Commercial property: a good contrarian bet?

Whilst some are claiming the shaky UK property sector is a good contrarian play, you can find better value abroad, says Eoin Gleeson.

"Canny investors often make a killing by going against the herd," says Paul Farrow in The Daily Telegraph, "so could this mean that there is a buying opportunity for contrarian investors in the crumbling British commercial property sector?"

In a word, no. And no again. This is most definitely not the time to be betting on UK commercial property. According to Jones Lang LaSalle, the world's second-largest commercial real-estate broker, transactions in the UK slumped 60% in the final quarter of 2007. Appraisal values are falling at a record rate as commercial real-estate outfits slash the value of the offices, shopping centres and warehouses that they can't shift.

As Will Hill of Schrder Property Investment Management told Bloomberg, finding a buyer at a high enough price is like "grasping an eel". Banks have suddenly developed a phobia about lending, which means just as is happening in the residential market the money to back commercial property purchases just isn't there.

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Given that kind of backdrop, how could the UK commercial property market be worth investing in? Farrow takes his lead from no less a contrarian than Anthony Bolton, who revealed recently that he bought into a number of British property stocks just before he retired because "the sell-off of listed property firms looks overdone".

It's not hard to see why Bolton is attracted to the stocks in all, stocks in the UK real-estate sector have fallen by an average 40% in the past year. Some real estate investment trusts (REITS) have taken such a pasting that they're now valued at discounts of 30% or more to their net asset values (NAV). And when you take into account the 6%-8% yield that some commercial property funds pay out, says Farrow, there's a case for making a play on one of the "ship-shape" funds that have simply been dragged into the mire by their association with property.

But there's every reason to believe that the sizeable discounts commercial property funds are trading on could widen further. Any fund with a high level of gearing is going to have an almighty struggle to stay inside its borrowing limits, as investors claw back their money and banks tighten up on lending criteria. And the banks' wariness is set to continue for some time. $90bn in US mortgage investments has already been written off, but Goldman Sachs reckons that there's another $300bn or so of toxic loans in the pipeline. Banks have a lot of mucking out to do yet.

Even those funds that are light on debt will still suffer as property prices fall. Just as the market is taking a nose-dive, consultancy CB Richard Ellis reckons that new offices are being built in London at their fastest rate in two decades. Talk about bad timing. Research group Capital Economics estimates that prices for commercial properties have already slipped 15% since their peak last June. And Barclays predicts they could fall 30% over the next three years. As Peter Hobbs of Deutsche Bank put it to Bloomberg: "The UK market is falling apart... [it may] suffer the biggest annual losses in more than 25 years".

But that's not to say you can't find value in the commercial property sector. You can just not in the UK. Mick Gilligan of Killik likes the look of Matrix European (MERE), a REIT listed on the main London market and largely invested in commercial property in Germany, Austria and France. The trust is trading at a 30% discount to its NAV and offers an 8% dividend yield.

Or it might be best to go even further afield and tap into the commercial market in Hong Kong. As Tim Bennett pointed out in last week's issue, the economy on the tiny island is very healthy at the moment, with rents in central Hong Kong climbing 28% in the first nine months of 2007. Champion Reit (HK:2778) offers exposure to offices in the financial district and pays a 7.5% dividend yield. It's valued on a p/e of 8.4. Prosperity Reit (HK:808) is another way to play office property in the city state. It's valued on a p/e of 6.2 and offers an 8% dividend yield.

Eoin came to Money Week in 2006 having graduated with a MLitt in economics from Trinity College, Dublin. He taught economic history for two years at Trinity, while researching a thesis on how herd behaviour destroys financial markets.

Eoin acts as managing editor of MoneyWeek's newsletters.