Offices A Top Performer
Offices are set to be the best performing commercial property investment in 2007, according to the latest research from Lambert Smith Hampton.
Based on an upturn in occupier demand in most office markets across the UK, LSH is predicting that the office sector will see total annual returns of 14.3% in 2007, ahead of industrial at 8.8% and retail at 6.4%.
Ed Jones, director and head of investment agency in LSH’s Birmingham office, says: “With yields expected to move out slightly on secondary assets over the coming months, we expect total returns in commercial property to be lower than in the past two or three years. However, rental growth is likely to offset this, particularly in the office sector.”
According to John Dillon, associate director and head of office agency in LSH’s Birmingham offices, stronger take-up has led to Grade A stock now being in short supply in many locations. Developers are addressing this shortage, though there is an inevitable ‘lag-time’, before new developments come on stream.
He says: “The outlook for the office market remains positive as demand for new and high-quality space remains high and pre-letting activity helps to keep availability rates down. Given improving market conditions, we have upgraded our forecasts of rental growth for the office sector as a whole and now expect rents to rise by 8.2% in 2007 before growth falls back to around 7% in 2008.
This growth is especially evident in Birmingham, where pre-lets for buildings which will be completed in 2008/09 are already rumoured to be achieving rental levels of £32 - £33 psf, well ahead of the current record of £30 psf for existing stock in the city centre.”
While the office sector is likely to perform well, conditions are more difficult for the retail market and LSH expects rental growth in this sector to slow down to around 2% this year.
Dominic Brown, associate director in the retail agency department, says: “The sector has performed better than anticipated and there have been some selective areas of rental growth. However, given weaker consumer spending, there are concerns about the structural changes that are affecting the high street. These include additional offerings by supermarkets, more business being taken by the Internet (which has been particularly difficult for book, music and travel stores) and competition from out of town shopping centres.
Another sub-sector which is likely to be affected is bulky goods retail warehousing, DIY, furniture and electricals. Saturation of DIY and furniture stores combined with the slowdown in housing, as a result of recent increases in interest rates, may decide the fate of this sector in the coming months.
Overall, increased competitive pressures are likely to squeeze the middle market further and create polarisation between value and aspirational retailing. To complete successfully, shopping places will need to meet three main challenges; convenience, differentiation and social responsibility.
In the industrial market, demand continues to be driven by distribution, Nick Ford, director and head of industrial agency says: “While the rise of internet shopping, improving trade and diversification of supermarkets into the white goods market will provide opportunity for further growth in the distribution market, rising interest rates and a strong pound are likely to hit the manufacturing sector. On the whole we expect industrial rental growth of 1.4% in 2007, while distribution is expected to outperform with 2.4% growth.
Will Rate Rises Bite?
Victor Ktori, head of the commercial department at the Nottingham office of Savills comments: ‘We are holding firm on our forecasts of

7% this year because the market can probably withstand a brief spell at 5.75% base rates. But the final quarter will slow if they stay there too long.
The latest news that CPI inflation is up above its target range at 3.1% and retail price inflation edging over 4.6% means that the financial markets are anticipating a further rise in base rates. One year LIBOR is now over 6% which means that expectations are of a 50 basis point rise from the current base rate level of 5.25% rather than the further 25 bpt that we factored into our forecasts at the end of last year. Our last briefing note on this subject warned that a prolonged spell with interest rates at or above 5.5% could put the brakes on growth rates in the UK housing market.
Our take on the importance of mortgage borrowing and the increasing use of equity in many mainstream markets makes us more sanguine regarding the impact of interest rate rises but the effect of a 50 bpt rise for a prolonged period would derail our forecasts and lead to lower rates of growth. Our forecasts for this year are 7% in mainstream UK markets, 20% in prime central London and 15% in prime Home Counties country house markets.
These forecasts allow for a brief increase in base rates to 5.5% and could probably withstand a brief period at 5.75% but only providing consumer expectations were for an imminent reduction in the near-term. If interest rates do stay at 5.75% to year end, with no expectation of reductions, then we anticipate a slower market and lower house price growth during the remainder of the year.
Even a prolonged spell at 5.75% base rates wouldn’t lead us to predict falls in house prices. We believe that the role of equity in the market and the robustness of affordability are under-estimated by most housing market analysts. We continue to believe that the household capacity to spend on housing is higher than many commentators presume. Our analysis of household finances and housing costs suggests that there is still a surplus in most UK households that will act as a cushion against house price falls.
The danger point comes when interest rates hit 6.5% and this cushion disappears. At this level of interest rates, mortgage repayments cost the average household so much that there is no surplus income left at all to pay for more than basics (food, clothing etc.). Even at this point, it takes a while for house prices to fall. Most impecunious households will stay put, some will adjust their mortgage repayment terms and others will dig into savings and reserves.
The first casualty of this level of affordability squeeze is turnover. In the last property downturn, the household income surplus actually turned negative (i.e. households were in deficit after basic spending and housing costs) before house prices fell. Interest rates of 6.5% increase the risk of negative house price growth. It is at the point where interest rates exceed 6.5% for a prolonged spell that substantial house price falls appear inevitable.
We continue to say that it would take expectations of further, long lived and significant interest rate rises to substantially affect residential property demand. If it looked like interest rates of between five and six percent were to become the norm then we would downgrade both our current and longer-term forecasts significantly downwards.
Our expectation, in line with the money markets, is that the longer term average will be between four and five percent. If the markets are wrong, then we would anticipate a downward adjustment in the value of many asset classes, not just property, over the medium to long term. For the UK property market, in the absence of harsher economic conditions, this would probably take the form of a long period of no growth and low turnover rather than the spectacular falls predicted by some.”