Long run risk premia for real estate could rise by as much as 100 basis points due to the effect of taxation, leases and leverage. Gerry Blundell examines the different factors at play
Over the last couple of years UK property investors have had a switchback ride. In June 2007 initial yields stood at 4.6%, 0.7% below gilts. By June 2009 yields had risen to 7.9%, nearly 4% above gilts, the conventional risk free rate. By January 2010 they had fallen again to 7%, driven down by quantitative easing, low interest rates and a weak pound.
These fluctuations led the Investment Property Forum (IPF) to initiate research into the risk premium for property, (in essence its required return margin over gilts). In May 2008 the IPF began surveying investor expectations. Although one-year expected property returns were poor, the poll reported a required margin over risk-free rates of nearly 4%, high compared with normal assumptions about the risk premium of 2 to 3%. In September 2009 the survey was repeated. Property's risk premium was still 3.6%. How far are these requirements met by current asset pricing, and is the apparent rise in property's risk premium likely to be a permanent feature?
The table below analyses prospective long-run returns from yields as at January 2010. Because it takes a long-term view over the next 15 years it makes no allowance for yield shift.
In 28 years of IPD records yield shift made virtually no contribution to returns, and at the expense of considerable short-term volatility. So total expected return is the balance of current yield plus expected inflation and real income growth in the asset class (if any) less all costs.
The figure takes a fairly jaundiced view of property's costs relative to gilts, allowing a full 2.5% for property depreciation and 0.5% for equity dilution. Arguably both have upside risk.
Despite the rise in yields since mid 2007, property still looks unattractive against gilts with a prospective risk premium after all costs of less than 1% compared with a required margin from the IFA survey of 3.6%. Either initial yields need to rise or income growth prospects improve. On their own initial yields would need to rise to around 8%.
This conflicts with recent evidence in the markets of renewed interest in prime income-producing property where yields are again falling. But just as the stock market rally since March was largely to do with re-rating while earnings prospects weakened, so the spike in prime property values may well prove short-lived without a recovery in occupational markets. The similar trend in both equity and property markets reflects the sharp rise in correlation since the start of the credit crunch.
Markets' perception of fair value varies though time as appetite for risk waxes and wanes. In the past estimates of property's appropriate return margin over gilts have varied from as low as 1% to the heights of 5%. The IPF's investor surveys illustrate how this margin can move through time. Because analyses like the table below are frozen at one point in time, it is difficult to account for changing conditions, so what can past data on the risk-free rate, rental growth and yields tell us?
In a recently published research paper the IPF reported on several ways of estimating fair long-term value for yields.* All of these methods pointed to the need for yields to rise in the absence of a rapid and strong recovery in occupational markets.
However these analyses were based on past trends in large part and the past is an unreliable guide to the future. The IPF paper argues that three factors were likely to combine to ensure that yields would be unlikely to fall back to historic levels: leverage, changing lease structure and climate change.
The level of debt in real estate is at record levels. De Montfort University estimate a total loan book of £200bn (€227bn) against a commercial property universe that is less than £500bn. Gearing at, say, at least 40% must increase the risk premium compared with what was a relatively ungeared asset over most of the 1981/2008 period. Even if they do not have debt attached the comparables process of valuation will eventually transmit the shock of forced sales to unleveraged stock valuations.
Shortening lease lengths and the slow unpicking of the upwards-only review clause are likely to increase risk premia as the owner is more frequently exposed to the possibility of market rental falls. The average lease length for most of the 1981/2008 period was 10 or more years. Looking forward it is unlikely to be much more than five. This effectively doubles releasing risk for which investors will, or should, require additional return, depending on the strength of the leasing market.
Finally, carbon related regulations, and related taxation, will increase the rate of depreciation. Anxiety about the uncertain impact of CO2 regulations will raise perceived risk about the asset class and will raise yields. This again will have an uneven influence across the market depending on location (flood risk) and the value of land as a proportion of total value. However, it is difficult to see anything other than an upward influence on depreciation rates and thus the level at which yields will settle to, as normal market conditions return.
As these factors slowly get baked into market prices we can expect the required margin over the risk-free rate to rise. We will see a divergence in risk premia within the property universe as not all types of stock will be equally affected by these factors. They should be a key area for research over the coming months as investors re-finance the market. Property as an asset class will never be quite the same again.
On a conservative basis these three factors could see long run risk premia rising by 100 bps. So when and if average yields begin to fall again they may not have as much downside as some are hoping, or as might be estimated from time series analysis and econometric forecasts. Shorter leases, leverage and taxation issues will all serve to move property away from its historic bond/equity hybrid status towards appearing to investors as more like an equity, albeit a high yield one.
When the IPF poll is conducted later this year, it will be interesting to see if any difference then remains between required equity and property returns.
*A copy of the full report is available from the IPF, tel: 44 20 7194 7920
Gerry Blundell is strategy adviser, Legal & General