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Prospects continue to look encouraging for the commercial property sector

The queues outside Northern Rock have piquancy for property investors. A good many savers will have wondered how safe it is to leave their savings in an intangible form with another party. 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 Investment Property Forum forecasts total returns of 4.3 per cent for direct commercial property in 2008 although the outlook is rosier for offices where total returns are forecast to be 6.8 per cent.

Monetary tightening has raised interest rates while the market turmoil surrounding sub-prime mortgages has led to tighter credit conditions. The opportunity for further yield compression in the UK is therefore over for the time being. This means the traditional drivers of returns from commercial property – income and income growth – will come to dominate.

It is no surprise that we have seen the re-establishment of yield differentiation between prime and secondary property. Prime property – grade A buildings in better locations – command higher rents and attract better quality tenants.

London offices should continue to perform well. Financial institutions are expected to survive current turmoil although it is likely to weed out those that are over-exposed and may lead to a slowdown in the City jobs market. The rise in financing costs and increased risk aversion could discourage developers from undertaking speculative projects. Real estate investment trust Hammerson will not proceed with its £650m Bishops Place project until it has secured a significant pre-let.

Rising construction costs may also stymie the desire to undertake development projects. Contributory factors include competing demand from the Olympics, rising raw material costs from higher commodity prices and higher financing costs.

Property consultant Savills predicts that within the City office market, it will take 18 months to lease all the 2008 speculative completions and this may lead to an increase in the vacancy rate. This is not necessarily something to be overly concerned about as the vacancy rate is 6.6 per cent, the lowest for six years.

Property consultant CBRE says prime Central London rents rose by 6.9 per cent in the second quarter and 23 per cent for the year. Savills estimates that short-term rental growth prospects for City offices are expected to be among the strongest in the UK and possibly Europe.

Within other sub-sectors, the emphasis is likely to be on selectivity. The internet and the push by supermarkets into non-food territory has been changing the retailing 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 opportunities should afford the best returns.

Prospects for the occupier market remain linked to economic performance. So far, the data is encouraging. Purchasing managers’ indices for manufacturing and services recorded expansion in August, despite poor weather and market turmoil. The jobs market also remains buoyant. It may take some months before we know the full impact of the credit turmoil on consumer and corporate behaviour but it would be alarmist to expect it to have a 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 at about 7.5 per cent. 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 rate cuts is predicated on banks lessening risk aversion and inflation remaining reasonably well behaved.

Stuart Webster is head of global property at New Star Asset Management

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