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Property development

Subdued domestic returns mean there is a strong case for diversifying globally in property


UK commercial property has seen significant volatility in the last few years. From the June 2007 peak to the trough in July 2009, capital values of the unlisted (direct) market fell by around 44 per cent, according to the IPD UK monthly index, represen-ting the sharpest fall in its 24-year history.

The index rebounded in 2010 with total returns (income plus capital growth) of 14.5 per cent, way above the long-run average. Performance has since stabilised and total returns are currently averaging around 9 to 10 per cent on an annualised basis, driven mainly by income. Nonetheless, capital values remain about 35 per cent below their 2007 peak.

Having experienced a sharp downturn and partial recovery, it is a goo time to ask what are the prospects for UK commercial property? Are we set for continued strong performance as values remain far below their previous peak or can we expect a setback? There are argu- ments for and against.

The bearish case rests largely on a weak and subdued economy. The Government’s austerity measures have yet to have their full impact on business activity.

Inflation is eroding households’ real disposable income. Consumer confidence has declined and house price growth has slowed.

Many businesses remain cautious about taking new space. Outside London, rental values for most market segments are either static or falling. A significant amount of debt secured on property has to be refinanced over the next few years. The positive case for UK property rests largely on its defensive characteristics.

Property yields remain at a significant premium to those of other UK assets. Rental income is relatively stable and secure. Property is often seen as a partial hedge against inflation, albeit with a lag due to infrequent rent reviews.

Development activity is gen-erally limited. Press attention on high-profile schemes in central London masks the broader picture that develop-ment activity is generally below historic average levels.

Compared with many other parts of the world, the UK is seen as being relatively safe and transparent, meaning it attracts attention from overseas buyers.

What is the most likely scenario? In the short term, UK commercial property is unlikely to enjoy the perfor-mance seen in 2010. Relative to current risk-free assets, how-ever, we believe it is priced to deliver a healthy return over the next five years, driven mainly by income.

Strongest performance is expected towards the end of the forecast period as improving economic cond-itions feed through to demand for space. As the UK looks set for a period of modest short-term performance, investors seeking higher returns may be tempted to look abroad, such as in rapidly growing emerging markets.

HSBC’s research team sugg-ests markets now regarded as “emerging” should overtake developed economies in their contribution to global growth in the current decade.

Stronger economic growth should be associated with increased demand for space although high levels of development in such markets typically bring higher levels of risk.

Including non-UK property can also provide potential diversification benefits bec-ause there tends to be strong differentiation between individual property markets. The case for diversifying globally in property – particularly when domestic returns are subdued – is strong.

Guy Morrell is manager of the HSBC open global property fund


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