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A fine prospect

With the uncertainty in financial markets, it is hardly surprising that the subject of income has taken centre stage. As commercial property often offers a yield of over 7 per cent a year, this sector has attracted great attention. However, there is speculation that the commercial property sector is overheated and about to crash. Is this the case?

Is there just one property sector?

One myth which needs to be exploded is that the residential and commercial property sectors operate in unison. It is not true.

The residential market is dominated by owner-occupiers and while supply is relatively static, demand changes dramatically.

The commercial property sector, in contrast, is dominated by investors who are usually attracted by a long-term, secure income stream.

These two sectors can both experience problems at the same time, such as when interest rates rose dramatically in the early 1990s, but it is uncommon.

Is there too much space?

A more relevant concern is that, in a recession, demand for commercial property space contracts with employment. This is particularly significant if an area is dominated by a single sector.

One example is the City of London and the financial services sector. It is possible that we will see a repeat of the early 1990s when nearly 20 per cent of the City was vacant. If so, who will suffer?

Some developers will inevitably suffer as well as some tenants. Those with uncompleted developments such as Swiss Re, which is building the “gherkin” on the old Baltic Exchange, may find getting tenants for the space takes a long time. However, most of the current crop of new developments are pre-let rather than speculative.

Tenants in leased buildings with surplus space may find it harder to sub-let but it is the tenant, not the landlord, who bears the cost. Investors may not see much growth but their long-term income stream will remain secure.

Overall, the commercial property sector is much more stable than it was in the early 1990s. The volume of development taking place today is not as excessive as it was then. Most banks now demand that developers obtain a pre-let before they lend the funds to erect the building. This has resulted in a much closer balance between demand and supply.

Is the property sector about to collapse?

Some believe commercial property must be due for a correction as it has performed well for many years so they think a slump must follow. This view argues that what goes up must come down. It is too simplistic.

Major corrections in the commercial property market historically have followed a specific pattern. If we review the IPD index (which covers the commercial property market since 1971), there have only been two major corrections.

The first one was in 1974 (a 19.8 per cent fall) and the second was in the early 1990s (a fall of 30 per cent in the period 1990-1992).

In each case, however, the correction followed a period of significant capital growth. In 1971-73, there had been growth of nearly 70 per cent and in 1987-89, there had been growth of 60 per cent.

Inevitably, this means we should look at growth over the last few years. The figures are shown above.

These statistics clearly show there is no reason to expect a correction. So, what is happening at present and why are some commentators expressing concern?

Where will the market go?

Change in investor profile

One major change in the market is the source of investment. Following the early 1990s, institutions massively disinvested from equities – a great mistake with the benefit of hindsight – and it is the private sector which has taken over. This makes the sector of interest to a wider audience and therefore more newsworthy. Inevitably, not all commentators can correctly predict the future.

City of London malaise

As previously noted, the City has a lot of empty space because of the current stockmarket malaise. Most City-based firms make money when stockmarkets are thriving but have to cut back when they are not.

Given that we are now in the longest stockmarket recession for many years, the current surplus of space is not a surprising result. However, the City is just one part of the country&#39s overall commercial property sector and investors should not dismiss an entire asset class because of a set of circumstances unique to the City.

Problems for tenants

The problems of speculative development, such as in the early 1990s, have not been repeated. There may be a lot of new building in London but most of it is let to tenants with strong covenants. These tenants may not need the space in the short term but the rent will still be paid.

There will, however, be little prospect for rental growth until markets recover. This will reduce investor returns but the solid income stream will usually underpin a return of at least 6 per cent a year until they do. This hardly represents an investment disaster.

Overall, commercial property still looks a most attractive option in comparison to other asset classes such as cash, even though the risk is naturally greater. It is the investor assessment of this risk which will sway the investment decision.

However, the simplistic argument that whatever goes up must come down, is very wrong because commercial property prices have not gone up. There is, therefore, no overpowering reason why they will now come down.

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