Solid resistance in turbulent times

Tangible assets backed by a relatively reliable income are likely to enhance the attractions of commercial property over the coming months as the credit crisis keeps banks under pressure.

The queues that formed outside Northern Rock as savers lost confidence in the bank have a certain piquancy for property investors. While most savers will simply have shifted their cash to another bank, a good many may have wondered just how safe it is to leave their savings in an intangible form with another party. That does not mean that every investor is going to go out and buy land, antiques or property, but there is a certain comfort from owning something solid.

It is this tangibility backed by a relatively reliable income that should stand the commercial property market in good stead over the next couple of years, although investors are going to have to content themselves with returns below those of the past three years. The 18% annual returns of 2003-6 are not going to be repeated in the near term. In fact, the Investment Property Forum forecasts total returns of 4.3% for direct commercial property in 2008, although the outlook is rosier for offices, where total return is forecast to be 6.8%.

Recent monetary tightening has raised interest rates, while the turmoil in the credit markets has led to tighter credit conditions and bondholders demanding higher yields. The opportunity for further yield compression in Britain is, for the moment, over. This means the traditional drivers of commercial property returns income and income growth will come to dominate.

In such a market, investors are likely to become more selective. It is no surprise, therefore, that during 2007 we have seen the re-establishment of yield differentiation between prime and secondary properties. Prime properties the grade A buildings in the better locations will necessarily command higher rents and attract the better-quality tenant.

London offices are expected to continue to perform well. Financial institutions are expected to come through the current turmoil, although in a Darwinian process it is likely to weed out those that are over-exposed and may lead to a slowdown in the City jobs market. If anything, the rise in financing costs and increased risk aversion could well discourage developers from undertaking speculative projects. Hammerson, the real estate investment trust, has stated that it will not proceed with its 650m Bishops Place project in the east of the City of London until it has secured a significant pre-let. Several proposed deals to turn property assets of owner occupiers into separate companies have already been mothballed or have foundered, which should mean a smaller pot of investment properties to choose from.

Rising construction costs may also discourage development projects: contributory factors include the competing demand from the Olympics, rising raw material costs from higher commodity prices and higher financing costs. That is not to say there is not already a pipeline of projects on stream. Savills, the property consultants, predict that within the City of London office market it will take 18 months to lease all the 2008 speculative completions and that this may lead to a tick-up in the vacancy rate. This is not something to be materially concerned about as the vacancy rate has fallen to 6.6% in the City of London, the lowest it has been for six years and well below the average of the past 15 years.

The graph shows that the pick-up in rental growth in offices across Britain is still in its early days. According to CBRE, a property consultant, prime central London rents rose 6.9% in the second quarter of 2007 and 23% on the year.

Savills estimate that short-term rental growth prospects for City of London offices are expected to be among the strongest in Britain and possibly in Europe. Investment volumes are expected to be lower, but some of this slack will be taken up by international investors.

Within other property sub-sectors, such as retail, the emphasis is again likely to be on selectivity. In retail, the internet and the push by supermarkets into non-food territory have for some time been changing the landscape. This creates opportunities in distribution and the return of the niche boutique shop. Affluent locations, specialist pitches in fashionable high streets and centres with anchor stores or the potential for development are likely to afford the best returns. Again, the divergence between primary and secondary asset yields is gathering pace, with the expectation that the yield differential could widen from the current 75 basis points to 125 basis points in the next nine months.

The prospects for the occupier market in Britain remain linked to economic performance. So far the data is encouraging. The purchasing managers indices for both manufacturing and services recorded expansion in August, despite it being another month of poor weather and in the midst of the market turmoil. The jobs market also remains in rude health. Nevertheless, the credit crisis is still young and it may be several months before we know its full impact on consumer and corporate behaviour. It would be alarmist, however, to expect it to have a sudden or significant impact on tenant demand, since most property take-up is a long-term decision.

The impact on the investment market has been more noticeable. The debt-backed buyer is priced out of the market with the all-in cost of finance now standing at about 7.5%, with no opportunity for yield arbitrage. This could change, but a change is not expected until rent rises have lifted yields and interest rates subside. The shift in rhetoric from most central bankers is welcome, but the success of any interest rate cuts is predicated on banks lessening their risk aversion and inflation remaining reasonably well-behaved.

The volatility in both the equity and bond markets has been a sharp reminder of why diversification is the basic tenet of a prudent portfolio. British commercial property has traditionally proved resilient in downturns and exhibited less volatility than UK equities or bonds. In the short term, commercial property may not offer the best return, but over the medium to long term it has historically proven to be a solid investment.