Recent repricing in the UK is unprecedented in its severity. But the market has not drifted into uncharted waters, says Andrew Smith

The UK was the first major commercial real estate market to suffer from the credit crisis, and has fallen furthest, although other markets are now playing catch-up. UK values started falling in mid-2007, as confidence ebbed in the face of the developing capital market instability.

Surprisingly, the US, at the heart of the developing credit crisis, was largely unscathed at first. Subsequently, as rents have faltered in the face of declining occupier demand, a more synchronised repricing has developed, spreading through Europe, the US, and more recently the Asia-Pacific region.

The UK downturn developed into a "double dip", as the early capital market repricing was exacerbated by weakening lettings market. Commercial property delivered a total return of -22.1% in 2008, exceeding 1974's previous record low by more than six percentage points - itself the weakest year since at least 1920 and a slump also triggered by a banking crisis.

Startlingly, if the decline in values during the closing weeks of 2008 were to be sustained, the value of the country's commercial property stock would fall to zero in April 2010. In reality, of course, there will come a point where the repricing means yields and prospective returns will start to look very attractive, underpinning a revival in investment activity and arresting the decline in values. In considering how the recovery might unfold, the property market reaction to the recession of the early 1990s offers some useful pointers.

Then, the cycle started with recession, exacerbated by the excesses of the Lawson boom (the rapid economic growth at the end of the 1980s associated with the policies of Chancellor of the Exchequer Nigel Lawson), and by a London office supply surge that followed financial market deregulation.

The UK's ejection from the Exchange Rate Mechanism (ERM) in 1992 resulted in a financial market crisis, but soon resulted in steep reductions in borrowing costs and bond yields, which supported the subsequent recovery.

Average capital values for commercial property started declining 17 months before rental values followed suit, anticipating the effect of the downturn on letting markets. The capital market double-dipped as the economic difficulties intensified and as occupational markets suffered more than was initially expected.

This time, a financial crisis has again been the catalyst for property pricing to start to look very attractive. The difference is that the crisis preceded (and largely caused) the current recession, and it will be more severe than in the 1990s. 

Demand for London offices is again correcting sharply from unsustainable levels, but the current development boom has been much less marked. As before, the financial crisis has brought steep falls in interest rates and bond yields, against which property is starting to look cheap by historic standards - although the non-availability of credit means the effect on borrowing costs has so far been limited. Again, the capital market adjustment has preceded the decline in rental values, this time by 10 months.

There is evidence that UK valuers have been more willing than most to mark assets down on the basis of market sentiment, without waiting for firm transaction-based evidence, which is one reason why the fall in values has happened in ‘fast forward' this time.

The ERM crisis laid the foundations for property's recovery from the last recession in spectacular fashion. Suddenly, as other financial markets repriced, property looked extraordinarily cheap. An upsurge in investment activity followed, and, with limited product coming to the market, capital values increased strongly, despite the fact that rental values were still falling.

By the middle of 1994, however, it was clear the rebound had been overenthusiastic, and values declined once again as investor appetite waned. There then followed a more sustainable recovery, synchronised with a revival in letting markets and the long awaited rental recovery.

This experience gives some interesting clues to how the market might eventually recover from the present downturn. The seeds are being sown. Development supply has been aggressively pruned. Repricing means yields and prospective returns will start to look very attractive, underpinning a revival in investment activity and arresting the decline in values.

While we are paying the price for a market overheating, we can expect a similar overshoot on the downside, generating significant mispricings and offering once-in-a-generation buying opportunities. As before, a double bounce recovery seems a likely scenario. Some features of the market could be as follows:

The UK's early and rapid repricing, coupled with currency depreciation, means the market will look very attractive in international terms and will be among the first to turn; Accordingly, UK returns in 2009 won't be as bad as they were in 2008. For most other markets, 2009 will mark the low point; Values will stabilise ahead of a recovery in letting markets, but the recovery will not be sustainable until fundamentals improve; As in 1994, the rise in values will pause and perhaps reverse for a while, against a backdrop of still falling rental values. Eventually, improving fundamentals will drive a more robust revival, as lending conditions normalise and occupier demand improves; However, the first stage rebound is likely to be more muted this time, with credit in short supply and some property owners, including banks, taking the opportunity to bring assets forward for sale;  Investors' efforts to deleverage will mean some investors will rediscover direct property, and seek to reduce their reliance on pooled funds; Property may benefit from a retreat from more esoteric forms of investment, such as highly leveraged hedge funds.


Although UK values have further to fall in the short-term, from a strategic perspective this is likely to result in significant mispricing, which will present some good opportunities for investors. Long-term real returns well above the annualised long-term average of around 4.5% will be readily achievable, even assuming flat rental and capital values.

In practice, both are likely to improve as economic recovery eventually takes root. While extreme events have caused the market cycle to reassert itself, and investment market pricing reflects considerable uncertainty, we are not in entirely uncharted waters.

Andrew Smith is chief investment officer at Aberdeen Property Investors