Cash buyers won’t sustain commercial market for ever

Real estate investors should keep the champagne on ice in spite of rising hopes that the bottom of the commercial property market has been reached.

It is true that capital value decline in certain sectors has stopped, even reversed, for now at least. But to say the market is out of the woods, given what will be a damaging rental recession for property owners, is going too far.

After a torrid two-year valuation slump that has seen more than 40 per cent wiped from the value of the average UK property, it is understandable that some are reacting with glee to evidence of a floor in prices.

Deals are being struck for some London offices and even some properties in the hard-hit retailing sector at lower yields than at the beginning of the year.

Land Securities’ 1 Wood Street in London is under offer at a yield of close to 7 per cent, at a value of more than £100m, according to King Sturge’s James Beckham. He also points to Friary Court, which is under offer to a private Middle Eastern investor, again at just under 7 per cent.

These compare to the 1 Fleet Place deal by London & Stamford at the beginning of the year at 7.75 per cent. In today’s market, says Mr Beckham, the property would command a yield of 7 per cent or better. Talk has it that London & Stamford has revalued the building at 75 basis points lower than its acquisition yield.

Similarly, in the retailing and industrial sectors, buildings that offer long income are trading at stable pricing of about 8 per cent. Agents suggest that there has been a marked increase in demand over the past month chasing what is a relatively small amount of stock on the market.

This resurgence in pricing clearly reflects demand for a specific type of building: those with long leases to good tenants, offering relatively safe and stable rental income.

Such buildings look attractive for cash investors who are holding money in deposit accounts yielding less than 2 per cent. Property is seen as a potentially good parking space for cash in a zero interest-rate environment, particularly for cash-rich private investors.

It also makes a good hedge on inflation in the medium term for such buyers. On the flip side, if interest rates stay low, and inflation hovers at 1 to 2 per cent, it is possible there would be a return to negative cost of debt for property, as JPMorgan analyst Harm Meijer points out.

Simon Hope, a Savills director, says there is now competition for the better let retail properties being marketed by the agency, with interest leaking even to more secondary properties.

He is advising one client about to buy a supermarket in an affluent market town that has been let to a chain for 23 years. The deal will reflect a yield of about 6.3 per cent, an attractive return for the long-term investor who has £100m on deposit earning just 1 per cent interest.

Such deals are also attractive to certain funds, notably the German real estate vehicles, which are seeking actively buildings that meet their conservative requirements for cash flow, aided by the strong euro.

There are other reasons for more optimism, not least the rally of more than 50 per cent in real estate stocks over the past month. Shares preceded the market slump by several months in 2007 and so could be factoring in a recovery at some point this summer. Derivative pricing has also come in during recent weeks, albeit still pricing in a hefty fall of more than 20 per cent for 2009. Added to this, there is interest again at auctions, sometimes viewed as the canary in the coal mine for the investment market. Allsop’s March auction saw average retail yields hardening 40 basis points to 5.9 per cent.

Time to break out the bunting then? Not quite. These buyers are only part of a properly functioning market and it will take more to reverse the wider average trend, which remains resolutely downwards.

At best, there will emerge a two-tier market separating properties with secure long-term income from everything else. A building across the road from 1 Wood Street has recently been sold for about a 10 per cent yield – a 300bp difference in pricing based on the comparative length of income.

At worst, this could be a false floor caused by a cash bubble from some very specific buyers – and some very specific banks that are willing to lend only on the same long-leased properties for which investors are willing to pay cash. For everything else, bank doors remain firmly closed.

The investment market will not be sustained indefinitely by cash buyers and many investors are waiting for the return of more institutional investors before weight of capital means that prices can more broadly stabilise.

A functioning lending market is even more crucial. The fallout of defaults caused by breaches of covenants and problems with securitised loans are only just beginning. Bank deleveraging will take years to unwind. Lenders have only just begun the process of clearing their books, which means that distress among overleveraged owners has only just started.

In the meantime, it is clear that the slide continues in other parts of the market, particularly for property that has less than five years of income. This seems right given expectations of rapid falls in rents in the next two years as the recession hits occupier demand for property.

Capital value movements could be coming to an end as the biggest headache for the industry, but investors should be wary of returning too soon.

The threat of distressed property sales, the fall in rents – and the rise of over-renting – and a lack of any substantial lending to the market belie broader recovery hopes for now.

dan.thomas@ft.com