Focus on cash flow over capital appreciation

The sustainability and management of cash flow is the key consideration for investors these days, writes Aidan O'Hogan

THE NATURAL tendency when reviewing the outlook for any property market is to focus on capital values, but this is to lose sight of what is probably the most important fundamental of all - the sustainability and management of cash flow.

The recession of 1973/74, triggered heavily by a dramatic and rapid increase in the price of oil and rampant inflation, came early in my career, but serves as a permanent reminder of the far greater importance of cash/income flow than capital value.

Capital values across the market at that time, fell by anything from 25 per cent to 50 per cent within a matter of months, and interest rates climbed rapidly, with many commercial loans rolling over from month-to-month at rates comfortably above 20 per cent.

In effect then, there was no market for sales, as the difficulties of securing finance, its cost and a general lack of confidence all combined to ensure a standstill. Instead, the focus was on cash flow generation, mainly for those fortunate enough to be holding buildings, rather than sites, through letting programmes. Those who successfully managed this process survived to fight another day and await a more vibrant market in which to realise capital and discharge their borrowings.

The similarities of that downturn to what is happening today are notable except for one critical element - that of interest rates. We now find ourselves with relatively modest rates and a greater likelihood of them declining than increasing.

Against that background looking at today's market, I foresee a period of temporary stagnation during which the general pattern of rents will either plateau or decline by modest margins.

Clearly many prime locations, with limited supply, will outperform this and continue to be in positive territory, but equally there will be areas of oversupply and more fringe locations, and in those situations the decline in rents may be more significant.

For the future, we can expect that the driving force for rents will be influenced to a much greater degree by the business generation potential of the location rather than by the scarcity of supply. Once it is generally clear to the market and to potential occupiers that further new speculative supply is unlikely, the stage will be set for a broader recovery in rental growth.

The wall of highly leveraged private investor cash looking to enter the market has all but disappeared. As many investors lick their property and equity wounds, and stretch to find further equity to prop up their contracted loan-to-equity thresholds, the returns on cash which are available look, understandably, much more attractive than the somewhat challenged liquidity of further property investment at a time of limited rental growth.

Yields, which have already been seen to move out at least 50 to 100 basis points, will in the short term move out at least as much again. And, in the present inadequately funded market, any forced selling could see them move out further, to reflect a significant risk premium above deposit rates.

In itself, that factor, although negative, will have a beneficial impact on the market in reducing new supply, as the prospective exit yields for many proposed developments will be inadequate to satisfy lending institutions or sufficiently reward the development risk.

Later, the consequent reduction in newly developed investment properties and an accumulation in savings should drive yields back down closer to the norms of the last two decades - although it is unlikely that heady record lows of the last five years will be seen again for some considerable time except in very prime locations.

Large lot sizes outside of the main city locations may also prove challenging. It is already and, for the short term will continue to be, a "tenant" or "buyers'" market and a time of opportunity for those end-users with the confidence to see their way through this storm.

To date, few appear to have had either the confidence or the vision to exploit this, but it may only take a couple of opportunistic concessionary tenant or purchaser deals to trigger such an appetite.

However, I believe that window of opportunity may be shorter than many might reasonably expect. The period of market stagnation will, in all likelihood, blend into a stage of adjustment and consolidation in which the market will get back to basics with the padding around deals to artificially boost headline rents being stripped away.

The market for commercial property investment has encountered numerous storms like this over the last 150 years and come through them on every occasion stronger than before, albeit after bumpy and sometimes quite painful, but never desperately prolonged, rides.

We need to acknowledge that the Irish experience, in recent years of very rapid and highly visible capital appreciation from year-to-year and at times from day-to-day, is the exception rather than the rule.

A repeat of the last decade's extraordinary value growth in commercial property is only likely on the back of some very significant economic transformation - a prospect desirable but improbable from where we stand today.

So it's back to basics: in the short term, the management of cash flow to satisfy and contain the lenders; in the medium term, a very strong focus on real end-user demand, quality of product, location and asset management; and in the longer term, prudent judgement of timing the exit and entry points.

You rarely go bust taking a profit!

• Aidan O'Hogan is chairman of Savills HOK