The strong recovery in the UK commercial property sector bears a striking resemblance to the mid-1990s market, when valuations rebounded sharply – despite falling rents – only to pull back again in the following year.
Having enjoyed a 12% uplift in bricks and mortar prices over the year so far, investors are now questioning how the sector will perform over the remainder of 2010.
Post-January 1994, quarterly annualised returns plummeted in just 18 months from around 39% to 1%. The underlying fundamentals suggest that while over the next 12 months the market will not mirror the events of two decades ago exactly, the two scenarios could certainly share a resemblance.
Hopes of rental growth
In early 1994, commercial property yields were already running below long-term corporate bond yields, with momentum in the market driven by a belief that strong rental value growth was not far away, given that a lift in economic output was being experienced at the time.
But over the following year it became evident a rise in rents was being held back by oversupply combined with an increase in base rates. These factors worked together to push up property yields and forced down annual returns from 26% nearer to 5%.
At the end of May 2010 property yields were at a high margin over long-term government bonds and estimated rent increases looked subdued.
Despite the restricted supply, however, few investors are anticipating a speedy uplift in lease prices, as specialists at Invista Real Estate Management pointed out in their quarterly review of the commercial property market.
The management firm said this is largely due to economic growth being weak.
‘While we are likely to see a repeat of the mid-1990s rental price, it is in the investment market that the outlook in the near term looks a little more favourable,’ Invista said in its latest sector report.
‘The Bank of England faces pressure to lift base rates to counter above-target inflation, but is wary of the lasting damage this might have on the current fragile economic recovery. Consequently, interest rates may rise over the coming 12 months but not by very much.
‘We believe government bond yields are, on balance, likely to rise slightly over the coming 12 months and that property yields should remain flat for much of the next 12-month period.’
Invista expects total returns of around 7.5% over the year to May 2011, but feels the risk to the market lies mainly in the downside. The company says: ‘Should government bond yields come under severe pressure either from a lack of investor confidence or as a result of bank rates rising more quickly than expected, upward pressure on property yields could depress returns in the short term.
‘We believe UK commercial property market returns are set to ease in the coming 12 months, but we are unlikely to see as dramatic a slowdown as we did in the mid-1990s.’
Although the growth in rental prices is forecast to be weak, the historic spread between bricks and mortar and government bond yields should protect performance over the near to medium term.
Sentiment picking up
Furthermore, sentiment in the sector is picking up. Over the first three months of 2010, commercial property produced a total return of 6%, with positive gains generated largely by income and the impact of falling yields, a reading of the Monthly IPD Index in May showed.
Confidence in the market has shifted upwards as well, perhaps reflected by a willingness among buyers to loosen their investment criteria.
More interest is being observed in developments outside prime areas such as London, and increasingly property investors are turning away from well-located sites and instead focusing on second-tier plots and buildings in need of active management and thoughtful redevelopment.