A faster pick-up in the economy which prompted an early withdrawal of the Bank of England’s Quantitative Easing (QE) programme of asset purchases would choke the economic recovery and push up gilt yields which, in turn, would trigger a rise in property yields and depress rental growth expectations, particularly in London.
This is the scenario, published by DTZ today in a research note authored by head of UK research Richard Yorke, in the event of early withdrawal of QE.
He warns: “London would be more adversely affected than other UK cities because of its exposure to weaker international investment and demand.”
London’s West End and City office markets would see the sharpest deterioration in attractiveness to investors, continued Yorke, reflecting the sharp slowdown in rental growth combined with higher yields.
Perversely, the continued improvement in the underlying economy – which surged ahead in the second quarter with GDP growing by 0.7% over the quarter, compared to just 0.1% in the first quarter – could tempt the Bank of England to begin selling the gilts purchased under its QE programme.
Yorke wrote that, ultimately, property investors should not fear QE withdrawal as it indicates a return to more normal economic conditions.
“However, although unlikely, investors should also be aware that any sharp pick-up in the economy which necessitated a more rapid withdrawal of QE could negatively impact the property sector, particularly in London.”
End of the favourable UK real estate relative value
The complexity and implications of the Bank of England’s eventual withdrawal of QE will vary around the timing of the central bank’s action, which in turn will directly impact property markets thereafter.
Quantitative Easing, the large scale asset purchase programme of predominantly gilts and government-backed securities designed to increase market liquidity and stimulate growth and jobs, was first implemented by the Bank of England in March 2009, in an initial £200bn programme.
Three subsequent smaller tranches of QE, between October 2011 and July 2012, took the central bank’s tally to £375bn, with guidance given last month to the effect that the Bank of England would loosen monetary policy when the unemployment rate falls to 7%.
Central to any withdrawal of QE by the Bank of England is stronger economic growth. “Indeed, central banks have to be convinced that the recovery is self-sustaining before pulling the plug on QE,” wrote Yorke.
The net effect of the Bank of England’s QE programme has been to increase the value of the assets purchased – 99% of which were in long term government gilts – as well as in the wider bond market, which lowers their yield.
This, in turn, lowered borrowing costs for firms and households, which was designed to stimulate consumer spending and private sector investment.
This central bank intervention artificially, and indirectly, increased the attractiveness of UK real estate, relative to fixed income investment, in the eyes of multi-asset class investors such as pension funds and insurance companies, which viewed UK real estate as more favourable on a relative value basis than other asset classes.
In part, this favourable environment for UK real estate – which emerged in the UK and beyond – has been a driving influence behind the so-called ‘Wall of Money’ with a ‘global hunt for yield’ emerging out of artificially depressed bond yield by central bank policies.
This has seen greater allocations by US pension funds in private equity funds, such as Blackstone and Lone Star, which have just raised $2bn and $3bn respectively in first closings of their current real estate opportunity funds.
Lower down the risk spectrum, in UK senior debt, non-bank lenders such as M&G Investments have also benefited from pension fund capital, on a relative value basis as compared to mainstream fixed income.
For example, the State of New Mexico pension fund has yesterday approved a $35m allocation to the M&G Real Estate Debt Fund II and III, split $22.5m and $12.5m, respectively.
The inevitable unwinding of QE, therefore, and possible early beginning of the process, bears some analysis, in respect of the extent to which the favourable dynamic for UK real estate would be reversed.
West End office rents would be worst impacted by early QE withdrawal
Under an early QE withdrawal scenario, DTZ assumes asset reduction in 2014 followed by a sharp increase in interest rates in 2015.
Gilt yields are forecast to rise to over 4% by 2015, and 4.5% by the end of 2017 while markedly weaker GDP growth of 1.4% and 0.7% in 2015 and 2016 would be realised, according to DTZ’s forecasts.
The net effect which would be most severely felt in London’s West End were rental growth would fall by an average of 1.7% per annum, compared to a fall of 0.6% in the City of London, according to DTZ’s analysis.
In addition, yields would initially fall in 2014 before increasing over the following three years to the end of 2017, with London property yields, particularly among City and West End offices, expected to widen more quickly than the regions, reflecting a bigger downturn in rental and capital value growth.
Yorke wrote: “In our early QE withdrawal scenario, an unexpected surge in economic growth is negated by precipitative asset reduction and interest rate increases.
“This leads to lower economic and rental growth, and higher gilt and office yields. London West End and City office markets are more negatively affected than other UK city office markets.
“US and Eurozone economic growth would also slow, continued Yorke, negatively impacting on international capital flows and demand. London would be more adversely affected than other UK cities because of its exposure to weaker international investment and demand.”