Property recorded double digit returns in 2013 and 2014 with a total return of close to 14% anticipated for 2015. While we believe it is unlikely property will make it a fourth year of double digit returns, given the backdrop of steady economic growth, low inflation and a continued low interest rate environment our central scenario is for property to return in the region of 8% in 2016.
In contrast to the previous three years, performance in 2016 will be driven by rental growth rather than yield movements. The drivers of this rental growth will be demand and lack of supply. In many sectors vacancy rates are at multi-year lows and although IPD has recorded an increase in development spending, demand is exceeding supply and there are indications that supply bottlenecks are emerging due to a fall in the availability of sub-contractors. Consequently, there seems little risk that the market will be flooded with a significant amount of space in the next year.
Property yields are expected to stabilise in 2016 at a headline level – although this will mask some movement on a more granular basis. IPD All Property yields are 160bps below the long-run average and as a result, we see little scope for further falls on a sustainable basis. Furthermore, we expect to see some upward pressure on bond yields over the next 12 months, which should also limit continued yield compression. This pressure is likely to be derived from increased illiquidity in the bond market forcing yields upwards and a first interest rate hike. In our view, an increase in inflation early in 2016, when previous drops in commodity prices fall out of the annual comparison, will start to put pressure on the MPC. As a result, we anticipate an initial interest rate hike early in the second half of the year. However, the impact of the renewed fiscal squeeze combined with improvements in productivity keeping inflation pressures subdued should ensure that any further increases will be limited and gradual. We do not expect interest rates to exceed 1% by year-end. However, we also do not anticipate outward yield shift over the next 12 months in response to higher bond yields. The spread of property yields over the 10 year gilt remains wide and while this partially reflects the distortion of bond yields by QE and a near-zero interest rate policy, the combination of this gap with the expectation of rental growth means property yields should be able to absorb a narrowing of the risk premium.