As long as interest rate hikes remain gradual and the economic recovery continues apace, we expect the real estate market to remain wellsupported

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1 September 1 Why rate hikes shouldn t yield trouble for UK real estate UK interest rates are expected to rise gradually over the next three years, in tandem with the economic recovery. Prime property shows a relatively weak correlation with gilt yields and base rates, whilst average property displays a moderate positive relationship. Broad fundamentals are supportive for real estate an improving economy, expected rental growth, limited supply and a historically high yield spread versus gilts. Potentially least sensitive to rate hikes: prime office and retail. Potentially most sensitive to rate hikes: secondary retail. Biggest risks for UK real estate: sharp and unexpected interest rate hikes; weaker than expected occupier market and rental growth. Against a backdrop of widely expected UK interest rate rises 1, this paper seeks to determine the implications for the real estate market. While some in the market believe that prime commercial real estate yields are highly correlated with interest rates, our analysis suggests that the relationship is less than straightforward. As long as interest rate hikes remain gradual and the economic recovery continues apace, we expect the real estate market to be well-supported in the medium term. Historical analysis UK real estate and bonds are both affected by swings in the economic cycle and the accompanying changes in the Bank of England s (BoE) benchmark interest rates. However, both are also impacted by asset class-specific factors, such as supply, which muddies the relationship. Fig. 1 Correlation between property, bonds and interest rates While the bond market operates with high frequency on a daily basis, real estate is a much less liquid market, with valuations usually performed quarterly. Furthermore, depending on market transaction volumes, valuations can be based largely on what occurred in the previous period. Consequently, property yields are on average slower to respond to new information, and lag bond yields. Factoring in a one-year lag for property, our correlation analysis shows a generally weak relationship between prime property yields and bond yields or indeed official interest rates (Bank Rate). IPD sector yields, which are an average of all property rather than just prime, show a more pronounced correlation. In most cases, though, it is still below the.7 watermark which divides a moderate positive relationship from a strong one. Correlations IPD yields (%) Prime yields (%) Lagged gilt yield Office Retail Industrial Office Retail Industrial 1yr index linked gilt yields yr index linked gilt yields yr gilt yields yr gilt yields Bank Rate Source: BoE, Bloomberg, IPD, CBRE. Prime yields are CBRE average prime. Gilt yields are lagged by one year. Correlations for index linked gilts and -year gilts are based on data for , 3-year gilts on and Bank Rate on As long as interest rate hikes remain gradual and the economic recovery continues apace, we expect the real estate market to remain wellsupported in the medium term Factoring in a one-year lag for property, our correlation analysis shows a generally weak relationship between prime yields and bond yields or indeed official interest rates 1 Median forecasts in a Reuters poll of 6 economists in July 1 point to the benchmark rate rising to.75% by March 15 from a current record low of.5%. 1

2 Fig. Regression analysis on property versus bonds and interest rates Regression: adjusted R IPD yields (%) Prime yields (%) Lagged gilt yield Office Retail Industrial Office Retail Industrial 1yr index linked gilt yields yr index linked gilt yields yr gilt yields Bank Rate Source: BoE, Bloomberg, IPD, CBRE. Prime yields are CBRE average prime. Gilt yields are lagged by one year. Correlations for index linked gilts and -year gilts are based on data for and Bank Rate on One possible explanation for the disparity in correlations between average and prime property lies in the different drivers of the two markets, as well as in the consequent lag between them of as much as six to nine months. Prime property is typically sought by investors for reasons including scarcity of supply, visibility and relative security of cash flow and the perception that prime assets provide some degree of capital preservation. Foreign investors in particular like owning trophy assets in the UK landmark buildings in key locations, which are seen as safe havens and are usually bought for the very long term. Secondary property tends to see less demand from foreign investors and greater availability. It also has a weaker reputation for capital preservation, especially in risk-off environments. Therefore, we would expect yields on secondary to be influenced more by the risk premium (spread over gilt yield adjusted for rental growth) and economic conditions than those on prime. An economic slowdown or an onset of deflation, while negative for property on average, may induce real estate investors to seek out prime, trophy assets at the expense of secondary property, especially where foreign capital is involved. This again suggests that prime yields are less determined by government bond yields. If this is the case, rental fundamentals, although important for property generally, is even more significant for secondary, in order to keep such assets attractive to investors. Linear regression analysis (again, with a one year lag for property) shows broadly similar trends to the correlation data, with IPD yields generally displaying a stronger link to gilts and official interest rates than prime yields do. The results produce the highest adjusted coefficient of determination (Adjusted R ) values for the nominal 1 year gilt yield regressed on the IPD yields, inferring that government gilt yields have historically accounted for approximately 6% of the shift in average commercial property yields. However, this oversimplifies a complex relationship that is not easily explained statistically. We would expect yields on secondary to be influenced more by the risk premium and economic conditions than those on prime Fig. 3 Historical moves in property, bonds and the yield spread Nominal yields (bps) UK 1yr gilt yield (%) Prime office yield shift IPD office yield shift Prime office yield spread IPD office yield spread UK 1yr gilt yield (on right hand axis) Source: IPD, CBRE, Bloomberg.

3 Clearly a relationship exists, but it is not strong enough to ensure that the yields on the two asset classes always move in tandem. For example, in 11 of the past years both prime and IPD office yields moved in the opposite direction from 1 year gilt yields. Interestingly, on several occasions, this divergence lasted for more than one quarter, most notably between 1-, and also in more recent years (8, 1 and 1). In other words, a rise in bond yields does not necessarily always imply a concurrent rise in property yields. Further multivariate regression analysis also reveals that, in an environment where business investment is strong, the impact of interest rate rises on commercial property yields may be dampened or mitigated. Of course, other factors are at play, but business investment is important in helping to drive rental growth which in turn supports property valuations. Supportive economic environment The UK economy has been steadily recovering since late 1, with growth for this year forecast at 3.% its strongest pace in seven years, and higher than for any other G7 country. Demand drivers have picked up, sentiment has improved and positive real wage growth is forecast by the end of 1 3. Current forecasts for rental growth, including our own, point to a continuing recovery in the short to medium term. The economic fundamentals, therefore, are all beginning to turn positive for real estate. At the same time, while consensus points to interest rate rises, the increases are expected to be gradual. According to the BoE itself, rates are unlikely to rise much above.5% by early 17, and are expected to be materially below 5% even when the economy has reached normal levels of capacity 5. The fact that the BoE is attempting to highlight the likely path for interest rates so well in advance suggests markets may have realised much of the adjustment ahead of the first actual rise. The UK yield curve (a barometer of macro expectations) arguably demonstrates this. With improvements in unemployment and the chance of a rate rise coming as early as the end of 1, the short end of the yield curve has recently risen. Levels of leverage and supply imbalances in each of which have caused major crashes in commercial property values over the past 3 years are both comfortably below where they were prior to the respective crashes. Indeed the current cycle has so far been largely equity-fuelled. While this does not in itself prevent a market correction, it does perhaps suggest a more conservative property valuation environment. On the supply side, meanwhile, most regional markets are not forecast to experience significant commercial property development in the next few years. Void rates are low and falling in most sectors in London and the regions. Retail development, specifically for shopping centres, is low by historical standards which should provide a fillip to this sector. Central London is seeing comparatively more development and refurbishment projects, particularly in the office space, but these are not expected to impact the supply/ demand balance in the short run given the strength of demand. Last but by no means least, real estate yields still look attractive compared to returns on offer in other asset classes, such as bonds (both government and corporate), and are expected to remain so in the medium term. In our view, this is likely to support investor appetite for and consequently prices on commercial property. Although yield spreads between property and benchmark 1-year gilts have moderated, they still remain significantly above the historical average, by approximately 15 basis points. Prime spreads have on average compressed more than those for average or secondary property (where rental growth expectations were lower and void rates higher), reflecting perhaps the more fair pricing of prime assets. A yield comparison shows that property, along with equities, looks attractive relative to history, while bonds look expensive. The relative stability of real estate income further enhances its attractiveness. In 11 of the past years both prime and IPD office yields moved in the opposite direction from 1 year gilt yields Levels of leverage and supply imbalances in each of which have caused major crashes property values over the past 3 years are both comfortably below where they were prior to the respective crashes Consensus Economics, July 1. 3 Experian Economics. BoE Governor Mark Carney interview with BBC, June 1. 5 BoE official monetary policy forward guidance, last updated February 1. 3

4 Fig. Historic and projected property and bond yields 1 Bond yield, IPD initial yield (%) Retail Office Industrial 1yr gilt yield Source: Bloomberg, IPD, Experian Economics, M&G Real Estate, June 1. Fig. 5 Current valuations across asset classes Neutrality 8 real yield, % 6 UK Cash US Cash Japan Gov Germ Gov UK Gov US 3Y - Italy Gov US BBB UK BBB UK Property US Equity German Equity UK Equity Japan Equity Source: Datastream, M&G Investments, M&G Real Estate, June 1. Italy Equity Spain Equity Hong Kong Equity Thai Equity Korea Equity India Equity Brazil Equity Mexico Equity Assessing the impact The weak correlation of prime property yields with bond yields and interest rates suggests that this segment of the market has in the past been the least affected by interest rates. Indeed, looking ahead, prime UK real estate is likely to be supported by continuing foreign capital flows and its safe haven status, while benefiting from the positive economic and occupier market developments discussed earlier. Secondary property is potentially more vulnerable, according to our regression analysis, but here too we expect values to be supported by the economic recovery and improving rental fundamentals. Indeed, given that rental growth expectations in secondary have lagged prime, and that prime yields have compressed more than secondary, it can be argued that secondary has more to gain from the economic recovery. Our research suggests that retail may be the sector most at risk from rising interest rates and bond yields. The outlook for rental growth is relatively weak in both nominal and real terms and the sector faces other headwinds, including the still negative real wage growth and the increasing impact of the internet on physical store sales (especially for the high street). However, although store rationalisation is ongoing, its pace has eased and the low overall supply pipeline is supportive of rental growth. Key risks Our upbeat outlook for the UK real estate market is based on a continued economic recovery, rental growth and a backdrop of gradually rising interest rates. The potential psychological impacts from rates rising, after six years of financial stimulus, may result in short term kneejerk reactions. Business and household A yield comparison shows that property, along with equities, looks attractive relative to history, while bonds look expensive

5 sentiment could experience a temporary dip as this change is processed. The deceleration in confidence alongside the initial reaction of capital markets may lead commercial property yields to over adjust, temporarily, as the market reacts to the first rise and begins to digest the real implications of this within the broader economic context. If rates rise more quickly than is currently flagged by the authorities, this may imply stronger than expected economic growth. However, it may still impact sentiment, resulting in rapidly rising gilt yields. This in turn could reduce the relative attractiveness of risk-adjusted returns on real estate, particularly from a liability matching perspective, given that commercial property is more capital intensive on the balance sheet relative to bonds. If rate hikes feed through into persistent and aggressive currency appreciation, that may also impact foreign investor flows. While inflation expectations appear to be well anchored, this can change quickly. Market expectations, as implied by 5-year UK breakeven rates (the difference between yields on nominal and inflationlinked government bonds of the same maturity), currently see inflation below 3%. However, should wage growth remain weak and core inflation rise strongly, this would be negative for property, in particular retail. Overall though, our base case is that interest rates will rise gradually as the UK economic recovery continues to gather momentum across the sectors, broadening out from the South East and London. Conclusion Historical analysis suggests there is no clear cut relationship between prime property and bond yields or official interest rates. The link between average property while stronger remains inconclusive, with history showing that a rise in interest rates does not necessitate a lockstep move in property yields. Looking ahead, a number of factors appear to offer strong support for commercial property: Broad based economic growth is gaining traction; Occupier demand is improving and rents are forecast to grow; Yield spread between property and gilts remains significantly above historical average; Supply pipeline is relatively limited; Leverage is low compared to previous cycles; Interest rate hikes are likely to be wellflagged and gradual. Any rise in gilt yields will be commensurate with an improving economy, and that is supportive of property pricing and yields. Corporate balance sheets are in good shape, credit risk has improved and business confidence is stable. It is therefore our view that UK commercial property is in a strong position to withstand gradual rate hikes over the next few years. Our upbeat outlook for the UK real estate market is based on a continued economic recovery, rental growth and a backdrop of gradually rising interest rates 5

6 Contact Adam Alari Senior Analyst, Property Research + () adam.alari@mandg.com Richard Gwilliam Head of Property Research + () richard.gwilliam@mandg.com Chris Andrews Head of Client Relationships and Marketing + (65) chris.j.andrews@mandg.com Lucy Williams Director, Institutional Business UK & Europe + () lucy.williams@mandg.com Stefan Cornelissen Director of Institutional Business Benelux and Nordics +31 () stefan.cornelissen@mandg.com IMPORTANT INFORMATION. For Addressee only. The value of investments can fall as well as rise. This article reflects M&G Real Estate s present opinions reflecting current market conditions. They are subject to change without notice and involve a number of assumptions which may not prove valid. The distribution of this article does not constitute an offer or solicitation. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of Professional Client as defined in the Handbook published by the UK Financial Conduct Authority. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G Real Estate does not accept liability for the accuracy of the contents. Notice to recipients in Australia: M&G Investment Management Limited does not hold an Australian financial services licence and is exempt from the requirement to hold one for the financial services it provides. M&G Investment Management Limited is regulated by the Financial Conduct Authority under the laws of the UK which differ from Australian laws. Notice to recipients in Hong Kong: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Notice to recipients in Singapore: This document has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, this document and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of shares may not be circulated or distributed, nor may shares be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor pursuant to Section 3 of the Securities and Futures Act, Chapter 89 of Singapore (the SFA ) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. M&G Investments and M&G Real Estate are business names of M&G Investment Management Limited and are used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under numbers with its registered office at Laurence Pountney Hill, London ECR HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. M&G Real Estate Limited is registered in England and Wales under number with its registered office at Laurence Pountney Hill, London ECR HH. M&G Real Estate Limited forms part of the M&G Group of companies. M&G Investment Management Limited and M&G Real Estate Limited are indirect subsidiaries of Prudential plc of the United Kingdom. Prudential plc and its affiliated companies constitute one of the world s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America. AUG 1 / 5365