Owners of UK commercial real estate have had a lot to be pleased with of late. But the 18 percent total return for calendar year 2014 approached the levels last seen in the credit-driven bubble that burst in 2007. The sheer pace of momentum begs the question as to whether the recovery has become unsustainable. In other words, ‘are we poised for another crash?’
No two crashes are the same, of course, but there are some consistent themes. Robust economic growth is often linked to construction booms that eventually lead to oversupply and falling rents. From an investment perspective, as cycles accelerate and mature, there is frequently an increasing role for short-term speculation and the use of leverage that drives prices to unsustainable levels. Whilst the event that ultimately pricks the bubble varies, the outcome is almost always a sharp drop in values and poor investor returns.
This highlights some key areas for gauging the likelihood of a crash. What is happening with economic growth, and how is the supply-side responding? As well as the occupier markets, we need to consider whether investment pricing is sustainable, and if credit and speculation are playing a major role.
On the economy, recessions linked to financial market crashes tend to be deep and long-lasting. That has been the case again. But the consensus expectation is now for UK GDP growth to average 2.4 percent per annum over the next five years, slightly ahead of the average over the past several decades. At Legal & General, we are also optimistic about the potential for transport infrastructure investment and decentralization of government control to boost economic activity in some of the UK’s major regional cities beyond London.
On the supply side, there has been limited construction activity. Despite an increase in development in London, commercial construction for the UK as a whole since 2010 has averaged levels not seen since the early 1980s recession. New build values are still below replacement cost in many locations, and there is limited appetite for speculative development risk. The context is of an economy and an occupier market that is in recovery but far from overheating.
From an investment perspective, the interest rate backdrop is central to any view on whether current pricing is sustainable. Whilst the IPD equivalent yield of around 6 percent is lower than historic averages, the current low level of interest rates means that the additional spread from real estate is relatively wide. The real question of course is where rates are likely to settle in the longer term. The Bank of England has signaled a view that while the neutral level of base rates may have been 5 percent historically, the new normal may be closer to 3 percent. This implies that the sustainable level of real estate yields in the long term may well be lower than in the past.
Credit conditions have undoubtedly eased. But we are not seeing leveraged purchasers be as dominant in winning transactions and driving pricing as was the case between 2005 and 2007. More broadly, most investors are underwriting transactions on the basis of rental growth rather than yield compression. With the majority of capital looking to derive a return ahead of fixed income but without equity market volatility, there is little evidence of a role for short-term speculative flows.
A recent development has been the announcement that there will be a referendum on the UK remaining in the European Union, most likely in 2016 or 2017. Whilst opinion polls suggest that a majority would vote in favour of remaining in the EU, the uncertainty may lead some investment decisions to be deferred until after the referendum. This could be the trigger that takes some of the momentum out of the real estate market and is an area to watch carefully in the coming months.
Bringing all this together, we should want to see the pace of returns slow from recent levels. This will signal that performance is coming from the combination of steady income and rental growth that most investors seek from real estate. But the fundamentals, whether on the occupier or investment side, do not point to a bubble that is about to burst.