Standard Life Savings & Investment Ezine

Standard Life's Savings & Investment newsletter for advisers

Issue 1: Oct 2006

Past performance is not a guide to the future. The value of investments can fall as well as rise. The views expressed in this article are those of the author and do not necessarily represent the views of Standard Life.

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 in the short-term, yields are likely to fall slightly further, driven by strong investor sentiment, the sheer weight of money looking to invest in property, and good rental growth prospects in some sub-sectors.

Market perspective
The economic outlook remains relatively supportive. Rental growth should average around 3% for 2006 with the potential for it to pick up from 2007. This is likely to be driven by the Central London office market where significant rental growth has begun.

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.

There is a natural concern that further reductions in property yields increase the risk of a correction at some point. We don't believe this is an imminent threat, but the potential for any such correction increases from 2007 especially against the prospect of somewhat tighter liquidity conditions.

Sectoral shift
As expected, offices have taken on sectoral leadership from retail, led by the Central London markets. Fundamentals have also been improving in some key Thames Valley and M25 office markets, illustrated by stronger take up, and falling vacancy rates. Many of the major regional office markets have also experienced good take up and some improvement in rental levels.

On industrials, the south east markets look to offer best prospects though we do not expect industrials generally to be able to show similar levels of rental growth to the office market. On retail, the outlook is not particularly strong although retail warehousing is attractive.

Why invest?
Once drawn to commercial property, investors discover that there is more to the asset class than just good performance.

Having a low correlation to equities and bonds, commercial property is an ideal portfolio diversifier and a powerful portfolio 'stabiliser'.
Investors seeking a high, steady income find commercial property investment a very useful provider.
Commercial property has historically shown lower volatility - values tend not to fluctuate as frequently or to the same degree as, say, equities or bonds.
Investor confidence is boosted by the tangible nature of property investment. You can see where your money has been spent.

Outlook
The outlook for commercial property continues to remain attractive and is on course to deliver total returns of around 15% 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 6% - 7%.

John Wilson, Head of Property, Resolution Asset Management

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