As part of a recent recruitment initiative, we asked candidates to fill out a series of questions online. One sought their views on the impact an interest rate rise would have on the UK property market.
The answers were mixed, ranging from predicting the end of capitalism as we know it to a fairly benign outcome. While the candidates weren’t economists, the range of answers is indicative of a wider ambiguity around the future of UK property once rates policy shifts from the current ‘low for long’ trajectory.
This uncertainty seems largely down to two factors. First, there are myriad ways in which the drivers of value in the UK real estate markets are interwoven with factors that influence interest rates, such that the precise pressure points and wider economic consequences are difficult to predict. On a macro level, if higher interest rates equate to higher gilt yields then commercial property as an asset class may look less appealing to investors on a risk-adjusted-return basis. Likewise, if higher rates result in sterling appreciation this could deter foreign inward investment in UK property. The impact may also be sector-specific - higher interest rates (and thus mortgage bills) may reduce disposable household income and encourage saving, which, in the absence of real wage inflation, would hit retailers and thus the retail sector.
Second, the duration of our current low interest rate environment is without precedent (in this country at least) and is on the verge of becoming an era. This lack of historical precedent in itself means forecasting the impact of a rate rise is challenging. It also means homeowners (and potentially businesses) are at risk of becoming institutionalised to a low-rate environment. When I ask friends with mortgages what impact a rate rise would have on their disposable income and their mortgage affordability, they often draw a blank.
There are factors that could alleviate concerns. First, the prospect of a rate rise is at least a ‘known unknown’ in that we know it will happen, even if we don’t know when or how. Markets generally react more favourably to anticipated hazards rather than events that take them by surprise.
Second, low inflation has resulted in the latest Bank of England guidance suggesting a rate rise in the next 12 months is less likely and, if deflation becomes entrenched, a further reduction in rates is possible. Even when rates do rise, the consensus seems to be a gradual and steady increase rather than a short and sharp upsurge. The current forward interest rate curve predicts three-month LIBOR to remain under 2.5% for at least the next five years.
Third, some argue that only when the UK has strong economic growth and real inflation will the BoE increase rates. Property as an asset class is a direct beneficiary of a strengthening economy.
One response from lenders has been a greater focus on ‘debt yield’ (net rental income/loan amount) as a means of assessing the interest serviceability of a loan as opposed to the interest coverage ratio (or ICR - net rental income/interest costs). Uncharacteristically low interest rates mean ICR is higher than it would be in a more ‘normalised’ interest rate environment, whereas debt yield removes the ambiguity of prevailing rates.
Another response has been more of a ‘back to basics’ property underwriting approach, where lenders look to establish the long-term sustainable rental income of a property (or portfolio) based on supply/demand fundamentals and size a lending proposal based on that figure.
The prospect of increased interest rates has been on lenders and investors’ minds for some time, yet the equity and debt markets have continued their ebullient run. It seems, for now, there are other forces at work in driving investor sentiment.
Richard Craddock is director of Wells Fargo Commercial Real Estate UK