Long-lease assets vulnerable to bond yields – L&G Property
UK – Real estate in the UK still offers good value, but pure long-lease strategies will be vulnerable to rising bond yields, according to Legal & General Property.
Director of research Robin Martin said recent volatility in government bond yields posed the "reasonable question" of whether real estate remains good value relative to the risk-free rate.
"The answer for us is it does," he said, forecasting that the UK property market would deliver total returns of 8-10% in 2013.
Martin cited a number of value indicators – most notably that the estimated risk premium for UK real estate was "still well above average" – but he also emphasised the importance of "creating resilience to rising bond yields" in property portfolios.
He warned that long-let property assets would be particularly vulnerable to further rises in bond yields and revealed that L&G Property had been adjusting the weightings of its funds in favour of shorter-leased properties.
"The next few years are going to treat different parts of the market quite differently," he said.
Assuming that investors have historically required a 3.5% return premium over government bonds, investors would be seeking a return of approximately 6.5% from UK property today.
Martin said this was comparable with the initial yield on long-let assets, according to Investment Property Databank (IPD).
"Those are now virtually identical," he said.
"Most forecasters – and I'd certainly include myself in this – would expect that risk-free rates are going to rise over the next 3-5 years.
"The timing and the extent is really pretty uncertain, but the direction is very clear.
"Without growth potential, those long-let assets, unless they have growth potential, are very vulnerable to that process. And, in fact, to deliver the kinds of returns investors will require, the yields will have to rise – i.e. the prices will have to fall."
L&G Property has been increasing the exposure of its funds to "higher-yielding assets that have growth potential and hence are more resilient in that process".
He added: "Portfolios that are tuned only to protecting against downside risk are going to find it very difficult to cope with a higher risk-free rate environment."
Asked whether this scenario would lead to a reversal in appetite for long-lease funds, Martin said there would be "continuing demand" for strategies that delivered inflation-linked income streams rather than just offering exposure to long leases.
"The key differentiation is about the degree to which the product matches liabilities," he said.
"The area that would concern me more is the pure long-lease funds, where it is just long income.
"If that doesn't have growth around it, that gets priced relative to nominal fixed income, and that is going to look increasingly difficult as government bond yields start to rise."
Invesco Real Estate has also warned that traditional long-lease strategies face a number of risks, and has proposed a secure-income, inflation-linked property strategy that would target relatively shorter leases.