Viewpoint: Different dynamic will keep this cycle on an upward track in 2015

REC 12.14 p 40 Paine, DavidThis time it’s different…’ is possibly one of the most exploited phrases by researchers, but it’s pertinent because every cycle is different.

Today we face similar pressures in a number of markets where capital flowing into real estate is driving up prices. In core locations, yields paid for some assets this year are nearing 2007 levels. However, we argue that the cycle has further to play out and 2015 will not be a repeat of 2008.

The yield margin real estate offered against medium-dated government bonds this autumn has averaged more than 300 basis points globally – a return to 2001 pricing, six to seven years before the peak.

Of course, prime assets in core global cities such as London, Paris or New York have traded at far slimmer margins of around 100bps above bonds. This is where the current cycle
is different; unprecedented stimulus has depressed the ‘risk free’ rate, so real asset pricing remains attractive.

Central banks will not remove this stimulus unless sustainable economic growth returns. Growth is appearing in markets such as the US and UK, so we expect a narrowing in the margin over benchmark bonds.

In 2015 we expect rental or income growth to provide the fillip for investor returns in US and UK  markets. In the Euro region, where the margin is larger, stimulus remains key. Here, growth is a more distant prospect and we expect capital flows and yield compression to be the key factors driving returns in 2015.

Take-up strengthened greatly this year across a range of key markets. In London, Dublin, Munich and Paris, office demand will exceed the previous decade’s average. For many markets, this year’s demand dynamics will continue in the year ahead. The prediction for business investment spending is critical and strongest in the US and UK, so we expect more upward pressure on rents here.

Technology and media companies still drive urban demand, while insurers and overseas occupiers, from Asia particularly, will be important to take-up in global cities in 2015.
Consumers keep spending
Logistics and manufacturing occupiers have been very active in the UK this year and we expect this to continue in 2015. For retail, while western consumers may feel constrained by a lack of wage rises, falls in fuel costs and low mortgage costs should buoy spending.

Almost all developed cities have had a lack of construction and modest supply in the run-up to the recent recovery in capital values. European development hit a 30-year
low after the global financial crisis.

Such a backdrop makes us more comfortable in econometric models telling us to expect rental growth in 2015 and 2016. However, we expect the supply outlook to change in 2015. Construction is gathering pace in London, while US REITs, unable to source stock at acceptable yields, are starting new developments in some supply-constrained gateway markets.

The lending market has perhaps changed most dramatically in 2014, in volume of lenders, loan terms and margins offered to borrowers. The UK market has become very competitive, with renewed interest in development funding, absent since the financial crisis, in the second half.

This, plus all-time low development levels in the past five years and the volumes of equity targeting the asset class, leads us to predict fresh enthusiasm for building in 2015. The only mitigating factor could be an escalation in construction prices.

This year’s best-performing real estate markets are likely to be those closest to Standard Life’s home, with the UK tipped for around a 20% total return, its strongest since 1993. Ireland could deliver twice that, to make it the country’s best year yet.

This year’s uptick in economic growth and expectations, combined with the real estate price correction during the downturn, support this sharp reversal in fortunes.

With respectable rental growth expectations for 2015 and 2016, we should not be worried about the near-term outlook. Unless, that is, the real estate risk premium disappears or the supply pipeline becomes too ambitious.