Fair value no defence for falling UK property market

The downturn in UK commercial property still has further to run despite prices being at or close to so-called fair value and cheap compared with other European markets

Having overshot on the upside, British commercial real estate prices are likely to overshoot on the downside.

"We're heading rapidly towards 'fair value' now but just because we're moving that way, doesn't mean it is sustainable," said William Newsom, head of commercial valuations at property services firm Savills. 

‘Fair value’ is a widely used long-term marker by which to judge relative value between different markets and asset classes. It is a fluid and debatable concept. 

When it comes to commercial property, the simplest practice is to compare rental yields with yields on government bonds. 

This yield gap was unusually negative in the UK in the first half of 2007, during the final phase of an extended bull market and before the onset of a global credit crunch. But it has since turned positive as property prices have tumbled. 

The gap is currently near its long-run average of one percent over 10-year UK gilt yields - about 40 basis points higher than the spread on triple-A rated European corporate debt.

So what was a strong 'sell' 10 months ago is now a borderline 'buy', especially for investors with long horizons who might be less concerned about calling the very bottom of a market, such as pension funds and life assurers, fund managers at Legal and General said.

UK commercial property could still however, dive into ‘undervalued’ territory, despite a plethora of potential buyers, including opportunistic funds which have raised billions of pounds to exploit the slump. 

"Our view is that the UK market is back at fair value," said Mark Callender, head of international property research at fund management group Schroders. "If the investment market was an entirely rational world, that would mean yields would now stay where they are. The reality of course is different and our feeling is that they will now overshoot on the downside too." 

Mr Callender is among more bullish UK property forecasters in that he expects benchmark IPD UK All-Property yields to rise 40 basis points to around 5.75 percent - or about 130 basis points over current gilt levels - before stabilising in the summer.

"As long as we avoid a recession that 5.75 percent could be the end of the story," he said. 

Differences in asset quality which may have been neglected as the market boomed and bank lending to property investors hit record levels are set to be accentuated on the way down as creditors get pickier and refinancing debt gets harder.

Prime UK property - such as well-located, modern offices or shopping malls with top-rated tenants on long leases - might be at or approaching fair value, experts say.

But everything else has much more downside as debt underwriters tightened their criteria, said Brenna O'Roarty, director of European research at Deutsche Bank unit RREEF, one of the world's biggest real estate investors. 

"Secondary (UK commercial property) has yet to be re-priced because the market remains relatively illiquid and so has much further to go," she said. 

Fair value measures also take no account of differences in rental growth prospects or supply between different markets, meaning the UK could continue to trade a discount to other European markets for a while yet, when in theory it should not. 

Britain's commercial property market is commonly regarded by property analysts as the least risky in Europe on several fronts, including size and maturity of market, level of transparency, legal framework, and length of leases.

"In theory, the risk premia should be higher in mainland Europe compared with the UK," Ms O'Roarty said. But in practice, yields on the continent could still trade below Britain's due to lower bond rates and differing property fundamentals.

Ms O'Roarty suggested fair value for property in Germany and Sweden could be as much as 1.2 percent over government bonds, and higher still for less mature markets such as Spain.

Due to slowing economic growth and rising debt costs, all these markets were likely to see property yields rise in 2008. Even so, yields on prime office property in Stockholm, Munich, and Paris were likely to stay inside London's for the foreseable future and below their theoretical fair value, she said.

Even Madrid and Barcelona were likely to remain expensive in fair value terms compared with central London, despite Spain's growing credit crunch pains and the potential for a much sharper adjustment in secondary property markets, she said.