Commercial property hit the headlines in 2004. The 19% return on the IPD Monthly UK index (a widely used industry benchmark) not only comfortably exceeded those delivered by bonds and equities, but also sustained a record of outperformance over one, three, five and 10 years. Looking more closely at the 2004 data, the return from the retail sub-sector, where rental growth has continued, was 21.6%. Offices and industrial property, where rents were more subdued, nevertheless produced returns of 13.9% and 17.5% respectively over the year. However, property is not a homogenous asset class. There are numerous micro-markets, relating to location, quality of tenant and development restrictions, which greatly influence valuations. For example, well-sited industrial assets close to expanding airports outperformed their counterparts in towns suffering from oversupply.Much of the recent rise in property values can be attributed to the buoyancy of investment demand rather than to the strength of the occupational market. This contrast is at its most extreme in the case of City of London offices, where rents have barely stabilised after a prolonged period of decline, but where valuations have, nevertheless, risen. A wide range of buyers, from wealthy individuals to pension funds seeking to make good underweight allocations, are competing in a market where available stock is in short supply. The result has been a consistent downward shift in yields, a trend which has been further influenced by declining bond yields and low funding costs. Recently, a retail park was sold on a yield of under 4%. The buyer, an insurance company, was seeking to match long-term liabilities and anticipating significant reversions (the potential for future rental growth). The momentum of the investment market for property is powerful and it is unlikely to be reversed unless the current range of positive fundamentals (for example, cheap funding and the absence of more attractive alternatives) are undermined. While weight of money alone should never be used as an argument for market optimism, it provides a following wind if the investment fundamentals are sound. On an average yield of 6%, property still represents good value. Nevertheless, some observers insist on classifying the widespread enthusiasm for property as evidence of an impending bubble, which is attracting the investing public just as everything is about to turn sour. Perhaps they see parallels with the technology bubble of 1999/2000 and are anxious not to fall into the trap imposed by over-optimism. Although property has traditionally been a less volatile asset class than bonds and equities, it is subject to well- defined cycles. Memories of the great boom of the late 1980s are not yet dead. However, many features that triggered those events are not present today, especially the prevalence of speculative development, and the unstable way in which much of it was financed. The current position is quite different: development is more limited (and much of that is pre-let) and the finances of the industry are generally sound. Perhaps some commentators have been influenced by mistaken comparisons with the buy-to-let market in residential property, which is driven by a different dynamic and is beginning to show signs of weakness. The outlook for commercial property is firmly anchored to the prospects for the domestic economy and is, therefore, a direct beneficiary of generally acknowledged improvements in its long-term management. Economic growth in 2005 is forecast to be about 2.5%, with no recession in sight. The outlook for interest rates (both short and long term) is steady. The combination of steady tenant demand and access to stable sources of finance should prove benign. For 2005, we see potential for a further modest decline in yields, coupled with selective rental growth, especially in the retail sub-sector. Forecasts for the return on the IPD index presently lie in the range of 8-13%, which compares favourably with consensus estimates for other asset classes (equities excepted). That is a helpful starting point. However, there are likely to be considerable variations in the level of returns from different sub-sectors and from individual assets. This brings into sharp focus the asset selection and management skills of the fund manager. We expect the investing public to become increasingly comfortable with commercial property as an asset class. This is particularly appropriate as part of a diversified portfolio, especially where a long-term investment perspective is required. Furthermore, by its encouragement of tax-efficient property investment funds (PIFs), the government has signalled its willingness to promote productive investment in this area. This should pave the way for increased publicity and media coverage. Managed funds are enabling the public to invest relatively small amounts of money as effectively as large financial institutions. In a relatively short time, investors will become as familiar with commercial property as they are today with equities and corporate bonds.