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Keep an eye on the bond and employment markets

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Deciding whether something is cheap or expensive will largely depend on where you are looking from. As the old saying goes, “A shilling is worth more to a poor man than a rich one.”

In uncertain times such as now, currency markets remain susceptible to a variety of commentary, particularly where it might infer future government policy. Take as an example the effect on the pound of the recent mutterings at the Tory party conference or the interpretation of what constitutes a hard or a soft Brexit.

Buying real estate simply because the currency seems cheap is a tactical decision but not a long-term investment strategy. Looking at both macro and real estate fundamentals is a much safer place to be.

So assuming your looking glass is focused from a domestic position, how does it feel? In short, better than many had expected. Despite the doom-mongers suggesting the economy would crater post-referendum, it has actually held up pretty well, with positive signs in a number of areas. Even the Bank of England recently had to concede that the economy is doing better, revising its near-term GDP forecast from 0.8% to 1.4%.

The issue now spooking markets is that sterling’s depreciation, although beneficial for exporters, is not so good on the import side. Unilever’s recent spat with Tesco over the price of Marmite highlights the issue. Although Marmite is a UK product, it is made by a Dutch company operating in euros, and that is a precursor of similar things to come. Consensus suggests inflation could push upwards to 3%, a figure last seen in April 2012 and well above the Bank of England’s target of 2%.

It has often been stated that inflation is generally good for real estate, with the effect being seen in rising rents. However, dusting down some old IPF research papers, I am reminded of an April 2011 paper entitled Property and inflation, which challenged that statement. It said: “While UK property delivers positive long-run real returns, it is not, in most cases, a hedge against inflation, where a hedge is defined strictly as moving at the same time as inflation.” Interestingly, the paper concluded that, in terms of investment performance, the three key factors were: position in the cycle at purchase, GDP growth, and inflation, in that order.


Buying real estate simply because the currency seems cheap is a tactical decision but not a long-term investment strategy

On the plus side and particularly from a real estate investor’s perspective, the employment market remains robust. The unemployment rate remained at 4.9% in August, with 106,000 jobs created, pushing the total employment rate to a new high of 74.5%. This suggests occupier fundamentals should hold up in the near term.

Investors don’t like uncertainty and this plays out in the market in various ways. As well as sterling depreciation and volatility in the bond markets, rising inflation expectations have seen the yield on 10-year gilts, which moved to as low as 0.5% in August following the Brexit vote, recently reverse and was at 1.28% at the start of November. This is still below the pre-Brexit 1.4%, but definitely on an upward trend.

With the 10-year gilt representing a proxy for the risk-free rate and against which the sector is judged, it is an important trend to keep an eye on. Running a simple cash flow assuming a fixed income for 25 years, acquired at 4.5% initial yield, and assuming a nil site value, results in a 1.28% IRR – the same as the gilt, albeit with the latter you get your principal back.

Run the same cash flow assuming 3% annual inflation on the income and a 40% residual site value, and the IRR is 6.3%, in line with current hurdle rates. At current levels, the returns are justified, but margins will be tested if bond yields continue to rise.

With inflation returning to the system, leases with inflation linkage will become highly prized. As the IPF research paper highlighted at the time, income provides all of the real total returns over most years and sub-periods. As a result, every effort is required today to retain it and enhance it where possible.

Here at Palmer Capital, we think the best way of doing this is to ensure we hold the best quality stock where tenants will want to be located. We intend to use the current period to create those “best” assets while keeping one eye firmly on the movement in the bond markets and employers’ hiring intentions.

Author: Nick Cooper, Deputy Chairman Palmer Capital