The medium-term outlook for UK property is far from clear. Peter Hobbs and Henry Stratton examine and assess some likely outcomes
The widely reported turnaround in the UK market over recent months has been staggering. The IPD monthly index for December turned in a record monthly performance of positive 3.6%, and the annual index generated a return of 3.5% for the year. This is an incredible turnaround from the negative 26% return for the 12 months to June, and the strong momentum seems to be continuing in the first weeks of 2010.
This dramatic turnaround raises the question of its sustainability, through 2010 and beyond. This is of profound importance for investors, lenders and managers as they plan their strategies for the coming months. Although important, the huge uncertainty facing the economy and property markets means it is even more difficult than usual to develop robust and meaningful forecasts of market performance. It is within this context that this short article seeks to add to the debate over short and medium term market prospects. It starts by summarising the ‘base case' outlook held by many forecasters, and then draws out a series of scenarios for potential performance during 2010 and the following three to four years.
The ‘base case' outlook
In terms of expectations for property performance in 2010, the general consensus can be summarised as follows:
Capital market driven recovery - the 45% decline in property values to mid-2009 coupled with the recovery in equity markets, the aggressive pricing of bond markets, and the very low interest rates has increased demand for property investment. Investment levels remain low but these volumes are set to double in 2010 compared with last year. Yields have started to harden and this momentum is set to continue, certainly during the first half of 2010.
Based on these drivers of performance, it is likely that IPD returns will exceed double digits during 2010. The latest IPF consensus forecasts is for 13.4% with the top quartile averaging 17% returns in 2010 and the bottom quartile averaging 9%. These strong returns are likely to be front loaded, as the market re-prices during the early part of the year. The second half of the year is likely to experience some weakness given the earlier re-pricing as well as the prospect of rising interest rates and the likely austere measures introduced by the new government.
Although there is a fairly tight consensus around the outlook for 2010, there remains huge uncertainty. This uncertainty exists in terms of the economic outlook (GDP growth, government policy, unemployment, interest rates etc ), fundamentals and real estate capital markets. The fragility of the economy and the property market, coupled with the range of important factors that could have a major impact on performance, means that the development of scenarios is far more helpful in developing investment strategies than single point forecasts.
Over the short term, two distinct scenarios can be constructed around the consensus - excess liquidity and a stalling of growth. Within the ‘excess liquidity' scenario, the recovery in the capital markets and the relatively attractive pricing of real estate leads to a surge of investor demand for UK property. Each of the main investor segments - domestic institutions, REITs, overseas buyers and private buyers - become more aggressive in seeking to build exposure to the market, driving down yields. Within this scenario, there is little change in fundamentals, although the generally improved confidence leads to less significant rental decline.
In the ‘stalling of growth' scenario, the UK capital and property markets suffer from the huge burdens facing the economy. A range of potential risks could translate into significant downsides for the UK market. These include macroeconomic risks such as the premature exiting of the stimulus packages and a slowing of the global economic recovery, and related risks such as loss of investor confidence. Within this scenario, bond yields could rise sharply, and investor appetite for property could reduce, preventing yields from hardening much beyond the levels they had reached by early 2010. Market fundamentals would also be weaker, with the large overhang of space combining with reduced confidence leading to steeper falls in rents.
While both scenarios are plausible, it is hard to quantify their impacts on the property market. When developing such scenarios, there is a danger that they are too ‘incremental', in being too close to the base or central view on market prospects. The need to consider dramatic changes is well illustrated by CBRE's history of property yields over the past 40 years. The chart shows that following major market dislocations, yield compression has tended to be swift and dramatic. In the early 1970s and 1990s downturns, yields rose to over 8% but, within two years, they had compressed to around 6% - a 25% compression. The compression was actually more dramatic (around 30%) from the highest yield to the cyclical low in the following recovery.
By the end of 2009, IPD initial yields had compressed by around 90 bps (11%) from their 7.9% in the summer, and most base case forecasts assume further hardening in 2010 by 60 bps or another 10%. But if the recovery of previous cycles is to be repeated, then cap rates could compress more dramatically, by a further 15% in 2010, taking the IPD yield to below 6% by the end of the year.
Based on this analysis, it is possible that even if rental growth remains marginally negative, the strong yield compression could lead to returns of close to 25% for the year as a whole. Although this would be an astonishing result, such 20%+ returns have occurred in eight of the past 40 years. The most comparable of these was in 1993 when the market was continuing to experience negative rent growth but the capital market drove very strong property returns. In contrast, the ‘stalled recovery' scenario would see cap rates remaining broadly stable during the year and, although income yields would be high, the steeper, perhaps double digit, rental decline, could lead to flat to marginally negative returns
2011 and beyond?
If there is considerable uncertainty over the coming months, this is compounded when looking into 2011 and beyond. With the huge debt burden and considerable global and macroeconomic risks, the UK economy is highly fragile and exposed to a range of shocks. Growth is likely to be weak, with most forecasters suggesting GDP growth of little over 2% a year between 2011 and 14, but could be far weaker. Against this is the prospect that the economy could recover more strongly than most commentators suspect. Global growth is recovering and most analysts tend to understate the scale of global economic recoveries.
The real estate market faces a similar range of uncertainties, in terms of fundamentals and capital markets. These uncertainties can be captured in four plausible scenarios over the period 2011-13. On the one hand, the short term scenario of ‘high liquidity', could be followed by one of two scenarios, ‘golden years' or ‘double dip'.
Within the ‘double dip' scenario, the property market could suffer from two different types of downside risk. First, an economic double dip due to the ending of quantitative easing, constraints on public spending and/or a significant slowdown in global growth. Second, more of a property market double dip, whereby the surge of liquidity during 2010 leaves the property market aggressively priced at a time when fundamentals remain weak. Income returns deteriorate due to deeper rental declines and continued rises in voids. Within this scenario, capital moves away from property so that yields rise, particularly in 2011. The combination of the two double dip pressures would lead to weakness in both fundamentals and capital markets. This scenario, in which returns would turn negative in 2011 before recovering in 2012/13, would be similar to the early-1990s and, on an inflation-adjusted basis, to the mid-1970s.
The ‘deflationary' scenario would be associated with lower economic growth and weakness in the property capital markets. Global economic weakness, the debt burden facing the UK economy and the debt overhang on the property market could combine to generate a period of prolonged rental decline and upward pressure on yields. Inflationary pressures would likely be low, but finance costs and bond yields could remain relatively high, leading to further downward pricing of the property market. Such a scenario, akin to Japan in the 1990s, could lead to rental declines through until 2013 but the persistently high yields and the correction of the market in 2010 mean that returns would be marginally positive in the period 2011-13.
Another set of scenarios could follow the short-term downside scenario, a ‘deflationary' and ‘late-recovery' scenario.
The ‘late recovery' scenario would involve a gradual pick-up in economic activity and market fundamentals. Rents would turn positive during 2011 and grow steadily over the following couple of years. Interest rates would remain low, and capital would come back to the property market leading to a compression of yields. Within this scenario, similar to the mid/late-1980s, the market would perform very well in the outer years, averaging low double digits between 2011 and 2013.
These scenarios, with their different magnitude and timing of performance, are useful in considering appropriate strategies for existing owners of real estate and investors seeking to increase exposure to the asset class. The probability of the scenarios is weighted towards the ‘base case', at maybe 50%, so greatest attention should be placed on the implications this scenario. Within the base case, real estate remains a potentially attractive asset class over the next three to four years. Existing owners should benefit, with returns averaging high single digits over the next four years, and values rising by around 15% from their mid-2009 lows. The market also remains relatively attractive for new investment but, given the momentum behind re-pricing over the coming months, this will be less compelling by the end of 2010.
Although the base case remains the most likely outcome, there are some significant upside, and downside risks, with the high liquidity scenario having a probability of around 30%. Given this, the other scenarios should also be considered as they have potentially very different implications for owners and investors.
The golden years scenario points to a need to hold existing assets and invest further capital to benefit from strong medium-term performance. The double dip scenario has very different implications, leading existing owners to consider the short-term disposition of assets, benefiting from the recent and near term recovery in market pricing. Within this, and the deflationary scenario, there is a case for new investors holding back from investing in 2010 until the market corrects and provides more attractive investment opportunities.
The uncertainty of the market outlook and its fragility and susceptibility to a range of shocks calls for a highly cautious and incremental approach to investment strategy. With the market changing so rapidly, participants should monitor and review the outlook, and its implications, on an even more frequent basis than usual. Beyond greater frequency, the analysis should be fully integrated into the investment process, at portfolio and asset-specific level.
The scenarios can help in structuring sensitivity analysis for portfolio weightings and for individual buy/hold/sell decisions. This building of scenarios and applying them to the investment process is a clear example of the way the broader trend for greater risk management can improve decision-making across the property industry.
Peter Hobbs is head of global real estate research at RREEFHenry Stratton is a European real estate researcher at RREEF