The property sector is not all doom and gloom

The Financial Services Authority this week issued a doom-laden warning of dark days ahead for the UK property market. Thanks for the heads-up, guys.

This warning might have been helpful if it had been issued in April, when evidence of a house-price bubble was everywhere, yet the FSA was still predicting another year of bumper growth for mortgage lenders and giving Northern Rock a clean bill of health.

Instead, the warning came after commercial property suffered its biggest monthly fall for 17 years, house prices were reported to have fallen three months on the trot for the first time since 1995 and the market for mortgage securities has virtually ground to a halt.

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So while the FSA makes statements of the blindingly obvious, the smart money is trying to work out how much of this doom and gloom is already in the price and whether there is a way to profit from it. In fact, the super-smart money has done very well out of the property correction.

Hedge funds such as Portland Capital, run by Sir Ronald Cohen, and Reeth Capital, have been betting against the market using the IPD index, which tracks a portfolio of 12,000 UK commercial buildings; and the HPI index, which does the same for residential property. Other hedge funds have made killings shorting stocks exposed to real estate.

As a result, the market is already discounting deep falls in the property market. The IPD index is indicating commercial property prices will fall 20%, while the HPI index is signalling house prices will fall 7% next year. Shares in listed real estate investment trusts, such as British Land (BLND), Land Securities (LAND) and Hammerson (HMSO), have tumbled this year by more than 30% and the stocks are trading at deep discounts to net asset values, suggesting investors are pricing in falls of up to 25% in commercial property.

Is this as bad as it gets or is there worse to come? There are three big risks. First, credit markets become so tight that investors can't borrow. This is what most worries the FSA, which reckons that many of the 1.4 million homeowners due to remortgage next year will struggle to find deals. That will lead to rising mortgage arrears and repossessions, and drive down prices further.

Second, investors start pulling out of the market, dumping assets at fire sale prices. That's more of a risk for commercial property, where a huge amount of hot money poured into the offshore funds during the boom is trying to get out again. So far, funds have managed to avoid forced sales by slashing unit prices and delaying redemptions. But for how much longer? The same threat hangs over the residential market, should buy-to-let investors decide to quit en masse.

Third, the economy goes into recession, leading to large-scale job losses, mortgage arrears, rising vacancy rates and no rental growth. That's the doomsday scenario, which is certainly possible, but goes beyond what most economists are forecasting.

It also goes some way beyond what is going on in the market, where demand for property remains high and rents are still rising, across most sectors. In commercial property, vacancy rates remain very low at around 4%. Usually, when vacancies fall below 8%, rents go up. In the City, which is most exposed to the credit crunch, vacancy rates for prime offices is about 2%.

As long as the economy doesn't dip into deep recession, the key issue is at what point new investors come into the market. The residential market should get support from armies of prospective first-time buyers desperate to buy a home. Similarly, there is a huge amount of money globally looking to invest in commercial property.

Yields on UK commercial property have only risen to around 5%, roughly where they were at the start of the year. Yet listed property shares seem to be discounting yields of more than 6% a level that only makes sense if you believe rental growth will grind to a halt. Unless you believe the UK economy is heading for meltdown, the FSA's warning could be a good buy signal.

Free trade

I may have been a little hasty last week when I listed the global political acceptance of free trade as one of five reasons to be cheerful. I wrote that before Peter Mandelson went to China and started threatening trade wars and before Hillary Clinton gave an interview to the FT in which she suggested she would abandon the Doha trade talks and perhaps review America's other trade treaties.

Perhaps the consensus in favour of free trade is not so robust after all. So that makes it all the more encouraging that Kitty Ussher, the UK City minister, has said publicly that she would welcome so-called Sovereign Wealth Funds, including the state-run investment funds of China and the Middle East, to London.

Usher seems to have grasped what Clinton has not; that when you are as deeply in debt as Britain and the US, you cannot be too choosy about the people you do business with. Both countries need huge amounts of foreign investment to make up for massive trade deficits. We're in too deep to back out of free trade now.