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Commercial Property Returns
Recent events in global credit markets have raised risk premiums across all asset classes and increased the downside risks to global economic growth. With the global economy set for a weaker period in 2008 following the rampant growth of the last four years, the returns outlook for UK commercial property has weakened.
Yields on commercial property are a function of the real interest rate, rental expectations and the risk premium which investors attach to the commercial property asset class to compensate them over and above a risk free rate of return.
The Bank of England have dissected the downward shift in yields in UK commercial property into its constituent components and concluded that a large factor in driving property yields lower since 2006 had been the reduction in risk premium attached to the asset class. Whilst strengthening fundamentals and wider risk management tools may account for some portion of this downward movement, the wider appetite for risk in credit markets appears to have played a significant role.
The sudden re-pricing of risk across global asset markets will undoubtedly raise risk premiums for commercial property putting upward pressure on yields. This adjustment is likely to be short and sharp in nature with the recent 50 basis point cut by the Fed likely to restore some calm to financial markets over the forthcoming months.
However judging from the re-pricing of risk in the credit markets which

is currently underway, commercial property yields are likely to end the year 30 – 40 basis points higher than at the beginning of 2007. A look at lower grade bond spreads suggests that a more marked re-pricing of secondary properties will continue, contributing to a return to more normal levels of spread between prime and secondary asset classes.
As such, RICS have shaved 5% from their annual return forecast for year end 2007 and 2008. This reflects modest declines in capital values over the next 15 months with annual total returns at 3% in 2007 and flat lining in 2008. RICS still expect a relatively soft landing for the commercial property market which stands in contrast to more pessimistic indicators such as those inferred from the current prising of real estate shares.
Property shares are currently trading at a discount of around 30% below net asset values suggesting that the market is expecting more significant declines in commercial property values than we are anticipating. Whilst both gearing and the impact of the wider stock market may naturally see the property share market underperforming the direct market, we expect to see some rebound in share pricing as more pessimistic scenarios pointing to sharp corrections, fail to play out.