By Ben Habib
Global economic recovery would appear to be on an upward trend, in particular in the UK where forecast GDP growth for 2014 has recently been revised up to 2.7%. The massive monetary experiment of quantitative easing (QE), low interest rates, as well as the Government’s Funding for Lending and Help to Buy schemes, have been key contributors to kick starting the economy.
After five years monetary policy remains very loose, but these initiatives will eventually have to be phased out. Institutional investors will be anxious to know how this will affect asset prices, which have become inflated in recent years. This is particularly true of the prime property market, which in some cases has seen asset price inflation rise to unsustainably high levels.
When the US Federal Reserve announced it would begin to taper its QE programme in May 2013 investment markets responded by selling off aggressively, particularly in the emerging markets. This knee-jerk reaction forced the Fed to reassure global markets about the pace of QE tapering. It takes longer for the effects of such events to manifest themselves in less liquid asset classes, particularly property. Nevertheless, the relationship between interest rates and asset values remains and, at current levels, prime property looks vulnerable.
Over time property rental income, not capital gain, is the biggest contributor to investor total returns, by a factor of some 5:1. It stands to reason that a higher income return should compound and lead to a higher total return, usually with less volatility. Since the credit crunch, the yield differential between prime and other property assets has widened to record highs, driven in large part by foreign investors’ seemingly insatiable demand for prime London property. Prime property in London now frequently changes hands at yields of circa 3-4% per annum, whereas a purchaser’s costs alone amount to some 5.6%[1] of the purchase price. Furthermore, the annual cost of debt finance is higher than such a yield, limiting the pool of potential buyers at exit to equity rich buyers.
So where are the opportunities for institutional investment?
Good secondary property is finally receiving investor interest, now that so many investors have been priced out of the prime market. Investor demand for good secondary property is, however, ahead of occupier demand, so investors need to exercise discretion even with prices being at relatively low levels. As the economy grows, occupier demand should follow suit and rents should rise but it is still early on in the cycle for this to occur on anything remotely close to a market wide basis.
Turning to residential property, there is a structural undersupply in the UK which is the primary cause for the widening gap between house prices and earnings. Demand is also being boosted by the aforementioned loose monetary policy and the Help to Buy scheme in particular, which was extended to 2020 in the recent Budget. The government is also promoting an increase in the supply of residential property by temporarily loosening certain planning restrictions, including to Permitted Development Rights, one aspect of which is to liberalise the conversion of offices to residential use. However, there is always a time-lag before finished units can be delivered to the market and, in the meantime, demand outweighs supply; residential values look set to continue to rise.
As ever there are plenty of opportunities to invest in UK property but the various sub-markets are unbalanced as a result of government initiatives and loose monetary policy. Investors need to step carefully to “mind the gap” between interest rates and property values as loose monetary policy is unwound.
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