Commercial property continues to outperform the equity market, with the latest set of annual results from the Investment Property Databank (IPD) showing a total return for 2006 in excess of 18 per cent, compared to less than 17 per cent for UK equities.

Milan Khatri, chief economist at the Royal Institution of Chartered Surveyors (RICS) points out that, although the performance of London offices was a significant influence, growth was not confined to the capital. ‘The booming City economy has led to office demand in Central London rising at its fastest pace in our survey’s history. But there was also a resurgence in occupier activity in the northern office and industrial sectors. The industrial sector continued to show solid activity growth nationally despite an appreciating pound and rising interest rates. However, buoyant high street trading is yet to raise retail demand, although take-up of prime retail space is no longer declining.

‘Commercial property values are rising at a marginally slower pace than the spring months of 2006. Interest rate rises have had little dampening impact on new enquiries for space as a stronger economy has supported business expansion. Amid a moderate slowdown in demand, investors seem to have focused more on “prime” assets across the commercial property market where activity has picked up.’

However, Jim Wood-Smith, head of research at Williams De Broë, has his reservations about the growing enthusiasm for commercial property investments. He argues, ‘It is time to sacrifice the holy cow of commercial property. There is no point in diversification for its own sake, it has to improve performance; and, while we may not be at the precise peak of returns for commercial property, in the name of prudence it is at least time to take the profits.’

He adds, ‘This asset class is something of a holy cow, and for good reason. Measured returns over the past five years show the highest gains and the least volatility, and an optimised asset allocation tool will thus automatically give it the maximum permitted weight in any portfolio. The benchmark – the IPD Index – gave a total return of 18.1 per cent last year, against 16.8 per cent from the FT All Share Index.’

But Wood-Smith continues, ‘The problem is that the asset faces being damned by its own success. At the start of 2006, the strong consensus was that commercial property was likely to give returns of mid to high single digits, most of which would come from yield. One year on, expectations are being pitched at the same level. The problem is that prices are some 15 per cent or so higher. If we assume that the rationale for holding commercial property in an investment portfolio is to diversify the other assets held, especially equities, and to provide steady growth of capital and income, then this now has to be brought into question.’

In the residential market, house prices continue to show steady, rather than spectacular, growth. The most recent FT House Price Index shows that house prices rose by 0.7 per cent in January, giving a total increase of 6.9 per cent over the previous 12 months.

Peter Williams, chairman of Acadametrics, which produces the index, notes, ‘These figures are both in line with the December figures and support the view that nationally house prices have reached a plateau. Prices in London and the South of England continue to have a large impact on the overall performance of the market, but price increases in some regions are now quite muted.’

He adds, ‘There is some evidence to suggest that the three interest rate rises since August 2006 are having an impact upon the market and there is an expectation that price rises will moderate during the year. The market in London will probably be slower to react as demand continues to outstrip supply. For the year 2006, the FT index shows that house prices overall rose by just under seven per cent, a significantly lower figure than the 9.5 per cent used by the Bank in its own deliberations.’

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