The average prime equivalent yield for the 12 property sectors tracked by Savills’ Commercial Investment Team now stands at 5.73%. This sits 2.86% below the average prime equivalent yield recorded when capital values reached their recent trough in early 2009. The pace in the fall of average prime yields over the last 12 months has been quite staggering. Since the average prime equivalent yield for all sectors recorded for February 2010 is only 1.23% above those recorded at the last peak in values in mid 2007, further yield compression at the same rate could quickly take yields lower than those recorded when the ‘top of the market’ was last called. The key question is of course: can such a continued drop in yields be sustained, or is the prime property market over-heated and ready for a significant correction?
It is firstly important that we consider the reasons why yields have dropped so quickly in the last 12 months. There are several explanations. The recent recession and fall in capital values has meant that fewer investors have been selling assets (unless of course they have been distressed or have needed to raise debt in order to address issues with their balance sheets). Investors have also been adopting a ‘flight to quality’ approach, being very selective about the assets they might look to acquire. As the number of active investors has picked up (including overseas investors taking advantage of the weak pound), this has then increased the demand for the very best assets. More recently, institutional investors have come back to the market in abundance, with a ‘wall of money’ behind them that has been gradually building up. This clear imbalance in supply and demand has forced capital values up, and equivalent yields down. Although the falls in equivalent yields over the last few months have slowed slightly, there is nothing to suggest that yields will soften over the course of 2010. Investor appetite for the best stock is still strong and debt is becoming more available for the best deals.
The occupational market clearly plays a critical role in the state of the investment market. The recent signs of recovery in some occupational markets are therefore feeding back positively to capital values. Nowhere is this more prevalent than in Central London where the low supply of lettable offices is enabling investors to justify some aggressive rental growth projections. In this context, even if a property is assumed to be rack-rented (i.e. there is no difference between the initial and reversionary yields), a cashflow model will start to produce some attractive returns with the rental growth assumptions adopted. The situation in Central London is having a dramatic impact on prime equivalent yields which now stand at 4.50% in the West End. The development pipeline also has a key interplay with the occupational market. Across virtually all markets, the pipeline of new Grade A space has been greatly reduced as the recession has taken its toll on the construction industry. The subsequent reduced occupational supply has then led to a supply / demand imbalance, helping to underpin rental values and having a positive effect on the investment market.
There are therefore numerous reasons why the investment market has re-strengthened over the last year, but the key issue is: can this be sustained? Logic would suggest that investment yields are only likely to soften in the event that there is a reduction in investor demand and an increase in the supply of stock. It seems unlikely that the first of these is imminent. On the other hand, there is however much more stock on the market now than there was at any point last year. There is, for example, much evidence of investors bringing some relatively cheap 2009 acquisitions back to the market, making a quick return as they do so. There is also a good chance that further distressed sales will come to the market this year where loan covenants are breached. The banks have now had some time to establish their exposure and make some decisions about where to take action with borrowers who might have rolled over loans from 2009 and be in breach of the loan covenants.
Investment agents also report a significant increase in Grade B stock coming to the market as confidence returns in the leasing markets. Where investors had been largely risk averse in 2009, there is now more justification for reintroducing asset management strategies. The effect of this has the potential to reduce the schism between prime and secondary yields, and broaden the market. If we are to assume this continues in the medium term, there will be less polarisation of the most prime assets and this should help to reduce the pace in yield compression.
Another key issue here is the link between equivalent yields falling and capital values rising. Another reason why the prime investment market has strengthened so much over the last year is the fact that rental values have fallen. Therefore, investors are appraising assets off a lower rental value base, which results in a lower capital value compared with the same yield being applied to a much higher income stream. This is another reason to suggest that there is perhaps more scope in the prime investment market to develop more over the next year.
In the context of all this, the wider macroeconomic position in the UK is of particular interest. Coupled with quantitative easing, the historic low Base Rate might have presented a real platform for strengthening across a broader spectrum of the investment market. However, the reality is that the British economy is still in deep trouble and continues to need nursing. If and when the MPC increase the Base Rate, this could potentially send shockwaves through the market. On the one hand, a raise in interest rates could suggest a certain confidence in the economy, but on the other had it could also imply a lack of confidence. It is of course crucial that the decision is made timely. Any increase in interest rates could have a detrimental impact upon the many tracker mortgagees across the country who have been benefiting from relatively low mortgage repayments. Any ensuing reduction in inflation could however have a negative feedback to the property industry which typically strengthens in a higher inflationary environment because property is a hedge against inflation.
2010 therefore could have much in store for the property industry. However, on the basis that investor demand remains sustained (but across a broader quality of assets), we do not envisage any softening in yields in the short term. What perhaps seems more likely is a sustained, supported but steady increase in capital values over the course of the year, and a compression in the expansive yield gap between prime and secondary assets.
Director - UK Head of Valuation
Savills Commercial Limited
www.savills.com
