The gap between the yield available from property and the yield available from UK government bonds has been around 4% for some time. For many, this gap means that property looks good relative value on the basis that the historic average gap has been lower. But judging this gap without a full appreciation of how property has changed, and continues to change, may be misleading, as we highlight in our new research paper, “Mind the (yield) gap”. While the quality of UK government bonds has barely changed, the evidence suggests the quality of the income streams available from UK property – and the risk attached to these – certainly has changed.
In simple terms, the yield gap is made up of two parts: the income growth that can be expected from property and the risk premium associated with property’s less certain income. Therefore, if the growth rate declines and the risk premium increases, a wider yield gap becomes appropriate, and vice versa.
We have looked at the trend rate of rental growth in the property market and several different measures of the risk to property income. To identify the underlying trend in rental growth, it is important to strip out the effect of inflation. On a five-year rolling basis, real rental growth has been negative since 2003. Looking at the full history of available MSCI data, we find that rents have declined by 0.7% per annum in real terms, with the rate of growth weakening over time.
With structural challenges, such as the transition of retail sales from stores to online, the denser and more flexible use of office space and the threat technology poses to jobs and the buildings those jobs are housed in, we find it difficult to argue for a reversal of this trend. In simple terms, the lower income growth we are seeing, and expect to see going forward, puts upward pressure on the required yield gap.
As for the risk to property income, this can be thought of in several ways. We have looked at two aspects: how frequently the property is exposed to a lease event (the end of a lease or a break) and how likely an asset is to produce no income following.
In 2002, over half of all new leases were signed for terms of 15 years or longer; by 2016, that had dropped to just 21%, according to MSCI data. In 2002, less than 20% of leases featured a break clause; by 2016 that figure had risen to more than 35%. Given accounting changes mean tenants have to treat leases as balance sheet liabilities, and considering the greater flexibility more and more tenants want to retain, we think shorter leases and more break clauses are here to stay.
Property income is at greater risk of falling away than previously and at risk more often.
More lease events implies a higher risk premium but the trend towards poorer outcomes for landlords at those lease events suggests further upward pressure on risk premia. Again, MSCI’s data shows a trend towards more units being re-let at lower rents than the previous lease and a higher proportion of units falling vacant at lease expiry. It also shows that a higher proportion of break clauses are being exercised and remaining vacant. There is clearly a cyclical element to this but the trends are clear: income is at greater risk of falling away than previously and at risk more often.
If risk is higher and growth is lower, the yield gap for property over government bonds should be wider than it has been historically. Only by thinking about the absolute level of risk in property and the sources of that risk, and making evidence-based forward-looking assumptions, can this conclusion be reached. That is why we use absolute, not relative, value analysis to come to our conclusions on where value lies. If you mind the gap then the journey towards better long-term performance is likely to be much smoother.
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