The worst may be over but this ‘mini-boom’ is not sustainable

By Philip Nell

So it looks as though 2009 will turn out to be a year of two halves — as 2007 was — but is this incredible recovery sustainable?

My own view is that it can’t possibly be, but what will be the shape of the performance graph from here?

Many commentators believe the sheer quantum of equity available today, combined with the complete lack of investment product, will sustain the recovery in the short term, until rental growth returns to the market in two to three years’ time.

So 2011 might be a year of income return only, but it is suggested that we are now looking at the prospect of no further capital declines over a five-year forecast period from the end of this year.

That’s all positive, but let’s not forget that we’ve just fought the equivalent of a world war. The country — which was already more highly geared than it should have been in 2007 — is saddled with debt that will remain a legacy of this economic downturn for some considerable time.

Not that I think the wrong action was taken by the UK government and central bank over the last two years — I don’t think anyone will really know the answer to that for some years to come — but in reality, flooding the financial system with credit was probably the only action available to them.

Inflation — yes, you remember that? — is coming and, for a highly geared economy, that’s a good thing.

Property has elements of inflation hedge, and so is a better bet under such circumstances than fixed-income investments. That adds to the argument that corporate bonds and government gilts are now overvalued.

Unfortunately, inflation will almost certainly bring with it increased base rates and increased bond coupons, particularly if central government needs to raise more funds through bond issues into an already-saturated system.

“There is a passive rebalancing of portfolio weightings. These have changed because the value of equities has gone up”

That’s bad for property. True, the spread of property yields over gilt yields remains at an all-time high, so there is some capacity to absorb gilt yield increases. But this is not simply a function of property looking cheap — it is also about gilts looking expensive.

So, where does that leave the question of the likely shape of the recovery? My view is that we are in a very different place from six to 12 months ago. There is infinitely more stability in the financial system, equities have shown that capital markets can go up, as well as down, and the worst of tenant default is almost certainly behind us.

Institutional investment

On the pure institutional side, there is a passive rebalancing of portfolio weightings. These have changed because the value of equities has gone up — meaning fund managers need to increase the allocations to property to keep the weightings the same.

But institutions are increasing investment not just to match their equity holdings, but also because they are going from negative to neutral or even positive to property. This means they need to invest even more in property.

Having said that, a weak currency attracts overseas investors and helps to retain UK ones, and low base rates only have one way to go — remember Play Your Cards Right?

But that also means that it will take a sustained recovery in the pound before UK-domiciled investors start to look overseas. The risks are too great. The value of sterling will go up against the euro again at some point and then you will lose out if you invested in euro-denominated assets — and hedging out that risk is still very expensive because of that.

On that basis, I think the total return graph from here will look more like my six-year-old’s attempts at joined-up writing than a smooth upward incline but, as we all know, markets very rarely respond smoothly to anything. (Philip Nell, Property Week).


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