Newsletter Q3 2017 UK

Newsletter Q3 2017

terms of risk-adjusted returns – also when factoring in the illiquid nature of property assets. Although we do not expect the yield requirements on prime property to continue downtrending at the same rapid pace as we have seen in the past three years, we still maintain that there is room for further – albeit marginal – reductions in yield requirements, provided the low interest rate level is maintained, in light of the historically wide inflation-adjusted yield spread vis-à-vis bonds. In addition, we do not consider a gradual and moderate escalation of interest rates a major short- term threat to the prevailing pricing mechanism in the investment property market. The greatest threat in this market is no doubt a renewed financial crisis in tandem with economic recession, which could limit monetary policy manoeuvrability as well as impact the occupational market. All other things being equal, however, that is the (probably greatest) fear of any investor, no matter which asset class the investor is exposed to.

spread denotes the illiquidity premium achievable when investing in real property.

In the years preceding the onset of the financial crisis, the spread between the inflation-adjusted bond yield and the net initial yield on residential property fluctuated between 0.91% and 2.30%. In 2002-2007, the spread averaged 1.68%. Today, the spread is as wide as 4.08%. The wider spread is mainly due to higher capital and liquidity requirements imposed on banks. Even if rate hikes will make it possible to achieve higher bond returns, making this asset class more attractive in relative terms, such rate hikes may well coincide with rising inflation. As a result, the above- mentioned spread is not likely to change much. Theoretically, we believe that the current spread between the yield on bonds vs. properties with a comparable risk profile is still sufficiently wide for the current property returns to tolerate an increase of 125 bps in 10-year bond rates before the net initial yield on prime property is driven up.

For this precise reason, investment property is still to be considered a highly attractive asset class in

Prime residential property yields greatly exceed government bond returns

6%

5%

4%

3%

+300 bps

2%

1%

0%

-1%

00 01

02 03 04 05 06 07 08 09 10 11

12 13 14 15 16 YTD17

Prime net initial yield, residential

10-year government bond return Inflation-adjusted bond return

Sources: Danmarks Nationalbank and Sadolin & Albæk

11