“The historic performance of the UK real estate market has been outstanding. It has out-performed all other asset classes over five to ten years, and delivered exceptional returns over one and three years. Capital appreciation from yield shift has been the main driver behind this performance. Recently, some commentators have suggested that the market is at risk from a pricing correction.

Some are concerned that the current enthusiasm for the real estate sector, reflected in the substantial quantities of both debt and equity capital chasing investment stock, has led investors to overstate the impact of the reduction in inflationary pressures on sustainable yield levels. As interest rates rise to reflect the pressure on inflation from commodity prices – and, potentially, an increase in protectionism – government bond yields will rise. In turn, this would undermine the base for current real estate pricing.

Another source of concern is that the likely slowdown in both house price and consumer spending growth, combined with increasingly fierce global economic competition, could undermine occupier demand. This would then restrict the upward pressure on rental values. To compound this, it has been argued that the recent increase in debt capital may fuel speculative development, thus limiting rental growth prospects.

Finally, some commentators have suggested that strong demand for government bonds driven by changes to pension legislation has led to over-pricing. If bond issuance or pension legislation change, the yield increases that result might undermine current real estate yields.

Some of these concerns may undoubtedly be valid, but I tend to feel that they’ve been oversold. While there’s a clear risk of excessive yield shift in the future, changes to date reflect a rational reaction to a successful shift from a high to a low inflation environment. Rather than creating a bubble, changes in yield levels have removed a pricing anomaly. Further, although there’s a risk of increasing inflationary pressures, most economists expect robust global price competition to continue to offset pressure from commodity prices.

Although the volume of debt available to UK real estate investors has increased, credit terms remain sensible. In particular, both development funding and loan to value ratios remain prudent. The amount of debt has increased, but it appears to be being used appropriately. While house price growth is likely to continue to deteriorate, in the absence of a dramatic reversal in economic prospects, a decline in capital value now appears increasingly unlikely. This limits the chance of a slowdown in consumer spending, and supports our expectation of a modest improvement in UK GDP growth from this year onwards. This change supports occupier demand, particularly in the office sector. Our analysis suggests that current pricing levels can be supported by relatively modest economic growth forecasts.

Provided investors remain sensible and don’t bid yields down to unsustainable levels, then we’re not in overpriced territory. Even though the weight of money suggests this could take some doing, if investors underwrite their acquisitions in a logical way we’ll avoid a potential correction.”

 

Paul Kennedy is European Research Director for INVESCO Real Estate

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