Exploring the rise of retail in the U.K. real estate market

Introduction & Key Calls

Value in retail

Relative to the last twenty years, the premium above the risk-free rate that real estate currently offers investors is at or above the average, with retail in particular offering strong relative returns underpinned by high day one yields.

Key call 1: Focusing only on the spread over the risk-free rate misses the point

The spread offered by real estate over the risk-free rate is often monitored and cited as a basis for an investment decision. While it is important to understand the day one income premium real estate will offer, this measure does not account for real estate’s ability to deliver income growth which differentiates it from fixed income.

Key call 2: Retail sectors look attractively priced relative to historical norms

The current premium offered by shopping centers and retail warehouses is 50-60bps above long-term averages at 340bps and 410bps respectively. In both cases, 220bps of that premium is delivered in day one income, a comforting level of locked-in outperformance.

Key call 3: Industrial and office also are appealing, but returns rely more on future rental growth

Industrial and office markets offer a premium of 0-30bps above the long-term average, suggesting these markets are also fairly priced. However, the majority of this premium is achieved through expected rental growth which, relative to retail, investors may see as less secure.

Real estate versus fixed income

Spread over risk-free rate is a much-watched metric

The approach illustrated in Figure 1 is perhaps the classic way investors compare real estate and fixed income; charting the MSCI yield (in this case for retail warehosues) against the risk-free rate (in this case, the ten-year Gilt yield). Subtracting one from the other shows the spread, the additional level of yield above (or very occasionally below) the risk-free-rate that real estate offers. On this measure, a current premium of 220bps versus a historical average of 280bps—and perhaps a hurdle rate of 300bps—might not be judged to offer good value.

Figure 1: Retail warehouse real estate yields vs. 10-year Gilt yield

But it misses real estate’s key differentiator over fixed income—rental growth

Real estate differs from fixed income in a key aspect—its income is not fixed. The income derived from real estate typically grows over time. The expectation of income growth must also be incorporated into pricing because it is a key input into the prevailing yields being paid by investors. Ideally, the measure for this expectation of income growth needs to be market-wide rather than for an individual investor or manager. The U.K. has a near 20-year hstorical record of market consensus forecasts for the main commercial sectors (retail, office and industrial)—the IPF Consensus Forecast. We focus on this source (rather than our own in-house forecasts) to understand what the market believes is the current relationship between real estate and fixed income.

Figure 2 shows an example for retail warehouses of the holistic approach and illustrates that with market consensus expectations of rental growth over the next five years at 1.9% per annum (pa), in addition to the day one yield spread of 2.2%, the total retail warehouse premium over the risk-free rate is currently 4.1%pa.

Figure 2: Components of retail warehouse premium over the risk-free rate

Accounting for the impact of Quantitative Easing (QE)

Comparing current observations of the real estate premium to historical averages is problematic for the time period covered since that time period is dominated by the QE era. One impact of QE was to reduce government bond yields significantly. If this is accepted as true, the observed historical premium delivered by real estate could be increased, making a comparison of the current premium versus the historical average potentially misleading. Ideally, this would be corrected, although doing so is not straightforward. Various papers have tried to quantify the extent of adjustment needed, and taking into account the range of estimates, we assume a 75bps reduction in the historical yield premium to account for the impact of QE.

Evaluating pricing across the market

All sectors offer value, but retail markets stand out

A full analysis of real estate pricing versus the risk-free rate, with and without the element of expected income growth, and with and without the adjustment to historical premia for QE, is provided in Figure 3, while Figure 4 summarizes key metrics. Key findings include:

• All sectors of the market offer at least fair value against the QE-adjusted long-term premium.
• Retail warehouses and shopping centers stand out as offering a premium of 50bps and 60bps higher than the long-term premium, with more than 200bps of that delivered in day one income.
• The industrial and office sectors currently match the long-term premium, but a far greater proportion of that relies on expected rental growth, which might reasonably be argued to be less certain, rather than day one income.

Figure 3: Summary of pricing measures

Figure 4: Current pricing versus historical QE-adjusted average