A fair reflection?

In the two years prior to June 2009, commercial property values lost 44 percent in the sharpest collapse ever recorded. So the 17.8 percent recovery over the last 12 months could be seen as an encouraging step towards normality. However, this would be misleading.

The recovery has been highly skewed, with prime asset values rising by around 26 percent, while secondary assets barely increased at all. In part, this reflects the nature of the investors. Foreign investors in particular target trophy assets in the West End and City. Institutional investors have invested with income security in mind. Thus Central London offices appreciated by 26 percent, office outside the capital and the M25 offices rose by only six percent.

Lack of debt finance for anything other than the best has deterred the investors that, in normal circumstances, would have targeted the secondary sector. But, risk aversion has been the dominant consideration. Fear has developed into almost irrational depression.

Take the Q2 economic results in the UK. GDP grew at 1.2 percent, the fastest since 2001: Job creation was the highest for 21 years, and export volumes grew at 15.5 percent, the fastest for 30 years. Banks are reporting profits, and the City of London seems to have weathered the financial storm with its global position intact. So why isn’t everyone celebrating?

Instead, the focus has been on double dip fears in the USA, turbulence in the Euro zone, and concerns that the Japanese “disease” may contaminate the west. Naturally, any single quarter may contain exceptional factors, but the prevailing sentiment is to reject good news and focus on the bad. A broad recovery in commercial property will not emerge so long as such a mindset prevails.

But, as and when what may become irrational optimism replaces dogged depression, the turnaround in the commercial property market could be dramatic. Some sectors remain 30 percent cheaper than three years ago. Yields offer a substantial income margin over the cost of debt. Commercial property can offer geared income yields that gilts lost 15 years ago. With development activity at a 16 year low, space constraints will arise at a much earlier stage of the recovery than normal.

Sticking with the here and now, the recovery that started in the middle of 2009 has seemingly run out of steam. Yet attractive investment opportunities remain. There are locations where economic activity is likely to exceed the UK average. The City of London is one example. Aberdeen, our oil and gas exploration capital, is another. A lack of development activity can create pre-let development opportunities, especially as the 25 year leases taken out by the big banks and professional firms in the late 1980s expire.

A broader recovery will emerge as and when occupancy statistics improve, or when there is a change in perception of a particular sector. In 2007, retail warehouse yields were circa 4.75 percent. By summer 2009, they had moved out to 9.25 percent owing to an overly pessimistic view of retail prospects. In the last year, they have been the star performer appreciating by around 30 percent.

Banks are ultimately: “the elephant in the room”. To date, slow and cautious workouts mean that there is a relative shortage of distressed property on the market. That could soon change. Furthermore, the attitude of banks to property as an asset class could also change. In the US there has been a revival in CMBS (commercial mortgage backed securities) despite the fact that the US property market has not recovered to the same extent as the UK. An announcement by UBS that it is bolstering its CMBS team in London could be an indication that sentiment to property may be warming on this side of the pond. For now though, it looks like it will be an icy winter for the property market.