The strong bull run commercial property has experienced over the past few years has driven prime yie...
The strong bull run commercial property has experienced over the past few years has driven prime yields to historic lows and it seems inevitable that the situation will become unsustainable – resulting in a market slowdown. However for the rest of 2006 and possibly into 2007 there is still scope for yields to fall slightly further, driven by strong investor sentiment, the sheer weight of money still looking to invest in property, lack of supply and good rental growth prospects in some sub-sectors.
The economic outlook remains relatively supportive with GDP forecasts for 2006 and 2007 relatively unchanged at around 2%. This is despite a sharp rise in household consumption during the second quarter. The residential housing market shows no signs of slowing down even though interest rates rose unexpectedly. Although another increase is likely before the end of the year the outlook for interest rates looks stable.
The outlook for rental growth remains positive with consensus expecting all property growth to continue at around 3% pa over the next 4/5 years. This seems a reasonable expectation given GDP forecasts but there will be significant divergence between sectors and regional markets.
Vacancy rates continue to decline in most office markets, with genuine shortages of supply in some sub-markets likely to drive strong rental growth. Office and industrial rental value indices remain below the long-term trend suggesting scope for a cyclical upswing.
Capital values continue to be driven upwards by strong investor demand from a wide variety of investors combined with a lack of supply. There is little to suggest any material easing of supply in the short term although there has been a significant rise in the number of office developments.
Property pricing remains stretched relative to equities but fair value against gilts. The positive yield gap property enjoys over gilts is now marginal. Nevertheless, the degree of risk of a mild yield correction in 2007 has increased. Any adverse impact is likely to be restricted to certain parts of the retail sector. Against the prospect of somewhat tighter liquidity conditions investment demand should continue to exceed supply next year, although investors will be reluctant to bid yields lower.
A return to the reverse yield gap remains a possibility – however the prospect of falling gilt yields and stalling property yields may combine to stave this off.
The outlook for commercial property remains attractive and is on course to deliver total returns of around 16.5% for 2006. Year to date, it has outperformed equities and gilts. As the scope for further yield re-rating reduces, stock selection and asset management will be key drivers of performance for commercial property funds. There are some risks on the horizon but the fundamentals are in place to ensure returns in the coming years are still attractive even if property performance, as expected, returns to more sustainable long-term average levels of around 7%.
