28/07/2008
Prior to last year, the UK commercial property market had experienced two significant downturns in capital values over a 50-year history.
Examining both will allow us to see how the lessons were learned from the past - and just how they could be applied to the present situation.
Large volumes of bank lending to property preceded each of the previous commercial property corrections and 2007 was no different. The main differentiator between history and today is lending in the current cycle is mostly secured on occupied buildings and not empty developments as was the case in the crash of 1974 and 1990. Therefore, despite the sharp decline in property values so far in the cycle – down by 18 per cent to end May 2008 – the volume of debt financing has not triggered panic selling. Debt investors have generally been able to service their loans and cover interest payments through rental streams. Going forward, it is likely to become increasingly uncomfortable for these leveraged landlords as the weakening economy forces more tenants into receivership or even the more resilient tenants to concentrate exposure in the most profitable units.
Institutional appetite for property has been key to pricing pressures and the duration of the two previous downturns. The 1974 crash was short and sharp. The market made a swift recovery as UK institutions continued to increase their allocations to property fuelled by accelerating inflation. The early 1990s collapse in prices was longer and more prolonged, driven by a variety of factors, not least the internationalisation of investment markets.
What, therefore, differentiates today’s commercial property cycle? And do we have any reasons to be optimistic? One clear positive is we are not in the midst of a supply-led downturn. Only a select number of markets such as London’s City are facing significant oversupply in the next couple of years. Even assuming surplus space is released going forward by tenants facing recessionary pressures, the outlook is still more favourable than following the late 1980's building boom.
Investor appetite also remains relatively resilient, with pension fund target weightings remaining at 10-15 per cent.
In many ways, therefore, today’s commercial property market is feeling the same level of pain as previous corrections and it is approximately two-thirds of the way through its correction in this cycle. Last year was the year the debt-fuelled boom abruptly ended as risk aversion spiked and borrowing costs increased. The duration of the downturn looks likely to be inextricably linked with the health of the underlying UK economy. However, as and when confidence does return to financial markets, UK commercial property pricing is likely to stabilise more rapidly than in previous cycles.
Anne Breen is head of property research at Standard Life Investments.
This was published in Investment Adviser on 28th July 2008.
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