The Risk Free Rate of Return in UK Property Pricing

Purpose: The aim of this paper is to consider the appropriate benchmark risk free rate suitable for pricing of property investments in the UK and in doing so investigates the financial characteristics and performance of UK gilt yields. European investors have been significant players in the UK commercial property market during the last decade and in order to be competitive in bidding situations with UK based investors, require to be aware of the pricing criteria adopted.

Design/methodology/approach: This paper analyses the stability, yield distribution and volatility of both conventional gilts and index linked gilts with different maturities over the period 1980 to 2010. It considers the changing structure of the UK commercial property market and reports on a questionnaire survey of the UK property investment community which focused on the rationale behind the selection of the appropriate risk free rate of return.

Findings: The analysis suggests that 10 year index linked gilts have been the most stable, but that if conventional gilts are preferred, then 5 year nominal appear to be more stable than 10 year nominal. 10 year real yields are smoother and relatively less volatile. In our survey of UK property investment fund managers and their advisors, the majority, but by no means all of the respondents, used the 10 year nominal gilt yield as their risk free rate of return. However, questions were raised as to whether it was appropriate to use spot or average gilt yields, particularly when rates in 2009/10 had fallen to such low level.

Originality/value: The findings provide a better understanding of how the different maturities of gilts behave. Insight is given on the criteria adopted by investors when selecting the risk free rate.