Why the outlook is bleak for commercial property

I mention the British obsession with property so often in this column you could be forgiven for thinking I'm obsessed with everyone else's obsession. And in a way it's true.

However, my thoughts are less about property itself than about how the fact that it has performed so well for so long has made people think it will keep doing so.

In fact, the opposite is true. And this isn't just the case with residential property - the fantasy has now spilled over into the commercial property sector too.

Commercial property: good past performance

Commercial property has done stunningly over the past few years: in total it returned (in capital gains and rents combined) 18.3% in 2004 and 18.8% in 2005, according to F&C Property Asset Management, with the rate of return accelerating to 25% in the last quarter of the year.

This hasn't gone unnoticed by either small or institutional investors. They're all pouring money into it - last year a record £ 5billion - and fund managers, several of which have launched funds in the sector, expect to see more of the same this year.

But is investing in an area that has done so well such a good idea? Not if you believe, as I do, that things generally revert to the mean - periods of outperformance are usually followed by periods of dismal returns and the whole lot averages out. So if we were to invest in something such as commercial property we'd want to do so after a poor run relative to the average.

That time, however, is certainly not now: the average long-term return from commercial property is about 6%-7%, not 18%. To invest today you'd have to be convinced that there was good reason for the extraordinary returns of the past few years to continue - and for any mean reversion to be delayed.

Commercial property: geared to the health of the economy

Unfortunately, there is no good reason to think this. Commercial property is 100% geared to the health of the economy - if times are good, people want to rent offices, shops and warehouses and they'll pay increasingly high rents to be allowed to do so, but when times are bad they won't. And right now times are bad.

There has long been ample evidence that the retail sector is suffering, but last week there was proof of it in a survey from the Royal Institution of Chartered Surveyors. It pointed out that in the fourth quarter of last year the number of inquiries from retailers about leasing space fell at its fastest for four years with the biggest drop coming from central London. At the same time the amount of retail floor space rose at its fastest since the beginning of 2003.

The bulls say there is no need to worry, the office sector will take up the slack.

But I don't see how this can be true. The pain in the retail sector is simply a reflection of the dismal state of the UK economy and as such is probably just a forewarning of what is to come in the office sector.

The economy is growing at well under 2% a year, and given our uncertain housing market, stunted consumer spending and rising unemployment, it won't pick up any time soon. So why should demand for offices?

The bulls point to the fact that the government has hired an extra 660,000 people in recent years but we know that the hiring boom is over (the money's run out) and that all 660,000 of them have probably found places to sit by now.

Commercial property: vacancy rates are high

Next they point to the excellent profits being made in the financial sector and claim that this is boosting central London's office market as the big banks rush to hire. Again that sounds good but it is worth remembering that vacancy rates in London are still around 10% (even Swiss Re's rather amazing Gherkin building still has five empty floors).

Property consultant Driver Jonas says more than 4m sq ft of office capacity is set to appear in London over the next three years - and none of it has any tenants lined up. The banks will have to do an awful lot of hiring to fill that kind of space.

Add it all up and it doesn't seem likely that there will be much in the way of demand-driven capital gains in the commercial property market over the next few years.

The final thing stopping me jumping on the commercial-property bandwagon is the poor yields on offer. Low interest rates have been one of the main drivers behind the boom of the past two years. As rates fell in the UK, the income streams available began to look very attractive so investors rushed in.

But now prices have been rising faster then rents for so long that yields are not high but very low indeed - usually between 5% to 6% but often as low as 4%, according to Investment Property Databank. Hardly enough, one would think, to cover the costs of capital given that the base rate is now 4.5%.

Commercial property: you'd be better off with a savings account

So there you have it, yet another kind of property you really should be steering clear of. There's a strong risk of capital loss should interest rates rise sharply or should the economic situation worsen and the yields you can get in no way compensate for that risk.

The bulls say that buying commercial property isn't about capital gains but about securing a stream of income. But if all you are securing is 4% why not get a nice savings account? That way you can get 4.5% and you won't have to worry about losing your capital.

And as for all the companies launching commercial property funds, before you give them your money it's worth wondering if they have done so because they think they'll do well for investors or because they can use the good figures of the past few years to lure you in regardless. I think we all know the answer to that one.

First published in The Sunday Times, 05/02/2006

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You can read Merryn Somerset-Webb's views on investing in buy-to-let property here: Why you should still get a Sipp.