Mind the (yield) gap. Why things aren t what they used to be in UK property June 2017

Transcription

1 For investment professionals only - not for use by retail investors Mind the (yield) gap Why things aren t what they used to be in UK property June 217

2 Aberdeen has an absolute value approach to property investment. We assess the fundamental, or intrinsic, value of the market and individual property assets and, as pricing fluctuates around that, we manage risk within portfolios and make investment decisions accordingly. In assessing fundamental value we use forward-looking inputs that explicitly take account of the changing nature of the UK property market. Relative value investing remains the norm in the property market, though, which makes us question whether changes in the market are being factored into views of relative pricing. Relative value investors have regularly used the large gap between the yield on property and the yield on UK government bonds as a reason to invest in the UK property market over the last five years. But there are various reasons why this widely used chart should not be taken at face value. And, more importantly, why a wider yield gap might be necessary and justified: Real rental growth has been in long-term decline; Lease lengths are shorter; Tenants increasingly leave at the end of a lease; Rent levels at re-letting tend to be at a lower level than the previous lease; Tenants are increasingly prone to break their leases. This all suggests that the property market isn t what it used to be and drawing investment conclusions from this chart, without a full appreciation of the changes, may not be sensible. The yield gap Chart 1 shows that the gap between the income from property and the income from UK government bonds is at an all-time high. Indeed, the gap is currently around 4. On this basis alone, property is often deemed a good investment i.e. the yield is attractive relative to that from bonds. It is implied that, at some point, that gap should normalise. But is that likely to happen and what is normal? To examine this question, we need to have a basic model of how property might be priced relative to other asset classes. Chart 1: Property initial yields, 1-year gilt yields and the gap between them Basis points May 97 May 98 May 99 May May 1 May 2 May 3 May 4 May 5 May 6 May 7 May 8 May 9 May 1 May 11 May 12 May 13 May 14 May 15 May 16 May 17 Yield gap (LHS) MSCI Monthly initial yield (RHS) 1 yr Govt. Bond yield (RHS) Source: MSCI Monthly Index, Bank of England, May Mind the (yield) gap

3 The model The standard model for how property yields compare with the risk-free rate is as follows: Property yield = risk-free rate + property risk premium expected income growth (net of depreciation A ) The property risk premium is added to the risk-free rate since income expectations are uncertain compared with UK government bonds. The income growth is deducted since there is no income growth expected for UK government bonds. In chart 1, the risk-free rate is represented by the yield available on UK government bonds with a maturity of 1 years. The yield available on UK property is represented by the initial yield (income / value). The gap is comprised of the rest: the risk premium, expected income growth and depreciation. Rearranging the model formula: Property yield risk-free rate = property risk premium expected income growth (net of depreciation) or, Yield gap = property risk premium expected income growth (net of depreciation) Critically, the gap should increase if either income growth is expected to be lower, or the risk premium attached to that growth is expected to be higher, or where a combination of both is expected. For example: Yield gap = 3 (the risk premium) 1 (income growth expectations) = 2 But, if we change the assumptions: Yield gap = 4 = 4 Thus it is possible, if the assumptions change sufficiently, that the current observed yield gap might be perfectly justifiable. The two main elements to consider when deciding whether the yield gap should be higher or lower than it has been are income growth and the risk to that income growth, along with depreciation. Income growth Income from properties is derived from the rents receivable the estimated rental value or ERV which has experienced lower growth for some time. If we look at ERV growth, in real terms, over rolling five-year periods (the average over five years up to and including the last year), we can clearly see that this growth is not what it used to be (Chart 2). A trend line is also shown to clarify the trajectory. The data used here includes the impact of depreciation, so some of the change is likely to be due to that. A Depreciation is a factor that represents the inability of an older property s income growth to keep pace with that of a new property due to physical, functional, economic or social factors. While sustainability is often cited as a separate concept, it is simply part of the potential depreciation of a building. We do not control for depreciation in this paper. B While it could be argued that the quality of these bonds has changed too, for the sake of simplicity we will assume it has not. Chart 2: Real rental value growth, all property, five-year rolling basis p.a Source: MSCI, National Statistics, AAM, May The Risk Premium There are a number of factors that affect the risk to income growth: 1. lease lengths; 2. what happens at the end of a lease; 3. what happens to the level of rent when there is a lease expiry; 4. what happens if there is a break in the lease. As we will see from the evidence below, an examination of these factors suggests that the risk to income has risen over time and that the risk premium that should be attached to the income growth should be higher than it used to be. 1. Lease lengths Lease lengths have shortened considerably over the last 15 years (Chart 3). In 22, the majority of new leases (weighted by rent) were struck on terms of over 15 years; now just 21 of leases are struck on those terms. This means that the UK property market is, on average, much more exposed to the likelihood of vacancy, re-letting expenses and consequent capital expenditure than it was 15 years ago. This would suggest that the risk premium attached to the income stream ought to be higher than it was 15 years ago. Chart 3: Proportion of new leases by lease length, weighted by passing rent p.a yr 5-9yr 1-14yr 15-19yr 2yr Source: MSCI, Strutt & Parker Lease Events Review, November aberdeen-asset.co.uk 3

4 2. Lease expiries At the end of a lease, the lease can either: be renewed (the same tenant stays in occupation at a higher or lower rent); be re-let (to a different tenant at a higher or lower rent), or remain vacant (in which case the property does not produce any income) Chart 4 shows the proportions and trends for each scenario. The general trend is for the percentage of renewals and re-lettings to decrease and for the percentage of lease expiries leading to vacancy to increase. Clearly, there are fluctuations around this but the trends seem unambiguous. As such, it would be reasonable to say that the risk that should be attached to a lease going vacant might be higher than it was 2 years ago. Vacancy creates a hole in the income stream and usually some associated capital expenditure to re-let the property. Chart 4: Outcomes at lease expiry Renewed Re-let Vacant Source: MSCI, Strutt & Parker Lease Events Review, November 216. Where not renewed, outcome is measured at end of calendar year in which the lease expired. 3. Rent levels on new lettings If the current tenant does not renew at the end of a lease, a new lease is arranged at a level higher, the same or lower than the previous rent. Chart 5 shows the percentages for these results and trend lines for each. The trends show that some new lettings are lower than the previous rent. This is cyclical as demand and supply ebb and flow. But, with shorter leases and more lease breaks (see section 4) assets are increasingly being exposed to the market and so the income stream is at risk of being re-set to market (higher or lower) more frequently. Longer leases have historically been protected from falling income by the UK s upward-only rent review clause. But as leases become shorter, that protection is being eroded. More rapid depreciation, or obsolescence of space as structural changes in the market take hold, could also be having an impact. In general, though, the evidence suggests that new lease agreements tend to be at a lower rent. Chart 5: Rent level of new lettings relative to previous leases, weighted by rent Higher Same Lower Source: MSCI, Strutt & Parker Lease Events Review, November Lease breaks The option to break a lease brings with it a number of possible outcomes: the break is not exercised (and the lease continues with the current tenant); the break is exercised and the property is re-let (to a different tenant); the break is exercised and the property goes vacant (and does not produce any income until re-let). Chart 6 shows that, increasingly, over the last 2 years, the trend has been for breaks to be exercised, leading to vacancy. Chart 6: Exercising of break clauses and outcomes Not exercised Exercised, re-let Exercised, vacant Source: MSCI, Strutt & Parker Lease Events Review, November 216. Where exercised, outcome is measured at end of calendar year in which the break is exercised. Compounding this, as Chart 7 shows, the number of leases that feature break clauses has also steadily increased over time. 4 Mind the (yield) gap

5 Chart 7: Percentage of new leases that include a break clause Equally weighted Weighted by rent Source: MSCI, Strutt & Parker Lease Events Review, November 216. Conclusion For relative value investors the yield gap, and the assumption that it will revert to a long-run average, is a key driver of whether an asset class is good value. For some years now the gap has been assumed to be too high and property has delivered a good run of returns. But, as we have shown, given some fundamental changes to the level of income growth, and risks to that income growth, the yield gap probably should be higher. In our view, property is not cheap because bonds are expensive nor because the gap in yields is too large. Property pricing needs to be considered on its own merits with forward-looking assumptions based on the evidence that we have to hand. That said, there is a very broad range around average property pricing; when drilling down to the individual property level, mispricing of risk is commonplace and opportunities to benefit from such mispricing always exist, albeit these opportunities are easier or harder to find at different points in time. Ultimately, successful property investing comes down to a deep and broad understanding of the forces affecting the property market and how these manifest themselves in the prospects for individual assets. In future papers we will explore in greater depth how UK property has changed and how this has created opportunities for investors, sometimes in unexpected places Graham Porter Head of UK Property Research aberdeen-asset.co.uk 5

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