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The Actuary The magazine of the Institute & Faculty of Actuaries

Property renaissance or bubble? (revisited)

In September 2003 the author wrote an
article in The Actuary entitled ‘Property renaissance...
or bubble?’ It was prompted by
UK commercial property’s strong performance
in the preceding five years, which significantly
exceeded its long-run average. The article
argued that prospective long-run returns from
2003 onwards would average 88.5% a year,
implying an attractive premium over risk-free
assets of between 3.5% and 4%. It concluded
that commercial property had enjoyed a renaissance
after dismal performance during much
of the 1980s and early 1990s, when it underperformed
other UK assets, but that there was
no sign of an asset bubble.
Over the intervening four years UK commercial
property has indeed continued to perform
strongly. Total returns over the four years from
July 2002 to July 2007 have averaged 16.5% a
year, according to the IPD Monthly Index, but
cracks are now beginning to show: returns have
slowed significantly this year and some UK property
funds have recently experienced net outflows.
Additionally, listed property markets have
fallen some 20% from their peaks. It is therefore
timely to revisit the question of whether
investors can expect continued strong performance,
or are they facing a market bubble?
Drivers to recent performance: a
decade of two halves
Total returns to commercial property can be
divided into two components: income (rental
receipts from tenants net of outgoings) and capital
growth. The latter is a function of the
change in rental values (reflecting demand and
supply in the occupier markets) and movements
in market yields (as investors adjust their
rental growth expectations or their assessment
of risk and liquidity). The importance of these
drivers to returns differed markedly between the
first and second halves of the past decade.
Over the past five years the impact of falling
yields has been the biggest contributor to total
returns. Initial yields (the ratio of rental income
to capital values) fell from 7.1% to 4.6%, boosting
performance by 7.5% pa. Rental growth was
modest at 1.7% pa, while the income return
from property was 6.2%. However, as figure 1
shows, the composition of total returns was in
marked contrast to the preceding five years,
when rental value growth (rather than the
effect of yield changes) was the main driver to
capital performance, and property income was
higher at 7.6%, around 140 basis points above
that of the past five years.
In short, the biggest driver to returns in recent
years has been the downward shift in market
yields. This is the result of the increased popularity
of, and demand for, commercial property
investment. In particular, the UK has been a
popular destination for foreign investment into
property. The availability of new property
funds, changes in legislation that allowed
authorised property unit trusts to be held in ISA
‘wrappers’, and a decade or more of strong,
stable returns that exceeded other asset classes
attracted huge inflows of money from UK private
investors. The Investment Management
Association reported that in 2006 net inflows
to commercial property funds rose by 320%
above the previous year’s level and, in the first
quarter of 2007, property accounted for more
than 40% of all retail investment.
There are two rational explanations for this
yield rerating: either investors have revised
upwards their rental growth expectations, or
they have revised downwards their perception
of the risk premium that should be attached to
What is implied by market yields?
Understanding what was implied by market
yields provides an explanation of past performance
and a context for considering the
future. By assuming investors’ return requirements
it is possible to ‘back out’ the rental
growth expectations implied by market yields.
The implied growth rates can then be compared
to the actual rental value growth that subsequently
occurred, to show how realistic
investors’ expectations were at the time.
The results are shown in figure 2, which
assumes that investors require a premium of
250 basis points over five-year gilts to allow for
property’s relative risk and illiquidity. A long-run
real rental growth rate, net of depreciation, of
1% pa (broadly in line with long-run history)
was assumed, together with property management
costs, voids and the impact of five-yearly
rent reviews. A similar pattern would appear
assuming alternative risk premium assumptions.
During the early 1980s, and the late 1980s to
mid-1990s, the rental growth implied by market
yields was higher than the growth in rental
values that subsequently occurred. For example,
at the start of 1992 investors were assuming that
rental values would grow by approximately
6% pa over the next five years. In fact the recession
of the early 1990s and the oversupply
caused by the late 1980s development boom led
to rental values falling by some 6% pa over the five years 199296. In other words, the market
was significantly over priced.
However, in the mid-1990s pricing became
more attractive because of a combined rise in
property yields and a fall in gilt yields. At the
start of 1996 property yields were at 7.9%
according to the IPD Annual Index, compared
with 5.2% in 1989. Gilt yields had fallen to
6.9% (from over 11%) during this period. The
implied five-year rental growth rate over this
period averaged 3% a year. In fact, rental values
grew more strongly at almost 5% a year.
Current pricing how reasonable
are market expectations?
The fall in property yields in recent years has
dramatically changed the future outlook for
pricing. The situation has been exacerbated
because five-year gilt yields have risen from
their low of around 3.7% in 2003 to 5.4% at the time of this analysis, increasing the required
return. As figure 2 shows, implied rental growth
was negative for most of the period between
1999 and 2006. However, more recently there
has been a sharp rise in the market’s implied
rental growth expectations. We believe that,
based on current yields, rental values would
have to grow in nominal terms by around 7.5%
a year on average over the next five years in
order for investors to enjoy a return in excess of
risk-free assets of 250 basis points.
We consider such growth to be unlikely. While
central London offices have recently experienced
increases in rental values of 1520% over the
past year or so, growth is expected to moderate
as new developments are completed, particularly
in the City of London. Consumer expenditure
is expected to weaken as interest rate rises
feed through to consumption. Development
activity in the retail sector has also increased in recent years. Industrial property is vulnerable to
any weakening in consumer spending (which
will affect distribution warehousing) and any
downturn in manufacturing that might result
from a weaker US or domestic economy.
Based on our expectations of rental value
growth, prospective nominal long-run returns
probably fall in the region of 5.56.5% a year
(around 34% in real terms). Such performance,
which is before transaction and investment
management costs have been taken into
account, is significantly lower than the returns
delivered over the last 1015 years.
Importantly, these prospective long-run
returns imply a narrow margin over risk-free
assets (of less than 100 basis points, based on
current gilt yields). Such a premium probably
does not represent an adequate reward for the
risks and illiquidity of investing in property. As
such, the market could be seen as being over
priced unless there is a dramatic and unexpected
fall in gilt yields.
The profile of future returns depends on what
margin above risk-free assets represents a fair
reward for holding property, and how quickly
the market adjusts to fair value. Assuming that
a 200250 basis points margin over gilts is considered
to be an appropriate premium for property,
prices would probably have to fall by
1015% in order for the market to represent fair
value, based on current rental growth expectations
and gilt yields. An alternative to a shortterm
adjustment would be a more gradual
move towards fair value, in which case investors
can expect mediocre, disappointing performance
over the next few years.
Since the original ‘Property renaissance or
bubble?’ article, UK commercial property has
delivered strong returns. The performance can
mainly be attributed to the impact of falling
yields as investors have increased their property
allocations and driven up prices. Rental growth,
the other component to changes in capital
values, has been muted.
Prospective returns have weakened dramatically.
In contrast to the conclusions four years
ago, the market cannot now be said to offer an
attractive premium over risk-free assets. A combination
of falling property yields and rising gilt
yields has increased sharply the levels of
implied rental growth that would be necessary
for total returns to be at an acceptable level.
Property’s renaissance now appears to be developing
into something of a bubble.