As UK commercial property begins to undergo a difficult period, bleak memories of Black Wednesday start racing to the fore. However, the enormous differences between then and now - rising rents, tighter supply and a strong economy - suggest there is really no need to panic
Some of the more bearish commentators are talking about UK commercial property facing a difficult period, and evoking memories of Black Wednesday and the ERM debacle to colour their claims. It is time for some sensible perspective here.
Few will forget Black Wednesday - 16th September 1992 - as the beleaguered Norman Lamont fought vainly to preserve the UK's membership of the Exchange Rate Mechanism (ERM) - progressively pushing interest rates higher through the day from 10% to 12% till they reached an eye-watering 15%.
The ERM debacle damaged the credibility of the Conservative Party for over a decade. And for a short while, it also damaged the UK commercial property market.
Black Wednesday was the lowest point, but the whole ERM saga was pretty disastrous for the UK economy. It brought unnecessarily high interest rates - in 1991, the only full year of ERM membership, mortgage rates averaged 11.39%. These were designed not just to maintain the value of sterling, but also to administer discipline on the British economy and rein in inflation. Discipline became torture, leading to the second-biggest recession since the Second World War.
In the late 1980s, banks had been virtually throwing money at property developers for speculative development schemes - office blocks, warehouses, factories and, to a lesser extent, the retail market. Arguably, with all that speculative development, the market was oversupplied and due a fall.
With the excruciating interest rates of the two-year ERM period and the world in recession, nothing was let. Canary Wharf was a prime example - a £1.5bn investment standing empty. Banks could not get their interest paid - there was no rental income to pay it. They foreclosed against developers, then had to do something with the buildings - they sold them at ridiculous discounts and lost money heavily.
At the same time as the banks were flooding the markets with property, sending prices everywhere plunging, there was also a rental squeeze. And that, generally, is as far as the collective memory seems to go on this period of economic history.
What few recall is that within 12 months, the market had recovered. Black Wednesday was the low point, but also a turning point. UK commercial property capital values returned 21% in 1993, and income yields averaged 10%, recovering much of the losses suffered during the ERM saga. Normal service resumed, which just serves to remind us of the long-term strength of UK Commercial Property.
Direct property has offered a better risk/return profile than UK equities and gilts over the past three, five, 10 and 20 years and beyond. Annual volatility over the past 26 years - from 1970-1976 - measured as a standard deviation percentage, was just 10.3%, compared with 14.4% for gilts and 25.2% for UK equities.
Past performance is not a reliable measure of future performance, but such long-term figures are reassuring. And it is clear then why for many investors UK commercial property has become an important part of a diversified portfolio - because of its record of providing strong, stable returns and because of its non-correlation with both equities and bonds.
Looking to the future, while certain properties will experience modest down-valuations in the immediate months, we believe a strong portfolio of good-quality UK commercial properties should continue to net relatively stable, appealing returns.
There are enormous differences between the situation in 1992 and now to support our view that the current UK commercial property market is more comfortably placed to hold its value than then. In short, supply is tighter, rents are rising and the economy is stronger.
Bank managers have long memories. One of the long-term consequences of that short-lived crash of the early 90s is that banks have since been very unwilling to lend for speculative construction.
That means there has been little of the kind of overbuilding of skyscrapers and prestige office blocks that is seen as the usual harbinger of trouble. With speculative construction in the UK so low, and gradually increasing demand mopping up spare space in all the various asset classes (even manufacturing is seeing a mini-rally at the moment), simple economics says that the competition for space will force rents to rise.
That is where we are now. Generally, in most sectors, rents have been creeping up; there has not been this sort of rental growth for some years. Looking at the office market in many provincial centres and also in the West End of London, some rental deals have broken new ground. That rental value growth will take over from capital growth as the key driver of performance in the coming months.
The economy is different too. Inflation was rising in the late 1980s and at above-average levels in 1990, and the economy was struggling. Today GDP, even after the pre-Budget Report's downward review, is expected to grow by between 2% and 2.5% in 2008, and between 2.5% and 3% in 2009. Inflation today stands at under 2%, and the current base rates stand at just 5.75%. That is some distance from those breathtaking double-digit interest rates of the early 1990s. Very recent indications in the money market also suggest that the next base rate movement will be down.
Investor sentiment remains strong, too. Overseas investors are significant players in the UK commercial property markets, representing 45% of all UK investment transactions in the first six months of 2007.
Investors from Ireland, Spain and Singapore have been the most active in the UK market so far this year, but the demand is far-reaching. Overseas investor demand is set to continue strongly over the medium term because of some key features of the UK market.
UK legislation is largely pro-landlord; there is a legacy of leases of 25 years or more, and even more modern leases are for 10 to 15 years (in Singapore these lease terms would be nearer 10 to 15 months!). Almost all leases carry five-year upward-only reviews, whereas in many countries, rents are linked to economic indices and can go down as well as up.
The UK market is also highly transparent - in fact, the most transparent in Europe (and fifth-most transparent in the world). This is a measure of key issues like the maturity of the market, the accuracy of market and financial information, clarity regarding taxation and regulation, and the ethical standards of its professionals.
These factors, which make the UK market so attractive to overseas investors, should also reassure their British counterparts. They help explain the resilience of the UK market.
Finally, though, in the current climate, prices are unlikely to continue to rise significantly, comparing UK commercial property with equities and bonds through a capital-asset pricing model, it is anywhere between 15% and 25% under-priced, based on its cash stream and risk profile relative to alternatives. This is of course a comparison of the market as a whole, and there are important nuances between sector types of property (for instance, office, manufacturing, retail), geographical location and quality of property.
We take the view that the best returns are to be had in the added-value arena, where active management skills can be used to enhance yield and capital returns. Some prestige buildings and entry-level commercial properties are generally over-priced because of the demand from petro-dollar rich investors, and from inexperienced private investors looking for properties to put in their Sipp portfolios. It would not be surprising if these two areas of the market experienced a short-term correction. But that is a far cry from the bearish stance taken by some commentators.
Lessons from history are useful, but it is also all too easy to apply those lessons incorrectly by focusing only on the similarities between two periods and not looking at the whole picture.
With equity markets nearing all-time highs, many are beginning to feel a little apprehensive, and few professionals could predict with confidence that any asset class is likely to outperform in the coming few years. But based on our long experience of the UK commercial property market and the current economic climate, there are plenty of reasons why both international and UK investors will remain loyal to this asset class.