Crudely described as 'printing electronic money', QE has pumped cash into the economy through the purchase of government bonds and corporate bonds in the hope this will inject liquidity into the financial system.
Since March 2009 when the programme started, £200bn has been spent on this artificial prop to the economy. The knock-on effect for both commercial property values and the FTSE 350 Real Estate sector has been extremely positive (see chart).
Property values and Reit prices rise in tandem with QE
Source: Normua/Thompson Datastream
So why the correlation? The simple fact is this - QE has made property look cheap. The principal side-effect of QE has been a weaker pound, meaning foreign investors have enjoyed a 'double discount' on UK property through the currency advantage. Currently, foreign buyers account for around 80 per cent of all commercial investment transactions.
Another partial consequence of QE, low bond yields, means property returns are also attractive to funds and institutions, who have all come back into the market. Increased demand for property assets from cash-rich buyers has caused values to rapidly inflate, with the industry benchmark IPD Index registering a record monthly rise in December.
However, there are growing fears that the suspension of QE will stop the nascent recovery in its tracks.
Pause for thought
Nomura real estate analyst Mike Prew is of the firm belief that real estate values have become dominated by capital flows, and not underlying market fundamentals. The biggest worry is falling rents, which stand to erode property income over time. This could have a detrimental impact on the future servicing of debt, not to mention property values.
Mr Prew has been bullish about property stocks since last March, when the market started its stratospheric ascent. Last week, he published an 84-page note outlining his new, bearish stance. So will the market start to decline after 4 February?
"I think it’s starting to happen already," he says. "We are looking at a spike in performance in the real estate sector." Mr Prew reasons that a year ago property yields were 8 per cent, and 10-year gilts were yielding 3 per cent. Today, property is nearer 6 per cent, and gilts are edging up to 4 per cent - and look set to rise further.
"London's already been re-priced," he argues, noting that properties that were changing hands for an 8 per cent yield at the start of the recovery are now doing so at 6 per cent. This is good news for the balance sheets of listed property companies, with rising property values boosting net asset values (NAV) across the sector. But how long it can go on for is a pertinent question.
"Approximately 80 per cent of UK property investment transactions have come from foreign currency buyers, and some of that overseas money is now beginning to look at continental Europe as a better value prospect," Mr Prew observes. The fear is that once foreign demand cools off, liquidity will evaporate, and property values will suffer. This will bring the old fashioned property fundamentals back into play - namely rental income - making the sector far less attractive.
Reversal of fortunes
The chill wind blowing across the sector has already impacted share price performance of the major real estate investment trusts (Reits). Last week, UK real estate was the worst-performing sector on the FTSE at minus 4 per cent, and the Reits have fallen 6.5 per cent so far this year.
Mr Prew expects British Land's third-quarter figures next Tuesday (9 February) to mark the high point of the current market. "British Land has bond-length lease income averaging 13 years, so it should bring the highest NAV growth [of its peer group]," he argues.
Last week, third-quarter figures from fellow Reit Great Portland Estates showed a dramatic 11.6 per cent leap in NAV. The chunky premiums that the real estate giants were trading on a few months ago are fast melting away, but Mr Prew fears NAV growth for the last two quarters of this year will be derisory.
"It's important to remember that quantitative easing doesn't just happen and stop - it gets reversed," he argues, comparing the process to paying back the principle on a £200bn mortgage. "To do this, the government will have to issue more gilts, or start selling assets. No one knows how it's going to be done, as it's never been done before."
The retreat of foreign buyers is not the only worry - the institutions are already becoming more wary of commercial property as an asset class. "In a recent poll of economists, 53 out of 54 economists think QE will be paused," reasons Peter Pereira Gray, chairman of the Investment Property Forum (IPF) and managing director of the Wellcome Trust's investment division. "Rationally, investors should reduce their exposure to illiquid assets in times of uncertainty. At the present time, the Wellcome Trust has an unprecedented high amount of cash. We are negative on commercial property, but positive on high-end prime residential around London. We are not negative about all UK commercial property types, but you need to be careful. Liquidity and flexibility are the two crucial requirements in our armoury."
Don't bank on recovery
The potential impact of QE's suspension on the banks has further negative ramifications for the property market. "If QE is suspended, banks may be rapidly faced with bringing forward their planned distressed property disposals, either in single lumps or as part of special purpose vehicles," argues Robert Fourt, head of investment research at Gerald Eve. "Going forward, raising new debt finance [for property purchases] will remain difficult and potentially expensive relative to the likely target returns."
However, UK investors should not write off commercial property as an investment class just yet. In the past, periods of uncertainty have provided a good entry point for shares in the Reits, which are already starting to cool down. As the market slows, property derivatives are an intriguing - if complicated - prospect, as demonstrated by Land Securities this week. The foreign investment boom will never totally desert London, which has proved itself time and time again to be a resilient long-term play. And an alternative trading strategy could be to follow the foreign investors to continental Europe and gain exposure to larger European Reits such as Unibail-Rodamco, which many UK analysts are becoming increasingly interested in.
