Leaner times loom for commercial property

"Shop 'til you drop" has been the mantra since the economy emerged from recession in the 1990s. So retailers have been scrambling to open new outlets and expand the square footage of existing stores, while supermarkets are busy with plans for more of the massive out-of-town developments that proliferated in the 1980s. The latter process halted a decade ago, when developers were told to focus on town centres instead, but Kate Barker's recently published Treasury-backed report into the matter suggests the current government is reversing that position.

Commercial property: retail rental values under attack

But just as the stores are looking to expand space, evidence is mounting that consumers are reining in their spending: a new report out from HSBC Global Research warns shopping centre rental values face "a three-pronged attack" from the imminent cyclical downturn in consumer spending, a development pipeline that will see an 11%-33% increase in floor space by 2010, and competition from supermarkets and the internet. This, it says, will cause an 8.5% correction in values in 2007-2008. A taste of what might be to come is offered by a few retail sub-sectors DIY, furniture and electrical goods retailers have cut back to the extent that 7% of their warehouse superstores lie vacant.

Commercial property: danger ahead for office rentals

It's a similar story with office rentals: there's huge enthusiasm today, but danger ahead. Norman Foster's iconic Gherkin' the Swiss Re Tower in London's City district has never been a big hit with tenants, yet reports suggest it could sell for £600m, or double its estimated construction cost. And last month, two Irish property magnates offered £400m for the derelict Battersea Power Station. More than a billion pounds has already poured into property funds this year, says Liz Phillips in The Observer.

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The amount of new office space coming onto the market will rise sharply next year and the "buzz around bricks and mortar" looks likely to go on, thanks to the launch next month of real estate investment trusts (Reits). Companies such as Hammerson and British Land plan to convert to Reits and take advantage of the tax breaks. The shares will depend on the value of the properties, their rental income and "market sentiment about their future performance" and that sentiment is positive.

Commercial property: are prices too high?

Still, is the fact that "cranes once again litter London's skyline" really a good thing? asks The Economist. British Land's retiring chairman, Sir John Ritblat, last month picked up £56.5m by selling 3.5 million of his 4.1 million shares just one suggestion that the smart money could be leaving the market. And as Investec Asset Management notes, it's not just "armchair contrarians" who have become bearish on the outlook for commercial property.

A growing number of experts and professionals warn that "prices are excessive and the market will break down" as they point to the fast-disappearing gap between property yields and costs of finance. Economics consultancy CEBR expects financial firms to be cutting back on staff by 2008 as the world economy slows which means many of the new buildings "will be opening just in time for the next wave of sackings". Office property can always be converted to residential use, so it may be better shielded if the business environment turns chilly but certainly, by next year, the rush by retailers from Debenhams to Next to build new stores and expand existing ones may not look so smart.

Which property stocks are most exposed to a downturn?

Shopping centres account for 80% of Liberty International's (LII, 1,317p) portfolio, making it a major potential casualty of falling rental values. Last month, the group raised £337.5m by selling 25 million shares - but these were priced at the bottom of the expected range. More ominously, it revealed that 20% of its ambitious 550,000 sq ft extension at Manchester's Arndale centre, which opened in September, had not yet been let out. HSBC suspects this is the first of a string of "vacancy issues" to come.

Less heavily exposed is rival Hammerson (HMSO, 1,507p); shopping centres account for a third of its portfolio, which is also made up of City and French office assets. The shares have recently performed strongly, leading some analysts to suggest taking profits ahead of a likely correction. Others think these concerns are overdone; as Hammerson is in prime locations with long leases, they are confident that there is still more mileage in the shares. A better bet could be Quintain Estates (QED, 878p), which, unlike many of its peers, is not rushing to convert to a Reit. Two of its core projects centre on London's continuing regeneration; the 70 acres surrounding the new Wembley stadium, and an 18.5-acre site, close to the former Millennium Dome. It trades on a p/e of 19, less than half that of its larger peers.