The bubble has burst. Once again property investors only have themselves to blame, right? Not necessarily, says Nick Axford

Think back to the spring of 2006. How did the world look to a European property investor? The global economic outlook was very positive, with Consensus Economics' monthly poll of 240 forecasters revealing average expectations of US economic growth at 3-3.5% for each of the next five years.

European forecasts were mixed. While there were concerns over the slow pace of structural reforms in some countries, the outlook was more optimistic in the UK and Spain. Inflation appeared under control and interest rates were low. Property yields had already been falling for over two years, and average prime office yields in Europe stood at 5.1%, 70 bps below their long-term average. So was it rational to put money into the market? To form a view, you need to appreciate what constitutes ‘fair value' for a particular investment.

Investment pricing is theoretically based on the ‘risk free rate of return', the best proxy for which is the yield on 10 year government bonds. Property is riskier than government bonds, so investors require a higher return. Opinions differ as to exactly what this ‘property risk premium' should be, but 3.5% is a relatively conservative estimate. In the spring of 2006 euro-zone government bonds were yielding 3.6%, meaning that the ‘target' return for a property investor was 7.1%. With prime initial yields in the office sector averaging 5.1%, the pricing of such investments was implicitly assuming at least 2% rental growth per annum (or around 22% in total over a 10-year period) to make up the difference.

This is an overly simplified view - but an interesting one nevertheless. Based on local bond and office yields, the rate of rental growth implied in many European markets was between 1% and 2%. In most markets, occupier demand was beginning to rise, availability was falling, development was restrained, and rents were starting to increase. Property therefore looked attractively priced, even before gearing. In fact, prime office rents in many markets have risen by 25% to 50% since the spring of 2006 - significantly more than the total growth needed over 10 years to justify the yield that was paid at the time. At the same time, commercial interest rates (as measured by the five-year swap rate) were just 3.5%. Even after adding a lending margin, investors could borrow money in order to buy prime property and make a significant profit over their finance costs - even before seeing any rental growth or capital gains due to further yield compression.

In September of 2006, a survey of CBRE pan-European investment clients showed that 70% of them expected prime office yields to remain stable in 2007, while 20% expected further falls. Over 40% expected secondary yields to rise somewhat, indicating that many already felt that the market was approaching a turning point - although almost as many thought secondary yields would fall further.
In the spring of 2007, the situation was not radically different. The early signs of trouble in the US were clearly evident, with a housing slowdown well underway - yet economists still expected growth of 2.3% in 2007, and an acceleration again thereafter.

The outlook for Europe had improved, with short-term growth forecasts strengthening.

In the property sector, using our simplified model, the situation had changed somewhat. A combination of rising bond yields and further declines in property yields meant that implied rates of rental growth had been pushed up to levels that, while not wildly excessive, looked more challenging to achieve. By this stage, concern was being raised more widely about the level of debt prevalent in the property market.

Highly structured finance packages to heavily geared investors were a significant feature of the market, with such investors often the ‘marginal buyer' setting the price in the market. Interestingly, the most common complaint from more traditional property investors - using lower levels of gearing and conservative rental growth assumptions - was that "we can't compete". A clear sign, it would seem, that many investors believed that pricing on some deals had reached a level which could only be sustained by a flow of cheap debt.

Today, the outlook is clearly somewhat different. ‘Irrational exuberance' is identified as having fuelled an unsustainable asset bubble in commercial property. However, the argument that property investors have once again been the architects of their own downfall is not necessarily correct.

Interestingly, commenting on the term as early as December 1996, Alan Greenspan said: "But how do we know when irrational exuberance has unduly escalated asset values…?" This was widely interpreted as hinting that the US stock market was overvalued at the time but the boom still had more than three years left to run.

Any fund manager that got out of the equity market then (or even worse, shorted the market) would have missed out on several years of spectacular returns and would most likely have been out of a job by the time the market crash finally came in March 2000.
With the benefit of hindsight, it appears easy to identify the point at which investors should have sold out of the market. But at what stage over the past two years should investors have actually been expected to recognise this?  Even then, is it true that subsequent investment decisions were ‘irrational'? 

Today attention is naturally drawn to the financing arrangements that lay behind deals rather than the outlook for property market fundamentals. Borrowing on a short-term basis at historically low interest rates in order to finance the purchase of a relatively illiquid asset at historically high prices is inherently risky. But the fact that the credit crunch has hit so sharply does not mean that all such financing was ‘irrational'.

Some would indeed argue that such deals were irrational because they were reliant on nothing occurring that would disrupt a market that was "priced for perfection". However, looking at the market as a whole, it is simply wrong to assume that all property investors who bought buildings over the past two years were doing the same things for the same reason.

First, many investors fully recognised the risks inherent in aggressive finance terms, and opted not to purchase buildings (or to purchase different assets) rather than utilise such financing.

Second, property investment is not like shorting equities. Selling a building to play short-term cycles incurs significant transaction costs on exit and re-entry - always assuming that the same property would be available to buy at a given time in the future, which it almost certainly would not.

Third, many investors are in the early stages of building significant international portfolios, focusing on long-term investment opportunities. No one wants to buy a property that subsequently falls in value - but for many investors this is an inevitable risk of investing throughout the cycle, with short-term losses on more recent purchases offset against the more significant capital gains made on properties held through the cycle.

Of course the headlines are focused on deals that with hindsight were poorly timed. However, in most markets the underlying property fundamentals remain sound. The main risk is the prospect of a downturn in demand due to the credit squeeze, which was hardly expected by even the most rational of investors.
It will be some time before we can look back on the last few years to identify how the investments purchased in that period have actually performed for their new owners.