Is commercial property set to disappoint?

Next month's inflation report will no doubt be like every other inflation report - hopelessly optimistic. And that will cause problems for UK retail investors' favourite asset class.

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Well, the Bank of England didn't hike interest rates in the end - it'll be interesting to see what the quarterly inflation report reveals next week.

We can imagine that it'll say the same as every other inflation report for the past two years. There's a short-term spike in inflation for energy-related reasons - but once that's out of the system, it'll rapidly fall back.

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And like every other inflation report, it'll be hopelessly over-optimistic, which will mean interest rates heading higher than the market expects.

Thats bad news for a number of asset classes - including current investor favourite, commercial property

Paul McNamara is head of PRUPIM, a part of the M&G Group which has more than £19bn of real estate assets under management, according to Reuters.

Mr McNamara reckons that returns on commercial property will slow more quickly than the market expects over the next two years. PRUPIM has used derivatives to cut its exposure accordingly. He tells Reuters that annual total returns are likely to slip to between 6% and 7% this year, and around 4% next year. That's sharply down from the 18% to 19% seen during 2005 and 2006.

We've no quarrel with that - PRUPIM is just the latest in a line of commercial property groups looking to cut exposure to real estate, primarily because rental yields are no longer remotely attractive when compared to safe assets, such as gilts.

But the reality is that the picture could end up being far far worse. "6-7% and 4% are predicated on the notion that retail investors will hold steady. If they don't it could be worse," said McNamara.

So what Mr McNamara is saying, is that if people keep buying into commercial property, it will keep rising in value - but if they stop buying it, it might stop rising in value. That's not really a very sustainable prop for any market to be resting on - it's a bit like saying, "This company's share price will keep rising as long as people keep buying the shares."

Retail investors have been piling into commercial property like there's no tomorrow - it was the top asset class last year, and PRUPIM has been taking more than £50m a month from private investors.

As McNamara puts it: "Alongside overseas investors, retail investors have been the main drivers of the market. They have been very influential on the way up."

But if there's a slowdown, and retail investors realise that they can get better returns elsewhere, and pile out to chase some other market higher, then commercial property could suffer a much more rapid slowdown.

Of course, it's not just commercial property that's looking peaky in the UK - the residential market is looking very pricey too. In a recent survey for Reuters, of 25 economists asked, 15 thought UK property was overpriced, eight thought it fairly priced, and not one thought it was under priced. Interestingly though, very few thought there was much chance of a collapse in the coming year - perhaps because they dont see what will make investors pile out.

Our experts have a few suggestions - you can read more about both UK residential and commercial property in the latest issue of MoneyWeek, out today. We invited five property pundits in for a Roundtable discussion of their views on the housing market and their forecasts for price growth this year - it's worth reading for John Wriglesworth's comments on Jade Goody alone. Subscribers can download their copy here: Latest issue

And if you're not already a subscriber, you can get access to all the content on the MoneyWeek website and sign up for a three-week free trial of the magazine, just by clicking here: Sign up for a three-week free trial of MoneyWeek.

Turning to the stock markets

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The FTSE 100 closed 23 points weaker, at 6,346, as blue chips such as Unilever and Imperial Tobacco fell amid a flurry of corporate news and results. For a full market report, see: London market close (/file/25284/london-close-blue-chips-weak-as-us-struggles.html)

Elsewhere in Europe, the Paris CAC-40 closed 37 points lower, at 5,665, as investors took profits. In Frankfurt, the DAX-30 ended the day 38 points lower, at 6,876.

On Wall Street, stocks closed lower as warnings from banking giant HSBC that bad debts were on the rise in the US spooked investors. The Dow Jones ended the day 29 points weaker, at 12,637, as financial stocks such as JP Morgan and Citigroup weighed. The tech-rich Nasdaq and the S&P 500 both lost one point each to end the session at 2,488 and 1,448 respectively.

In Asia, the Nikkei jumped on strong machinery orders data. The index gained 211 points to close at 17,504 today.

Crude oil was trading at $59.90 this morning, whilst Brent spot had climbed nearly 3% higher to $58.25.

Spot gold rose above $660 in Asia trading on the back of the firmer oil price, but had slipped back down to $658.90 as of 0747.

And in London this morning, bus company FirstGroup announced that it would buy the operator of America's Greyhound intercity services, Laidlaw International, for $3.6bn. FirstGroup shares had fallen by as much as 0.3% in London today.

And our two recommended articles for today...

Seven reasons why the uranium price will hit $100 this year

- A six-week stalemate on the uranium spot price has finally broken - and there are multiple reasons why the price could now climb as high as $100 in 2007. To find out why the second wave of the uranium bull market is about to begin, read: Seven reasons why the uranium price will hit $100 this year

As goes January, so goes the year?

- Will the old investors' adage prove true this year? John Robson and Andrew Selsby of the Onassis newsletter read the January barometer - and see how it compares to the other leading stock market indicators. For their latest stock market analysis, click here: As goes January, so goes the year?

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.