Independence and its Impact on the Scottish Property Market
I hope you will forgive me for starting with my conclusion, that independence would be bad for the Scottish commercial property market. Indeed, what I want to do is to signal to you that I think it would be not just bad but catastrophic.
This conclusion is based on what Scotland would look like in 2016 after the yes vote had been negotiated and implemented. The starting point for the analysis is to look closely at the UK economy that Scotland is currently a part of.
The UK is a very highly indebted economy. By this measure UK debts, as a proportion of GDP, are among the highest in the world, up there with Ireland and Japan and way ahead of Greece and Portugal. This includes private and public debt. However, if we look at public debt alone we actually find a very different picture: UK public debt, as a percentage of GDP, is dwarfed by some of the more extreme countries like Portugal, Italy and Greece. The UK isn’t far out of line with Germany or France.
The cost of government borrowing is important to the property market as this links to how much domestic investors are prepared to pay. The required returns from property are based on the ‘risk free’ rate of return from lending the government money plus a risk premium. This risk free rate of return can be seen as the yield on ten year government bonds (gilts), so this is an obvious platform for property yields. The lower the income yield acceptable to investors the higher is the value of an investment. At the moment in the UK yields on 10 year bonds are at just under 3%, in Ireland they are at a surprisingly low 4% whereas in Greece with its widely publicised problems they are over 10.5% and that’s an improvement on where they were. There is no direct correlation between public debt levels and government bond yields but they have to be borne in mind.
So what would bond rates be in an independent Scotland? Scotland is bound to start its independent life with its proportionate share of UK debts. It is going to be an oil-based economy and will therefore be regarded globally as a volatile economy. It will be a small country, which perhaps makes Norway an interesting model with its bond rates of 3% – the same as the UK. However Norway has public debt of 30% of GDP, and an investment pot which could pay that many times over. Scotland, like the UK has huge unfunded obligations on pensions, healthcare and others. Scotland may well have the constraints of the Euro-zone to handle. It is probable that Scottish bond rates will be somewhere between 1 and 2% above UK levels – say 4.5%. And that is the platform for Scottish property yields. If you take a conventionally accepted yield premium of 3%, property yields would start at 7.5%.
An important additional factor is an independent Scotland in the wider global economy. In 2013 looking around Europe Standard and Poor’s ratings of the various countries sees Britain with a nice healthy triple A green with Scandinavia, Germany and a few others. Ireland, Spain, Italy and Iceland are all brown and therefore in the Bs. An independent Scotland will have changed colour by 2015. In addition public debt in the UK has risen in recent years, including under the coalition’s policy of austerity. Basically this is an ocean liner with very little control over its speed, as a result of unfunded social promises including health care and public sector pensions. This is going to keep rising in or out of the UK.
Despite the mounting debt burden the UK has had pretty good economic performance over the last 13 or 14 years, relative to other European countries. With an economy representing 4% of global GDP it is a healthy size. There is a big question mark over the future economic performance of an independent Scotland as a small economy on the world stage. To understand what we are playing at with independence it’s helpful to look at Scotland’s export markets. The EU is Scotland’s biggest overseas export market with £11bn. But exports to the rest of the UK are £45bn. It is impossible to imagine that with the barriers that will be put in place between Scotland and England post independence, whether there is a physical fence, or currency difference, or different tax rates there is likely to be a radical reduction in the exports from Scotland to the rest of the UK.
It is possible to begin to paint a picture of what Scotland will look like in 2016. National debt will be in line with the UK. Currency – well if it all goes wrong it will be its own currency, if it goes as well as the SNP predict Scotland will continue with the pound but the likely outcome is the Euro (and control by the European Central Bank). Bond yields will not be as bad as Greece but higher than for the UK yields, so 4.5% is likely. The precise economic policies will depend on the colour of the government. The SNP no doubt see themselves in permanent power with some kind of centrist approach and the likely scenario based on many years of Scottish voting is that there will be a Labour government in for the long term. The SNP will have done its job and will have handed over to others.
What does that mean for property investment? Well for prime properties the main buying universe remains insurance companies, pension funds and of the big institutional investors. Much of the money involved is either from England or at least managed from London. The majority of these investors track the UK Investment Property Databank in some shape or form. So if IPD reports that the UK market has 10% of its assets in Scotland, these funds feel something of a need to acknowledge that, albeit underweight or overweight. If Scotland is outside the UK it will undoubtedly be outside the main IPD universe- like the Republic of Ireland- and therefore generally off the radar for both of these investment funds. Likewise most of them will have a fund strategy which excludes international investment – so Scotland will not qualify as a target location for investment. One major investor this year raised £700 million earlier this year to lend to real estate in the UK. That would not include an independent Scotland.
With increased devolution of decision making there will be inevitable differences in tax rules and other legislative areas. Investors will be concerned about these and yet have no say whatsoever in them. And while this paper sets out the expected position in 2016, there are already investors who are reacting to the current hiatus by reducing their Scottish exposure and who can blame them? If there is a positive vote for independence these investors will be in turmoil in their need to reduce their Scottish weighting. This will lead to a collapse in property values, with no obvious replacement capital wanting to invest.
I think we should also look at the likely position for occupiers in an independent Scotland. Cross border retail fails more often than it succeeds. A good example is Tesco, who are winding down their US operations at significant cost. It cannot be taken for granted that English retailers will want to trade in Scotland, especially if it has a different currency, tax base etc.
On offices, there is no doubt that government space will rise – Scotland will need to replace many of the functions which are currently run from Westminster. However, someone somewhere is going to have to pay for all that. Meanwhile, there is no doubt that corporate space will fall, including the inevitable demise of the two big banks who will not run their operations as they are from an independent Scotland. Likewise organisations like Standard Life will not continue in their present shape in Scotland. Even distribution property will be hit not least because as noted above there will be significantly less cross border trade.
So to conclude, Scottish bond rates are bound to be higher than UK ones and that property yields would have to rise accordingly. Similarly demand for investment property would fall and there would be a dramatic sell down by UK based financial institutions. Occupier demand would suffer rather than benefit and as a result rents are going to fall. I would contend that a vote for independence is a vote which will destroy the Scottish commercial property market as we know it.
David Hunter is a Scottish-based international property consultant, and he is an Honorary Professor within IHURER. His background is as a leading fund manager, originally with Scottish Amicable and ultimately as Managing Director of Aberdeen Asset Management’s £6.5bn UK and international property fund business. He was President of the British Property Federation in 2004, and had a leading role in the introduction of REITs to the UK. He was also inaugural Chairman of the Scottish Property Federation.