It is predicted by the RICS that commercial rents are poised to rise as the economic recovery gathers pace and the commercial property market is expected to see further good returns to investors in 2004.

The economy has shown significant improvement over the past 9 months, with the annual pace of growth accelerating in the first quarter of 2004 to the highest in the 3½ years. The rebound has been fairly broad based. Consumer spending and business investment are both rising, though the performance of export and manufacturing has been quite disappointing due to the UK’s dependence upon demand from a sluggish euro area economy. However, even in these areas there are positive signs coming through from business survey evidence.

The rise in business spending is a positive indicator of confidence coinciding with good growth in corporate profitability and is a harbinger of improved labour demand. Indeed, full time permanent employment positions have been rising in early 2004, partly reversing some of the falls that occurred through last year. As such, the prospective for the commercial property market have improved markedly, with chartered surveyors reporting business enquiries for space up in the first quarter at the highest pace since the peak of the stock market in early 2000.

Indicators from the RICS commercial property survey suggest that market conditions are responding to higher demand and the better economy, with available space falling in the office and industrial property sectors in the first quarter, however, the downturn in vacancy rates is from a fairly high level for certain sectors, like London offices, and will keep a lid on rents even as demand strengthens. Even without significant rent rises, commercial property is likely to enjoy a strong acceleration in financial returns as investors continue to diversify portfolios away from equities. The relatively low volatility and better returns on commercial property compared to equities over the past 5 and 10 years, will keep investor interest strong, despite renewed strength in equity prices in the past year.

Real rents are only likely to bottom out in mid 2005, although the decline from peak to trough will be around 3% in total over a 3½ year period. For the office market, which has seen the largest downturn in the past 2 years, declines are still much milder than in previous downturns. The moderate fall in rents reflect a very stable economic cycle. Whilst the slowdown in the financial services industry/telecommunications has hurt some markets, the strength of the wider economy has compensated.

Moreover, real rents are still 15% higher than the trough of 1994. This also contrasts with the early 1970s and 1990s during which periods real rents ended lower than the initial starting point of the boom or had given back the majority of previous rises.

What are the prospects for rents? – The global economic recovery is gaining traction with a long awaited rise in US employment apparent in early 2004. This augurs well for growth in the world’s largest economy and points to better demand prospects in the UK. As such real rent rises are quite possible again by the end of 2005. The key factor underpinning rents will be stronger increases in employment within the private sector. The UK construction cycle alone is unlikely to prevent rents rising although will help to moderate the upturn. The RICS expect overall rents to rise 0.9% in 2004 and 1.3% in 2005, compared to a 1.2% fall last year. The risks to rents are on the upside as global growth is showing an acceleration according to survey evidence for both the service and manufacturing sectors.

The comparative stability of the real rental cycle in contrast to previous decades has surprised investors. Investors valuations of the market worsened (pushing yields higher) for almost 2 years in the aftermath of the stock market crash. However, pre-emtive monetary policy loosening together with reflationary government policy has limited falls in rents, giving investors confidence to re-enter the commercial property sector. Geo-political uncertainties and fears over the value of pensions have also enticed investors into the sector, with yields in early 2004 down to the lowest level in 14 years.

Last year, the market was buoyed by foreign and private investor demand, with the latter using low interest rates to get a foothold in the market. Borrowing costs are set to rise into 2005 due to fully fledged global recovery, removing some of the positive stimulus to demand. Investor interest for property may also wane if the equity market shows signs of a sustained upturn, following strong outperformance of 2003.

However, the performance of the commercial sector is still substantially better over a 10 year period and for equities, giving investors a 174% return compared to 81% for the latter, also, volatility of return has also been much less though this is partly because the UK has not experience a recession over the period. As such, we expect investor interest in real estate to remain firm, nudging yields lower and capital values up as funds continue to diversify away from equities. Total returns for commercial property will rise to 11.5% in 2004 compared to 10.9% last year. Looking ahead to 2005, both higher interest rates and slightly slower economic growth will lead yields to stabilise, curtailing the returns on commercial property to less than 10%, but still remain positive.

Ewen Sparks : e.sparks@shepherd.co.uk

Source: RICS Policy Unit – www.rics.org.uk