30 July, 2020

Grim news from the OBR – or is it? What the Fiscal Sustainability Report means for Real Estate?

On the 14th July the Office for Budget Responsibility released its long-term look at public finances. It contained some eye watering projections of where public borrowing and debt could get to in 50 years’ time if the broad mix of policies in existence before the COVID-19 crisis stayed in place once the crisis was over. In the spirit of Keynes famous dictum that “in the long run we are all dead”, and mindful that things can happen in the long-term which are hard to anticipate (such as changes in technology, working patterns, migration and climate change) we will focus on the five-to-ten year horizon which is long enough for most property investment decisions. The OBR also offers three scenarios, including an upside and a downside, but we only have time to focus on the OBR Central Case here.

The Central Case looks painful enough with a 12.4% fall in GDP in 2020. To be precise, however, that is a 21.1% fall in Q2 with a reasonably rapid recovery in the second half of 2020 and growth that averages 4.3% p.a. between 2021 and 2024. Despite the rapid bounce back, end-2019 GDP levels are still not reached until mid-2022. Overall, that’s a little to the downside of the consensus and a bit weaker than the CBRE House View but it is still very much a V-shaped recession and recovery, albeit a rather lopsided one.

This leaves forecast public sector net debt at 109% of GDP in 2029/30, up from 88.5% in 2019/20 and an upwards revision from the 75.6% in the March Budget report. Most of the gap between the old and the new forecasts opens this financial year and is the result of the COVID-19 hit to the economy and the Government’s countermeasures. To put this in context, this would be the highest debt to GDP ratio since 1958/9. That would be higher than the debt that most other countries have now (Japan and Italy being notable exceptions) but by 2029 it is unlikely to be out of the ordinary for many countries who will be grappling with the same fiscal problems. Also, of note the projections for the interest that has to be paid on the debt. It is still projected to be 1.5% of GDP in 2029/30. That is the same as in the 2018 report when debt was only forecast to be 82.2% of GDP by 2029/30. This hints at one of the other big revisions to the OBR’s planning assumptions. Gilt yields are projected, based on market expectations, to be at 0.5% or lower until 2024 and then not to pass the 1% threshold until FY2026/27. This could have major implications for real estate.

The OBR’s own views on real estate are not all that positive. Residential values are expected to fall by over 8% this year and not to return to 2020Q1 levels until mid-2022. Their prognosis for commercial property is even worse, with an expected fall of 13.8% over the year to 2021Q1 and only a slow recovery thereafter. Is this pessimism justified? Property prices have certainly fallen back in previous recessions, but this is not an ordinary recession. Rather than being caused by economic imbalances that take a long time to unwind, it has been driven by public health policy in response to a pandemic. Now the restrictions have eased or are easing the economy is bouncing back – even in the OBR projections. There are certainly many potential stumbling blocks on the way to full recovery, but a recovery does appear to have set in. We have also had a massive monetary easing on the back of an already persistent global savings-investment imbalance. The result, if the OBR are right, is the prospect of sub-1% gilt yields for a further five years. Surely that combination of economic recovery and low long-term interest rates should be supportive of property prices?

The OBR’s pessimism on residential values appears to be out of line with other forecasters for this year. The average of recent forecasts on the Treasury’s July comparison was for house prices to fall by 3% in 2020 followed by a 2.7% bounce back in 2021. That’s still negative overall but nowhere near as negative as the OBR’s view. So far (June) the Nationwide House Price index is down by less than one per cent since December and the most recent RICS survey points to a one per cent rise over the coming 12 months. The Stamp Duty holiday is a big potential upside. It does look like OBR may have overdone the pessimism on residential values at least.

OBR gives structural change as a reason for its pessimism on commercial real estate and it may have a point. The expected upsurge in ecommerce during the lockdowns and the less expected success of working from home have given investors plenty to think about. Their 13.8% fall in values is also not too far away from the 12.4% fall in the IPF’s recent survey of forecasts. Both of these, however, might be a little negative in light of recent evidence. The June CBRE Monthly Index showed a fall in commercial real estate values of 4.6% between January and June but the change in June slowed to -0.7%, a much slower fall than seen in the previous three months. It is also worth noting that, unsurprisingly, the bulk of the fall in values has been in retail (down 12.2% between January and June) while offices and industrials were more robust (-3.1 and -2.5% respectively). Offices and industrials values also stabilised considerably in June (with falls of just 0.2 and 0.1% respectively). The OBR’s view has probably been influenced by the 20% fall in REIT prices seen this year (July to date relative to December) but REIT pricing is more often influenced by equity markets than changes in the value of the underlying real estate, at least in the short run.

Notwithstanding the fact that valuation is difficult when trading is thin (and there may well be more price corrections to come), it does seem that the OBR has erred on the very cautious side when making assumptions on real estate values. There is evidence that residential values may be bottoming out and that commercial property values may be levelling off rather sooner than in previous recessions. The reasons for this lie in the OBR’s economic and financial assumptions. Even if there is still a long way to go and there are structural difficulties, the economy is bouncing back rapidly. Sub-one per cent Gilt yields are also evidence of a very supportive financial background. It may still take a while for real estate lending markets to return to normality, but finance is cheap where available and the risk-free rate on alternative assets is undoubtedly very low.