Almost since the end of the 2008/2009 recession, economists have been forecasting that interest rates are going to rise in around 18 months. Even as the years progressed, so the period seemed to remain at a constant 18 months.
Yet it is also widely acknowledged the western world’s economies, while recovering, are still not strong enough to be completely sustainable. The Federal Reserve, while introducing a tapering of its $80bn/month quantitative easing programme, has been warned by the International Monetary Fund not to proceed too quickly for fear of plunging the country back into recession. In the UK, even the relatively new governor of the Bank of England cautions that rates will rise, but not soon.
But why should we expect interest rates to rise? The UK’s inflation rate is well below the Bank of England’s 2% target. More than that, the nation’s biggest trading partner, the eurozone, experienced an almost historically-low rate of 0.7% in the year to April, way below its own target rate of 2%. Less than a couple of weeks ago, the European Central Bank lowered its growth forecast for the eurozone to 1.2% this year, and its inflation forecast to 0.8%. The bank is now under pressure to introduce its own form of quantitative easing to avert the risk of deflation.
Even if deflation does not occur, it increasingly appears that we could be experiencing a protracted period of low inflation. We are certainly not accustomed to that in the UK. Academic works have demonstrated that, in the short-to-medium term, property is not a hedge against inflation - despite the received wisdom in the industry - but it raises the question as to how property might perform in such an environment.
In Europe, most rent reviews are linked to inflation, and in the last six months most equity analysts have been reducing their forecasts for rental income growth, particularly in the retail sector. Generally, however, low inflation is not a good environment for businesses. As demonstrated in Japan, consumers would rather conserve their cash and await lower prices. Growth slows, which might be why the eurozone GDP forecasts are being reduced. That will, in turn, reduce the ability of businesses to pay rises in rents or expand into larger premises.
So there seems little reason why interest rates will be rising. This will keep the cost of capital low. Even though debt margins may be well above what they were pre-recession, they are gradually falling and residential mortgage rates are not far above historic lows.
Long-dated bond yields, which are important indicators for property yields, forming both the risk-free rate and an asset class comparator, have been falling or at least stabilising after the initial shock of the announcement of US tapering. Expectations of low growth and low inflation may well be the key factor determining that.
The UK’s IPD Monthly All Property average initial yield was 5.9% in March, in contrast to that of the 6.2% of the 2001-2006 period - the ‘golden age’ pre-recession period of low inflation and high economic growth, when real returns from UK property averaged 10.3% per annum. We may not be expecting much growth in rental values, but in that period rental values only rose by an average of 1.7% per annum, around 0.1% above inflation.
Rental values rose by 1.2% in the year to March 2014, 0.4% points below inflation. The difference is that now we are only at the beginning of the economic recovery phase; rental values lag economic growth, so we can reasonably expect some further rises. If inflation stays low, that might turn into real rental value growth.
That would be icing on the cake, as the real benefit to holders of property in a low inflation environment or, at the extreme, deflation, would be its relatively high yield compared to bonds or equities. In a low inflation environment, stable income becomes much more significant. This was a key driver behind the €475m acquisition we made this week in Brussels together with ATP, Denmark’s largest pension fund AXA Belgium. If low inflation persists, expect further downward pressure on property yields.
Anne Kavanagh is global head of asset management and transactions at AXA Real Estate