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Office market faces tough start to 2009

Given the credit crunch, it is little wonder that the commercial property market is suffering. By Nigel Shilton

The 10 years ending in December 2007 were a prosperous time for commercial real estate investors. The challenge is how those in the sector now deal with the sting in the tail.

With limited debt and an uncertain economic outlook, the expectation is that property values and returns will have further to fall - as shown by a significant drop in transaction volumes.

Funds aimed at the retail market were hard hit as investors rushed for the exit. Valuations were quickly slashed, which has resulted in negative total returns. Investors have capital, but they are biding their time, hopeful of further reductions.

Although the Bank of England has tried to intervene in the credit market, lending intentions are weak.

The contraction of the Commercial Mortgage Backed Securities market has made it hard for banks to originate loans.

But liquidity is not the only challenge. Inflation is equally important, particularly given the prospect of stagflation - where we experience lower economic growth, higher inflation and higher interest rates.

The dilemma for the Bank of England is that, while base rates have reduced, the London Inter Bank Offering Rate has hardly moved.

Occupier demand in the first part of 2008 was remarkably robust, but this might change towards the end of 2008/early 2009, leading to a downward pressure on rents. But the rising cost of construction will curtail the supply of new space, providing some counter to this.

The key to a soft landing is economic resilience supported by pro-active lending. A weakening economy, resulting in increasing tenant defaults and voids will jeopardise the servicing and refinancing of investment loans as well as new developments.

But as economic fundamentals start to shift, property might start to look better value than it has done for some time.

Discounted secondary properties could offer value for the developer looking at the potential for extracting value through active asset management and accommodation upgrades.

The investor with a close eye on asset management is likely to outperform the market.

Nigel Shilton is the construction partner at Deloitte

For more on the office market see the construction downturn