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Prime movers

The first half of this year has seen capital values in the UK commercial property market continue to fall, although the rate of decline is slowing.

The Investment Property Databank monthly index fell by 0.9 per cent in May, following a decline of 1.6 per cent in April, itself an improvement from that experienced in the first three months of 2009, and considerably better than the successive record monthly falls in the last quarter of 2008.

In the prime commercial property sector (well located assets that generate strong rental income) there are signs of yields stabilising, at least where they have good quality tenants on long leases. There are even some instances of prime yields firming, albeit selectively on property deemed “oversold”.

However, secondary yields are still moving higher. These properties are more vulnerable to the poor occupier market, where tenant demand is down and the risk of tenant insolvencies is increased.

There has been a marked improvement in investors’ sentiment towards commercial property. For now, prime yields appear to have risen sufficiently to discount the negative outlook for market rents.

Given the recession, the combination of businesses curtailing their expansion plans, management rationalising workforces and more companies at risk of insolvency, has resulted in increased concern around tenant demand. This affects rental growth prospects and hence values applied to properties.

Indeed, the industry is braced for double-digit percentage falls in market rents for both 2009 and 2010. So any further weakening of the occupier market than is already being discounted probably remains the greatest risk to a sustained recovery in prime commercial property prices. This will essentially depend on the length and/or depth of the economic recession.

Interestingly, on our current forecasts for rental growth, the aggregated figures for market rents are heavily influenced by falls for central London offices, particularly in 2010. Indeed, factoring in these projections, while our forecasts for market-level total returns from UK commercial property continue to be negative in 2010, central London offices and shopping centres are the only two sectors actually forecast to have negative total returns for that year. All other sectors are expected to have positive total returns in 2010.

The backdrop for commercial property investment remains challenging but security of income remains our prime focus. It is worth remembering that, over the long term, 70 per cent of the total return from commercial property investing comes from income.

Indeed, despite the sharp fall in rental growth during the last major property downturn in the 1990s, the actual income return of the IPD monthly index remained consistent. Prices are generally already well below what we would consider fair value and at levels that, on current forecasts, discount both lower tenant demand and deteriorating rental prospects.

We believe the next few months may be an opportune time to invest selectively in core, defensive assets with strong tenants on long leases.

Secure income streams with few tenant expiries are key at this stage in the cycle as we still believe that properties with weaker income profiles are likely to see further yield expansion or capital erosion before evidence of a broader, sustained recovery emerges.

Fiona Rowley is manager of the M&G property portfolio

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