Economic backdrop indicates further yield sharpening for UK property in 2015

Instead, they fell as investor demand for safe assets increased on the back of mounting deflation fears and a weaker global outlook. UK property yields, according to the monthly IPD index fell from 6.1% in January to 5.4% in November and double digit capital growth for the entire second half of the year verified the strong demand for these assets

As 2015 gets underway, investors, grappling with increasingly volatile markets are ramping up their exposure to low risk investments. Yields on long-term UK and US debt have fallen by more than 100 bps in the last 12 months, and in Europe the average yield on core country debt has fallen by almost 200 bps. This year, further sharpening in UK property is to be expected as the recent fall of long-term Gilt yields begins to drive market yields lower.

In 2014 forecasters failed to predict the decline in yields across global markets. In the UK and US, the recovery occurred at a slower pace than previous recessions, requiring monetary policy to remain accommodative. Stagnant growth in Europe sparked fears of a deflationary crisis and the likelihood of a QE response by the ECB. Chinese investment dwindled and Japan entered another recession, despite the implementation of bold monetary and fiscal stimulus.

At the start of 2015, none of these factors are showing signs of improvement. Moreover, additional turbulence from the fall in oil prices has exacerbated the low inflation outlook and stalled growth in commodity driven emerging markets. Brent Crude has fallen by almost 10% since the start of the year, and more than 50% since mid-2014.

UK Commercial Real Estate as an asset class has proved in the last year that it can perform well, offering stable returns in the context of capital markets, despite external threats to the economy. As an investment class in 2015, it will offer refuge from volatile equity markets. The current yield on a 10-year Gilt is 1.5% and, given the outlook this current rate could fall further as the year progresses. This will ensure the spread between even the lowest yielding UK properties remains attractive. Highly sought after investments, such as central London offices where initial yields are currently at a near-historic low of 3.3%, will still offer a positive spread over the risk-free rate even as they sharpen further. All of this taken together suggests that last year’s growth in UK real estate has the legs to continue through 2015.

Kallum Pickering is a UK Economist at BNP Paribas Real Estate in London