It was almost inevitable that the property market would react unfavourably to the unexpected rise in interest rates at the beginning of January. Royal Institute of Chartered Surveyors (RICS) economist Oliver Gilmartin noted: “The most recent inflation data has sounded alarm bells amongst central bankers that higher inflation expectations could become embedded unless a firm signal is sent to the market. The worry is that inflation pressures could become more prolonged with the retail price index rising to a 15-year high. Any likely feed-through into wage settlements at the start of 2007 will need to be nipped in the bud.”

He points out: “Higher rates in 2007 will start to dampen house price growth, although a supportive global economy and firm housing demand will maintain house price inflation at 7 per cent. January’s surprise interest rate rise is likely to soften new buyer enquiries in the coming months, as was the case in mid-2004 following four successive interest rate hikes in five months.”

Indeed, the RICS reports in its latest housing market survey that the November base rate rise was already taking the heat out of the market. RICS spokesman, Ian Perry, observes: “Interest rate rises have started to cool the housing market and the latest rise will have a further impact in the coming months, but the market remains strong. However, the rate rise will do nothing to aid homeowners struggling with affordability conditions, with more repossessions looming on the horizon. As we move further into the new year, consumers will begin to tighten their belts as finances come under pressure, but rising wages and employment will continue to boost the economy and RICS expects interest rates to finish at 5.5 per cent by year end.”

Jonathan Bell, chief investment officer at Stanhope Capital, feels that commercial property prices could also be vulnerable against the current economic backdrop. He says: “The consensus amongst market forecasters this year is for a fall in the return from property investment. Given the strong performance of this asset class over the past 5 years and the contraction in property rental yields, it is highly unlikely that the impressive returns of the past few years will be repeated. However, property remains an attractive long-term asset class offering income yields at or above bond yields and the prospect of inflation protection and, for this reason, we may not witness the setback that many Cassandras are predicting.”

And this despite a buoyant end to the year for commercial property returns. The Investment Property Databank (IPD) reports that the return on UK commercial property for December 2006 was 1.5 per cent, higher than November’s 1.2 per cent, and meant a total return for the year 2006 of 18.1 per cent. This was slightly down on 2005 (18.8 per cent).

More than two-thirds of the 2006 figure was accounted for by capital growth (12.4 per cent), and was primarily driven by returns from office space, due to a pick-up in rental value growth. Malcolm Frodsham, IPD’s research director, notes: “The sector return trends have switched from offices lagging both retails and industrials in 2004 to offices leading the sector hierarchy in 2006. Investors who have been able to switch their portfolio weightings to capture these performance differentials should be topping the three-year fund rankings”.

At the same time, New Star Asset Management is warning investors looking for exposure to commercial property to seek it directly, rather than relying on the arrival of REITs. Phil Wagstaff, New Star’s UK sales and marketing director, observes that: “Direct commercial property and REITs are entirely different entities. My concern is that investors may select an individual REIT or a fund with a high REIT content in the mistaken belief that they are lowering risk as well as diversifying their portfolios. In reality they may be adding risk. If investors want to benefit from the low volatility and diversification that commercial property can offer, they need to consider funds with a high content of physical property.”

This article is from the February 2007 issue of What Investment.