Both the commercial and residential property markets face headwinds given the state of the economy — but volatile markets deliver excellent buying opportunities.

The performance of any asset class is always relative. In other words, it can perform strongly for the simple reason that alternative asset classes look unattractive to investors. To some extent this explains the strong performance of UK commercial property of late.

Over the past year, according to a report by the Investment Property Databank published in August, UK commercial property, comprising of industrial, retail and office, returned 8.9%, with yields, at an all-property level, at 6.3%.

In the UK, we have issues of our own of course, such as a stagnant economy, the threat of rising unemployment, stubbornly high inflation and as seen in the August riots, unprecedented social unrest. Despite this, our overall position — in part due to the Government's robust deficit reduction plan — is perceived to be relatively stable. Compared to other asset classes — equities and government bonds, especially in the Eurozone — UK commercial property is a relative safe haven and this is reflected in its out-performance. Investors have been buying it up in their droves, sending prices north.

London and the rest

Of course, when you talk about UK commercial property, you are essentially talking about a two-tier market. There is London and the South East, which have a far stronger 'local' economy and are supported by international investment — and there is the rest of the UK.

There is currently a strong, almost unprecedented divergence between these two geographic markets. In its latest outlook on UK commercial property, Cluttons estimates that the disparity between prime and secondary yields currently stands at a record 400 bps (basis points) — and will widen further during Q3 as prices continue to weaken in poorer quality markets outside of London with significant occupier risk.

At the same time, it reminds us, such yield disparity will throw up opportunities. There will, after all, always be exceptions to the rule within the secondary market: high quality properties in good locations that are very under-priced relative to a medium-term recovery scenario.

Sub-sectors

The recent spate of big name high street insolvencies says all you need to know about the state of the retail sector. Consumer confidence and disposable incomes are both very low and could fall further as unemployment rises in at least the short term. People not spending or spending less will hit retail hard. As discussed above, the secondary market is likely to be hit the hardest, although certain affluent towns could prove more resilient.

The office sector follows the two-tier market trend, namely that while London is proving fairly robust, offices beyond the capital and South East face especially challenging conditions due to the ongoing weakness in the economy. Offices in towns and cities reliant on public sector employers could be particularly hard hit.

As ever, some local markets will buck the trend and offer high-yielding investment opportunities for those with the patience to look to the medium-term.

As for the industrial sector of the commercial property market, manufacturing growth has slowed in recent months and this, coupled with high commodity costs and the weak pound, will continue to weigh down on industrial assets.

Once again, London and the South East, where supply is limited, continue to outperform the rest of the UK but downward pressure in the secondary market will always amplify the yield potential and ROI of the right property in the right place.

Residential market sees Mexican standoff

You could write a thesis on the subject, and many do, but as we see it the current state of the UK residential property market can be summed up in the two findings below:

1. So far in 2011, according to figures released by the property website 'Rightmove,' 7 out of 10 properties put up for sale remain unsold.

2. Recent research issued by the National Association of Estate Agents has declared that the number of unsold properties on agents' books is at a two-year high.

The two key points to be drawn from these statistics are firstly that vendors, while lowering asking prices slightly in recent months, are still putting their properties onto the market at unrealistic prices; and secondly, demand from prospective buyers remains very weak.

Now, even in isolation, either of these two factors can cause all sorts of trouble for the property market. But when they appear together you have the recipe for a grand stalemate, a Mexican standoff of staggering proportions. This, of course, is exactly what has happened.

Why are vendors instructing at silly prices?

Sometimes it's because they refuse to accept that their properties are worth less than they were three or four years ago. But at other times it's because they simply have no choice. If they lower their prices, even marginally, they could end up in negative equity. So they have to hang on and simply hope. Things aren't helped by the fact that many agents continue to overvalue to get properties onto their books.

Why is demand so weak?

No shortage of reasons here. The economy is in a poor state of health, having grown by just 0.2% in Q2; unemployment, despite having fallen back slightly over the summer, will rise again once the public sector job cuts begin in earnest; consumers are (feeling) cash-strapped given high inflation and are extremely cautious generally; even if people do want to buy, many, especially first time buyers, will be denied the opportunity as they won't have sufficient equity, a large enough deposit and a flawless credit history that all lenders now require; and lastly, even if people do have the finance in place to buy, many are holding back waiting for prices to fall even further.

Is this a nationwide problem?

No. London continues to operate in a bubble of its own and is the one area where demand is relatively strong, transactions are occurring and prices – unbelievably given the general climate – have actually been rising. But even within London there are weak areas and strong areas. The prime areas of the capital have fared particularly well, helped by demand from overseas, accentuated by the weakness of Sterling.

The latest Land Registry figures, which are based on completed sales, confirm the disparity between London and the rest of the UK. Over the past year, average UK prices are down 2.5%, whereas London is in the black – up 0.8%.

Is this a buying opportunity?

It most certainly is — the laws of supply and demand say as much. With properties languishing on the market, buyers are very much in the driving seat right now, although they will not have quite the bargaining power inside London that they will outside it. If you are in a position to buy, chances are you can transact at very favourable prices.

Looking forward

Over the next 12 months, there is likely to be continued stagnation across the UK, with only London and other higher end, highly sought-after locations having a chance of staying in the black. Those areas that are heavily geared on public sector employment, such as Liverpool, Cambridge, Canterbury, Newcastle and Swansea, could fall even further into the red.

Although there has been speculation within the media that rates may be cut further to 0.25%, in reality this is unlikely given already high inflation and the limitations of what could ultimately be achieved by a quarter percent cut.

Although you can never predict the direction of monetary policy, a more realistic question to ask, most would agree, is when will interest rates rise? Indeed, the timing and pace of interest rate rises will have a major impact on house prices, as will the performance of the economy in 2012 and beyond.

If there's one thing that will break the Mexican standoff, it will be the inability of households to pay their mortgages if the Bank of England is forced to raise interest rates too soon or too quickly to combat inflation. If this happens, property prices could plummet as people are forced to sell, which, depending on your position, will be very good or very bad.

Philip Clarke
Managing Director, Fisher Property Services

E pclarke@hwfisher.co.uk