London is seen as one of the markets most likely to feel the impact of the credit squeeze. But the outlook is not so bleak, says Alex Williamson
Although the credit squeeze has filtered through to some parts of the finance sector - our view is that the problem will eventually resolve itself, without having too significant an impact on the rest of the economy.
Indeed, most of the data has been positive in recent weeks: inflation has edged down, retail sales growth remains healthy, house price growth remains sturdy, and both equity and gilt markets have recovered. However, it is wise to consider the downside risks, and the likely impacts on the property market as a whole and by sector, should the credit squeeze extend beyond the short term.
If market conditions were to worsen, then our view is that the central London office market would be hardest hit. This would be more the case for the City office market, which has higher levels of supply than the West End and is more dependent upon the well being of the finance sector. Other parts of the office market are likely to be less affected because of their broader occupier base. This can be demonstrated by the levels of take-up accounted for by the finance sector within each of the key office markets: finance companies accounted for around 53% of take-up in the City office market in the five years to 2006, a far higher proportion than the West End (21%), big six regional office markets (18%), and M25 West office markets (9%).
There have been a few stories in the press highlighting the impact of financial market turbulence on particular occupiers, for example Bear Stearns pulling out of a deal at Cardinal Place, Victoria; there have also been announcements of job losses at some investment banks (for example UBS and Merrill Lynch). It is too early to tell if the credit crunch will have any lasting effect on office occupier demand: latest data from Strutt & Parker showed weak take-up in the West End in September (the weakest since early 2006), although this could be a temporary pause while occupiers wait to see the full effects of the credit squeeze on the economy.
The retail and residential markets would also be badly affected by a credit crunch because of the higher mortgage rates, which impact on consumer confidence and spending, on top of weaker confidence as a result of slowing economic growth and job losses. However, under such a scenario, interest rates would be cut relatively quickly, in an effort to boost consumer confidence, countering the negative impact of higher mortgage rates, and leading to a recovery in consumer spending towards the end of the decade. In addition to weaker consumer spending, we believe high street retail will be affected by the high levels of supply expected to come through the pipeline in 2008. Out-of-town parks (particularly fashion parks), are expected to hold up relatively well because, on average, the sector still benefits from discounted rents compared with the high street, plus a tighter supply. Supermarkets should also do well given their defensive characteristics.
Under a credit crunch scenario, we believe the best performing sectors would be: the South East office markets, which have a broad occupier base and a limited supply pipeline at present; the retail warehouse market which also benefits from tight supply; and residential. Although house prices will moderate, we believe values are likely to hold up better than the commercial property market owing to undersupply. Student accommodation in particular should be relatively insulated from the external economic shocks. With regards to style of property, we believe prime will outperform secondary property. This has been our view for a while - but a credit squeeze has essentially accelerated the re-pricing of risk. We believe values of secondary property will fall further than prime, as investors price in additional risk. We believe the impact on property will be limited, although we believe our focus on the core fundamentals of rental growth, whether in a stable economic environment or a credit crunch, should lead to outperformance of the property market.
Alex Williamson is property research analyst at Schroder PIM