Downturn accelerated over the year

MARKETRETURNS:Driven mainly by a collapse in capital values, all property yields have increased from just 4 per cent at the end of 2007 to 5.5 per cent at the end of September 2008

THIS YEAR has been one which Irish commercial property investors will never forget.

After five years of stellar growth, total returns turned negative in the first quarter of 2008 and have plunged dramatically since.

Over the first nine months of this year capital values fell by 23.7 per cent, with the bulk of the price correction having come in the third quarter, compared to an increase of 5.8 per cent over the same period last year.

Dramatic falls in capital values have, however, marginally improved income return over the year to September 2008, at 4.7 per cent, compared to 4 per cent in the year to September 2007.

Analysing the drivers of total returns this year reveals an interesting story. The drag on capital values was solely down to the outward movement in equivalent yields. Yields increased by 34.8 per cent in the year so far, representing an increase of 141 basis points, the greatest shift seen since the inception of the SCS/IPD Irish index in 1984.

The increase in yields pulled down property values by 25.8 per cent in the nine months to September 2008. At the same time rental values improved, growing by 1.9 per cent.

Within the sectors, the retail sector has taken the brunt of the downturn in commercial property returns, with a year to date total return of -25.4 per cent compared to -19.4 per cent in office and -9.3 per cent in industrial property.

Retail, as the lowest yielding of the sectors, continued to suffer the lowest income return, but it was the dramatic fall in capital values that really brought down the total return. In the first nine months of 2008, retail capital values fell by 27.5 per cent compared to -22.2 per cent in office and -13.1 per cent for industrial.

Surprisingly, the retail sector has actually seen growth in rental values since the start of 2008 with an improvement of 3.2 per cent to September 2008. In fact, all sectors have seen rental growth in 2008 so far with office rental values improving by 1.1 per cent and a 0.9 per cent increase on industrial property. It is the increasing yields which have been detrimental to total returns, detracting -30.2 per cent from capital values on retail property, -24.1 per cent on office property and -14.1 per cent from industrial capital values.

The increase in yields and resulting fall in capital values has not come as a surprise to those involved in the property market. Cash-rich and debt-backed investors have piled into the market in recent years driving up capital values and consequently pressing down yields. Property yields were compressed to unsustainable levels, below the risk-free rate in many cases, making property only attractive to speculative investors expecting increases in values to outweigh the low income return.

The correction in yields reflects an adjustment to more sustainable levels. What has come as a surprise to some is the speed of the correction. All property yields have increased from just 4 per cent at the end of 2007 to 5.5 per cent at the end of September 2008.

UK commercial property has seen a similar change of fortunes, with a dramatic downturn after a sustained period of growth. In the UK, the downturn came in mid-2007. The first negative total return was seen in the third quarter of 2007, whereas Ireland did not see a downturn until the first quarter of 2008.

However, so far, from peak to trough, both markets have seen very similar movements with total returns in the UK at -18.2 per cent since June 2007 and total returns in Ireland at -21.2 per cent since December 2007.

Looking at capital growth the UK has seen a fall of -23.3 per cent, whereas Ireland has seen a drop of -23.7 per cent in capital values. However, in both countries rental growth still looks surprisingly robust, with improvements in rental values in both countries over the year to date.

Office rental values have fallen in both countries in the third quarter of 2008. However, the weak economy is likely to have an effect on the occupier market and therefore rental values - this is a significant risk to commercial property returns in the near future.

• Angela Sheahan is head of indices at the London-based Investment Property Databank (IPD) which is a global provider of performance measurement for the property industry