It’s amazing to think a decade has now passed since Lehman’s collapse, the centrepiece of the largest market property crash in living memory. With prime yields returning to historic lows, a desire to “re-normalise” interest rates and uncertainty over Brexit, is history about to repeat itself? asks Ezra Nahome, chief executive, Lambert Smith Hampton.
Over the past five decades, the UK commercial property market has endured three severe downturns or “crashes” since the 1970s. The timing of each crash has been remarkably consistent, occurring at intervals of 16 years. So, on that basis, the next traumatic episode is “due” in 2024.
We shouldn’t shy away from the fact that cycles are inevitable – a downturn in the UK property market is on the way. The real puzzle is when it will happen, and what will be its severity. Are the alarm bells of the past now ringing?
Reasons to be cheerful
The good news is that there are plenty of reasons to be cheerful.
Let’s look first at yield spreads. An old rule of thumb is that property offers “fair value” if the yield spread over gilts is circa 200bps. Prior to the crash of 2008-09, such was the degree of speculation that average property yields were lower than those of 10-year gilts. In this cycle, extremely low interest rates and bond purchases by central banks have pushed gilt yields to low levels, giving a substantial 400bps spread.
The Monetary Policy Committee’s recent vote to hike the prime interest rate raises questions about current sustainability. That said, regular assurance that upward movements will be gradual and limited should allow the market to adapt.
In the previous boom, pricing of secondary assets was fuelled by easy credit and valuations that assumed rental growth was virtually guaranteed. While prime yields are currently low, secondary assets are more clearly discounted to account for occupier market risk.
Speculation
Secondly, a consistent feature of each previous pre-crash era was intense speculation in the market, linked to a rapid expansion of credit. Property lending in the last cycle was so profligate and ill-judged that the UK government had to intervene and rescue the banks when crisis struck.
Hard lessons were learnt, and today lending institutions are stringently regulated to avoid past mistakes. The lending environment is structurally more cautious; the scale of outstanding loans to property is lower than it was, lending margins are higher and loan to values are far less generous, down from typically 75% in 2007 to 55% in today’s market.
Previous severe market downturns coincided with a development boom in full swing. The “double-whammy” of recession and oversupply left capital values extremely exposed. This cycle is different. The development response has been muted, so levels of supply are relatively tight.
Risks remain
The full picture isn’t completely rosy, though. Less familiar risks are apparent in the current cycle.
There are only six months until a deal on the terms of the UK’s departure from the EU need to be agreed, yet the macropolitical situation remains precarious. There is a clear link between certainty and levels of business investment. If clarity is not forthcoming, there is a risk that economic growth will stagnate and occupier demand will suffer. This would make 2019 a tricky year to navigate.
The UK market, in particular central London, is highly exposed to a drop-off in demand from overseas investors. Increasing hostility over trade from the US could be a trigger, so this area is most certainly one to watch.
Taking everything into account, there is a low risk of a market crash over the short to medium-term. Property returns are increasingly driven by income, a trend which should shield the market from the risk of a dramatic downturn. That said, a minor correction is plausible over the next 12 to 24 months, and how Brexit plays out could be key.
More diverse market
Yet there is something quite unique to this cycle. The market is now more diverse and niche sectors are attracting significant volumes of capital from institutional and overseas buyers. Likewise, some traditionally solid sectors are staring headlong into the abyss – or at least that’s the common market narrative.
While retail is going through significant change, there are always new opportunities to be had. So, as the polarisation between the retail and distribution sectors demonstrate, structural factors are becoming just as important as economic factors in determining asset performance, and could have a far greater role to play in future cycles.
