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A different blueprint

No one can be in any doubt that sentiment towards commercial property in the UK has taken a severe knock over the past six months. This has led some to suggest that we are heading towards a recession and property downturn similar in scale to the 1990s crash.

Yet it is not that long since investors were basking in returns from commercial property that were the envy of virtually all other asset classes. From March 2002 to June 2007, cumulative property returns were 110 per cent or over 15 per cent a year. In real terms, that upswing was the longest period of sustained high returns in the 21-year history of the IPD monthly index – the most prominent monthly index in the commercial property market. But since June 2007, sentiment has turned rapidly away from commercial property. The total return for 2007 was -3.4 per cent, which was the worst year-on-year figure since 1991 when the country was in the midst of the last big property recession.

The stockmarket anticipated the downturn first. Share prices of the newly created real estate investment trusts started to weaken almost immediately on conversion. From a premium to net asset value in January 2007, share prices fell to discounts of around 30 to 40 per cent. The tipping point proved to be the credit crunch, which grew from being a local US housing problem into one of global proportions. The resultant lack of affordable finance, coupled with the hike in rates resulting from the credit squeeze, finally drove away any remaining investors.

Compounding this lack of demand was the equally sudden flight of retail investors. Having profited from astute purchasing of property unit trusts and other retail products prior to 2007, investors were prompted to take profits as media and public sentiment turned against commercial property. The industry moved from having the support of a wide range of investors into one where there were few buyers and a growing number of sellers. A harder landing scenario was widely anticipated.

Despite this, the property market is in better shape than at the beginning of the 1990s. Economic growth remains steady and interest rates and unemployment are both low. Tenant demand is still firm and development remains relatively muted. In addition, corporate health remains fairly good and rents are still rising. Even during the second half of 2007, when capital values were tumbling, rental growth was still positive in the retail, office and industrial sectors.

This is in contrast to the early 1990s which saw a deep and prolonged recession, high unemployment, high interest rates and high levels of development, plus weak tenant demand and falling rents.

We believe that property values will decline from their peak in mid-2007 by around 15 per cent but predicting the peaks and troughs of any market is impossible, as market movements tend to accentuate both. A 20 per cent fall from recent highs may be realistic in coming months, if sentiment fails to recover.

Recent figures from the IPD monthly index show average property values have fallen by around 14 per cent since last summer, suggesting we may be approaching the nadir.

The big caveat to the projected outcome is the state of the economy. Global economies are slowing from the combined effect of higher interest rates earlier in the cycle and the impact of the credit crunch. The property market is cyclical and with office and retail development picking up, the market is right to factor in a period of less strong tenant demand and rental growth. On the positive side, property values have fallen significantly from last year’s peak and less marked falls are possible in the coming months. This is likely to throw up buying opportunities for funds with cash. The real danger to our positive but cautious outlook is the possibility that continuing fears in financial markets may spread to the corporate market and consumer spending. That would prompt a downward reassessment of likely returns over the coming months.

Swip is not forecasting such a downturn in the UK but it does anticipate a period of sub-trend economic growth in 2008 and 2009. Our outlook remains cautious while global uncertainties remain. We believe income and rental growth will be the key drivers to property performance. We forecast returns in the next three and five years of around 6 to 7 per cent a year – still 4 to 5 per cent a year in real terms.

Stewart Cowe is investment director, property, at Scottish Widows Investment Partnership


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