In our regular update on drivers in real assets we assess how real assets could appreciate amid lower long-term rates, we look at how lower bond yields are likely to extend the real estate cycle in the UK, but note that lending at senior level has reduced interest rate sensitivity.
Long duration real assets could appreciate amid lower long-term rates
- Fears of a potential global economic slowdown have put interest rate rises on hold.
- Longer duration assets (infrastructure debt and equity, real estate long income) should capture the higher capital gain if long-term rates fall but are quite insensitive to short-term rates.
- Despite higher leverage in infrastructure versus real estate, most borrowers have fixed rate long-term debt. Real estate borrowers should capture the benefit of lower rates on income return more quickly.
UK forecast assumptions: lower bond yields to extend the real estate cycle
- In late 2018, we expected interest rates to start rising and demand for real estate to be subdued. This narrative has changed in 2019, with expectations that central banks may be forced to keep rates on hold for longer or even cut again as economic growth slows.
- Lower interest rates will extend the real estate cycle: even at current levels, real estate yields are significantly above government bond yields.
- Real estate pricing is attractive compared to a host of other income-producing asset classes. With the outlook for interest rates now more supportive, investors can now find positive total returns in several areas across the UK.
But conservative lending at senior level has reduced interest rate sensitivity
- Over recent years, lower borrowing costs have not translated into higher profit for commercial property investors, due to yield compression and more conservative lending terms, i.e. lower loan-to-value ratios (LTV).
- If senior LTVs had stayed unchanged in the last 10 years, the levered equity income return would be around 25 per cent higher today. Nevertheless, we expect leverage to continue to be used relatively conservatively.
Where funds are invested in illiquid private assets, investors may not be able to switch or cash in an investment when they want because private assets may not always be readily saleable. If this is the case, we may defer a request to switch or cash in shares or units. Investors should also bear in mind that the valuation of real estate is generally a matter of valuers’ opinion rather than fact.