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Sean O'Brien assesses the balance of influences
This time last year I showed that the Irish commercial property market offered fair value on the basis that the yield on property at 6.7% pa was more than sufficient to beat the risk free yield on long bonds at 5.3%, given projected medium term rental growth, taken to be 5% pa. Clearly the market has had a bumper year in the intervening 12 months so how stretched are property values now?

In fact, although property yields have dropped to 6%, bond yields have dropped even further to 4.4% thereby actually increasing the risk premium offered by property. This, on the face of it, makes property even more attractive: unless one were concerned that:

· Rental growth slowed rapidly and/or
· Long bond rates softened significantly.

Rental Growth
Rental growth, in the medium to long term, is very much dependent on economic growth (GNP) driving demand for business space and the supply of new space. As it appears to be difficult for economists, at this stage of 1999, to agree on the GNP growth figure for 1998, one can appreciate the degree of uncertainty about GNP forecasts for this year, which range from 5.75% to almost 10%. This makes medium to long term forecasting even more problematic. However, having regard to medium term, growth projections for labour supply (2%) and productivity (3.5%) it is not unreasonable to adopt the figure of 5.5% for medium term GNP growth as a floor for projecting rental growth. In fact rental growth is currently running at about 15% pa.

This is strongly supported by current market conditions characterised by:
· an office vacancy rate down to about 2%, reflecting a severe shortage of available space;
· tight supply conditions in the prime retail sector;
· keen competition for investment or funding opportunities that come on the market.

Bond Rates

At present, with the main European economies still showing little signs of growth and no sign at all of inflation, there is little risk of a rise in Euro bond rates, certainly none big enough to dent the property market in Ireland. In fact the European Central Bank is under renewed pressure to lower short term interest rates even further.

The outlook

In the longer term total returns from property in excess of 20% pa are not sustainable. However current values are certainly sustainable, given the strong income profile of property in a low interest rate environment. It is important to remember that the value of property, in a portfolio context, has two fundamental elements.

Firstly a secure or fixed income component, analogous to bonds, and secondly a growth income component, analogous to earnings growth. And because of the contractual nature and structure of commercial leases (upward only rent reviews) the secure income can be discounted at a long bond yield, plus a property risk premium of say 2%, to arrive at a value for the fixed component. The difference between this latter figure and current property valuations then represents the element of value attributable purely to the growth income.

The graph shows the valuation of Irish Life's pension property portfolio split between fixed and growth components, over the last 6 years.

At the trough of the last recession late in 1993 almost all property value was accounted for by the fixed element: in other words property was ex-growth. However, even after 5 years of rapidly accelerating rents, the growth element now accounts for only about 25% to 30% of total value. Accordingly the dominant risk to property values is that long bond yields will increase thereby depressing the value of the fixed income component. The secondary risk is that economic growth will evaporate, removing the basis for projected rental growth.

As stated above, the prospect of softening Euro bond rates in the foreseeable future is remote while the consensus view on continued economic growth is very positive, albeit at slower rates than in recent years. In conclusion, property is still an attractive asset going forward, in spite of recent strong growth.

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