UK rental growth most likely to nullify rising bond yields – study

Rental growth in the UK is likely to “cancel out” a 100bps rise in 10-year government bond yields in the next four years, according to new research.

A study by Heriot-Watt University suggests that commercial real estate yields would only rise by around 0.25% between now and 2019 under a “central scenario”.

Commissioned by the Investment Property Forum (IPF), the finding is based on what it deems the most likely outcome: 10-year gilt yields rising from 3% to 4% over the four years and rental growth accelerating to between 2% and 2.5% per year.

The research was intended to consider the implications of a rise in long-dated UK gilt yields for UK property equivalent yields and total returns.

By examining the behaviour of property yields and long-term bond yields over the past 30 years in the UK, US and Australia, the research has produced a number of findings, including an apparent closer relationship between property yields and index-linked bonds than with conventional 10-year gilt yields.

The finding has implications for assessing the risk premium of real estate.

“The yield gap between property and 10-year gilts is a useful benchmark, but it incorporates rental growth expectations,” the report says.

“A purer estimate of the long-term risk premium for property is given by the yield gap between index-linked gilts and the property equivalent yield because both include inflation expectations.”

The report, produced by Colin Jones, Neil Dunse and Kevin Cutsforth from the Institute for Housing, Urban and Real Estate Research at Heriot-Watt University, also considers alternatives to its central scenario and still finds little evidence to suggest a significant rise in property yields could be on the cards.

Under a stagflation scenario, with low economic and rental growth but accelerating inflation, 10-year gilt yields would rise to 5% but equivalent property yields might increase by 0.6%.

A “financial repression” scenario, whereby the Bank of England resumes quantitative easing and gilts yields remain fairly stable at 3%, equivalent property yields would barely change.