 2010 coalition government convinced international lenders and enabled the UK government to borrow cheaply through the 2015 election and up to the Brexit vote. However, since the referendum, the Office for Budget Responsibility is predicting a £58bn annual shortfall, with no clear target for deficit stability and an almost certain spurt in inflation through 2017, brought about by the huge currency declines.
Even if the 2017 inflation works its way out of the system by 2018, we cannot expect international lenders to be happy with either their currency losses or the indeterminate deficit. The rates at which the UK government borrows must rise and other interest rates accordingly. Indeed, the evidence for this was already emerging at the end of November as National Savings announced a retail bond issue at 2.2%, where less than 1% had previously been available.
The impact of this on demand for UK real estate has not yet fully emerged, although we do not believe that investors in real estate will abandon the asset class completely and revert to investing in bonds. However, they may find it harder to justify investing for a 4% pure core return in favour of investing in strategies further up the risk curve, moving into “manage to core” and value add.
Jos Short is executive chairman at Internos Global Investors
