Britain can avert property crash despite growing risks

Britain can avert property crash despite growing risks

Focus turns to business property market in UK amid US subprime crisis

(LONDON) A UK commercial property crash this decade is a growing possibility as borrowing costs rise and as a cold wind begins to blow through the white-hot market, but the risks are still small, despite growing nervousness.

The broad consensus is for UK commercial property returns - which combine rental income and capital growth - to halve this year and to halve again next year.

'There has to be a significant slowdown in returns but the scope for any sort of crash in the true sense of the word is limited,' Nick Tyrrell, head of research and strategy for European real estate at JPMorgan Asset Management, said.

As the US subprime mortgage crisis has unfolded, reminding investors of the risks attached to bricks and mortar, so the attention in Europe has turned to Britain's commercial property market, which is expected by property valuers and analysts to decelerate sharply after a protracted boom.

The broad consensus is for UK commercial property returns - which combine rental income and capital growth - to halve this year and to halve again next year, after three exceptional years in which the market averaged 18-19 per cent a year.

Rental income is expected to account for a greater share of future property returns, as prices stabilise or even ease and as interest rate rises make debt-funded purchases of UK property increasingly unprofitable.

The dangers are reflected in the UK property derivatives market, where spreads have fallen sharply this year and where zero capital growth was priced in for next year, traders said.



According to investment bank Eurohypo AG, capital returns on UK commercial property have averaged less than zero in only five years since 1971 - and four of those were during the country's last property crash in the early 1990s.

Capital preservation has also become more of an issue for some funds, in anticipation of a tougher investment climate. The Henderson UK Property Fund, for example, has switched its focus to higher-quality buildings in prime locations with prime tenants from slightly higher-yielding secondary property assets.

On the surface, the market appears increasingly vulnerable since average UK property yields have fallen below 5 per cent from more than 7 per cent in 2001 as property prices have boomed, while the Bank of England has raised rates to 5.25 per cent.

Yields on a property measure rental income relative to capital values.

In a note last month, Kelvin Davidson of independent forecaster Capital Economics said the threshold for UK property prices to begin falling was closer than commonly thought. Worse still, he said little was needed to trigger a crash, which he defined as a cumulative 10-15 per cent fall in property prices over three years.

One possible catalyst was for the gap between UK property yields and yields on 10-year UK government bonds to revert to 2005 levels by 2010, by moving to a positive 120 basis points (bps) from about minus 20 bps, Mr Davidson calculated.

Another was for the property/gilt yield gap to widen by half as much and for yields on 10-year government bonds to rise to 5.25 per cent from 4.95 per cent and stay there, he said.

Neither scenario was wildly unrealistic and depended on the inflation outlook changing a little and economists factoring in more than just one more UK rate hike.

'The risk of a hard landing is non-negligible and, given that even small shifts in sentiment and/or interest rates could have such large effects, monetary policy holds an important key to the property market's future,' Mr Davidson said.

Nonetheless, Capital Economics's central forecast is for no meaningful falls in commercial property prices over the next four to five years, in line with the vast majority of other forecasters.

'We still think a significant correction is very unlikely,' said David Wiley, head of UK economics and forecasting at property services firm CB Richard Ellis (CBRE). 'A soft landing is our central view and beyond that it looks fairly steady.'

Mr Wiley said that CBRE was looking for total returns above 10 per cent this year and 6-7 per cent in 2008 and 2009, placing it above the consensus, according to Investment Property Forum. He also said he was not minded to change these forecasts in the absence of an external trigger, such as a marked deterioration in the US property market and economy.

Underpinning his confidence and that of others was the strength of the UK economy, which was fuelling tenant demand for office space and was also set to keep demand for retail and industrial space ticking along, even as new buildings went up.

London's office market, especially, was benefiting from the city's expansion as a global financial services hub.

'If the timing works out nicely you could actually accommodate a reasonable drifting out of (property) yields and still have robust property returns because rents are growing, and there is a fairly good chance that that will actually happen,' JPMorgan's Mr Tyrrell said. 'So you wouldn't get a decline in values, all you'd have is rising yields but rising rents at the same time.'

The alternative, he said, was for yields to remain flat or to continue falling as rents improved, risking 'a substantial decline in capital values several years out from now'. - Reuters