Comment: Swimming with the sharks


New Star's Stuart Webster says the decline in international property markets may have been exaggerated by irrational fears, but the fallout from the credit boom has exposed fundamental faults and the mispricing of risk throughout the financial system.

The Discovery Channel's annual Shark Week generates a short-term decline in visits to Florida beaches every year. The risk remains the same but bathers no longer swim. This is known as an 'availability heuristic' - the subversion of rationality by easily available sensationalist images.

Comparisons can be drawn with the European commercial property markets of late, particularly in the UK. While price corrections were overdue, the extent of the falls suggests that irrational fear played a part. Doomsayers sensed blood in the water and images were conjured of a property crash. The risk/reward balance, however, has remained relatively healthy, especially in prime property, and it is arguable that the falls were accentuated by sensationalism.

This supposition is, however, overly simplistic. The fallout from the credit boom has created deeper currents. These have the potential structurally to alter the way money is managed across all asset classes. If investors are experiencing a fundamental shift, then the focus should be on the conditions ahead.

Fundamental faults in the financial system have been exposed, with risk mispriced across all asset classes. The availability of cheap credit in recent years made it relatively easy to make money in commercial property. This attracted investors and a steep rise in valuations followed, particularly in secondary and tertiary markets.

This knocked the risk-pricing mechanism out of kilter. As financial market participants awoke to the credit boom hangover, debt quickly dried up and capital values fell. The question now is where investors will feel safest in the new debt-light environment.

Traditionally, volatile stock and bond markets have led investors to move into high-quality, tangible assets. For many this meant property, but has this relatively safe haven now been breached? The UK commercial property market has taken some of the early hits, but the question is whether these are fully justified and if they provide an indication of future movements of other established European property markets.

On a historical total-return basis, the performance of UK property remains compelling. Over the 15 years to the end of January, property produced stable growth, gaining 403 per cent against a 285 per cent rise for equities and 201 per cent for gilts.

Income levels were also supportive, with the initial yield on UK commercial property at 5.30 per cent on January 31, compared with a 3.33 per cent dividend yield on the FTSE All-Share Index and a 4.47 per cent yield on the benchmark 10-year gilt. It also compares well to returns from cash, which are trending south.

With the asset class having undergone a needed reversion to trend, the underlying assets are also in better health than many presume. The UK, particularly London, bore the brunt of markdowns but remains a core market for quality. Values may have got ahead of themselves, but sentiment appears to have contributed to downgrades overshooting the level justified by the fundamental characteristics of the sector.

International investors view the correction as a chance to buy into a fundamentally sound market at bargain prices. The vacancy rate for prime office space in central London was 3 per cent at the end of 2007, its lowest level since 2001, with annual take-up above the 10-year average.

In 2007, GBP17.2bn was invested in central London offices, the highest recorded annual total, with overseas investors acquiring GBP9.9bn. Activity did slow toward the end of the year, but there are reasons to question the doom and gloom. New Star's UK property fund has clearly experienced a shift in investor appetite back toward the domestic market in recent weeks.

Prime properties in established continental European markets provide similarly attractive opportunities. France, Germany and Italy stand out, although the full extent of the slowdown may be yet to come, with price movements in these markets lagging those in the UK. It is imperative to be in prime locations. Secondary markets in central Europe are likely to feel the credit drought most acutely.

Within the favoured markets of New Star's international property fund, Parisian office space is particularly attractive, with supply limited and demand strong. In Germany, recent industrial production data beat forecasts, suggesting the economy is in better health than expected.

The office sector in leading German cities is buoyant and high street retail space is experiencing steady rental increases. Retail space is also appealing in Italy, particularly in Rome and Milan, where demand from domestic and international operators for limited supply has maintained or boosted prime rents.

Established Asian markets should be a mainstay of a balanced property portfolio after the credit boom. While the risks are higher than in Europe, the rewards are commensurate. The decoupling argument is overshadowed by globalisation trends and a sustained US slowdown would affect the region, again making quality paramount.

In Japan, the labour market remains healthy, with December's unemployment figures below expectations. Land prices have surged in Tokyo and Osaka and vacancy rates have recently been falling. In Hong Kong, confidence is high in response to robust economic growth and thriving financial markets. Singapore is also being spurred on by positive sentiment. Financial service firms are stoking demand and, with supply falling short, rents are forecast to grow strongly.

As investors seek quality assets and markets, the reassessment of risk is also likely to spread to styles of investing. This will potentially direct investors toward funds adding value based on fundamental investing rather than through the use of financial engineering or excessive borrowing.

For property investors, blood in the water means risk is likely to take prominence in the risk/reward equation - which is arguably a good thing. The extent of markdowns on a global basis, particularly in the over-leveraged West, is yet to fully emerge, but investors are becoming increasingly aware of how far they have strayed from the shore.

The tangible asset base of property offers a welcome bedrock and has clear diversification benefits. In such circumstances, the property funds that are free of heavy debt burdens and can access international markets at different phases in their cycles are best placed to deliver the stable lower-risk returns that investors seek.

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