The optimism that surrounded commercial real estate funds from 2005 to 2007 has found the past two years to be depressing. The benchmark Investment Property Databank (IPD) monthly index peaked in July 2007 as investors committed large sums of money into real estate investment trusts. The asset class has since suffered serious setbacks, with the IPD Index dropping more than 35%, faster and sharper than the 1990 to 1991 property downturn.

There are indications, however, that the commercial property cycle is bottoming. A bfinance poll asked a large universe of property managers which sectors and countries offer better prospects to investors. Ten large property managers responded (see list at end) by providing their return forecasts for office, retail, industrial and residential property in 10 geographic regions for each of the next five years. Return forecasts reflect yield income and capital appreciation.   

Our results show considerable difference between high and low forecasts, most noticeably in the office sector. The range in 2010 was 34% for Spain: the lowest forecast is -30%, the highest is 4.4%. This compared to 20% for the UK, with Canada showing the smallest variation, a reflection of its relatively resilient economy and stable property market. The office sector is also expected to be one of the worst performers in the near-future. “The variations reflect the fact that we are at a turning point,” notes John Buckley, property economist at Aviva Investors. “The second leg driving our forecasts is what is happening to rents and income received, and here, there is still a lot of pain to come in some markets.”

Overall, office space is expected to provide the lowest average returns among the four sectors in 2010 and 2011; however, it is set to outperform residential, industrial and retail starting in 2012. In the near-term, the worst performer is Spain, where the average forecast for office is for a loss of 8.06% in 2010, followed by the Nordic countries, which are expected to post a loss of 1.08%. France is next with a small projected loss, followed by modest gains in Germany and US. The average projected return for the UK office market in 2010 is 4.75%. The UK was the most over-priced office market two years ago and also the first to re-price.

Projected UK Returns

Negative near-term catalyst

The office market is expected to be adversely impacted by rising unemployment in Europe this and next year. The segment is projected to shed its underperformance status in 2010 and offer the best returns in 2013 fuelled by an economic recovery and higher payrolls. Our forecasts confirm that this change will take place earlier in the UK than in other countries. The exceptions are developing Asia, emerging Asia, and Canada, where the outlook for office remains relatively better in the shot-term. In Canada, which will likely lead all industrialised nations in economic growth in 2010, the average return for office is 5.40%, almost the same as industrial and ahead of retail and residential. In 2011, the office sector is expected to outperform with an average expected return of 8.17%.

We also asked our respondents to comment on their projections. “We expect the bottoming of the property markets to start in the near future,” says one property fund professional. “The UK has seen the first signs of stabilisation, leading the way in Europe. It is followed by France. Regarding property type, we expect office markets, which have suffered the most, to show the strongest potential to recover.” In the US, the average forecast of our respondents shows office returning 10.24% in 2013 compared to 9.32% for retail, 9.01% for industrial and 4% for residential. Office also recovers sharply in Spain in 2013 with an expected return of 14.97%. It is the second best performer in the Nordics after retail, while the best performer in the UK (12.31%), Germany (9.41%) and France (13.85%).

Projected Spain Returns 

The Paris commercial property market, which has the most office space after Tokyo, is already showing signs of recovery, following its worst year for investment in at least a decade as falling prices revive demand from French insurers and German mutual funds, according to Bloomberg. Paris is attracting property investors after prices dropped as much as 40% in the last 20 months. Landlords in prime central business districts can now expect rental income to equal 6% of building values or more compared with about 4% at the end of 2007, estimates Jones Lang LaSalle Inc. Our results show that office space in France is expected to return - 0.07% on average in 2010; however, its prospects improve markedly in 2012. The same trend can be observed in Germany.

Projected France Returns

Two property markets

“An important trend we expect to emerge in real estate is for there to be two markets: one for good quality prime assets and a non-prime market which will suffer more,” notes Alessandro Bronda, head of Global Investment Strategy at Aberdeen Property Investors. “Our forecasts are for the prime market. For the UK, capital values at the prime end have stabilised. There is even now a little bit of yield compression emerging in Central London for top quality buildings. The risk-premium for investing in prime property in the UK has been re-established. In addition, if you are a Euro zone investor, the British pound is much cheaper than 18 months ago. While the UK looks good, I have to stress that the rental outlook is very bad in the short term for commercial property. If you buy now, you can get in cheaply and expect some yield compression in the coming three to four quarters. It is really a yield play.”

The downside risk to Bronda’s forecast is a weaker than expected economic recovery. Another risk is how future covenant breeches by real estate investors will impact banks and lending institutions. In a scenario where banks force property investors to dispose their real estate assets at distressed prices, yields will move higher. Forecasts could also be adversely impacted should central banks begin to raise rates too quickly, tempering the strength of the recovery. In addition to Aberdeen and Aviva, Delta Lloyd Asset Management, RREEF Investment (Deutsche Asset Management), SEB Investment, Invesco Perpetual, PGI, Cordea Savills, Fortis Investments and LGIM participated in the poll.

Property Performance Tables 2009

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