Pessimism has taken up residency in the commercial property market. However, when consensus opinion becomes singularly gloomy, opportunities often present themselves.

Pessimism has taken up residency in the commercial property market. However, when consensus opinion becomes singularly gloomy, opportunities often present themselves. Our proprietary analysis indicates that there is, in fact, scope for a positive surprise in many prime European office markets, with particularly punchy rental growth likely in several key financial centres. This financial sector success should broaden out to other property sectors in 2011, if the economic recovery regains momentum.

Rental growth (the increase in the income property owners can draw from their real estate) has historically made up the most significant part of growth in capital values within the European prime office sector. But this growth is cyclical. In periods of economic growth, it can rise rapidly, but in downturns it can fall even faster. This is because when the economy suffers, businesses falter and often need to cut back on expensive office rentals, or abandon them altogether if they fold.

As businesses recover, however, so too do commercial property markets. The further a recovery progresses, the more pronounced this effect becomes. As the market rally becomes more mature, we tend to see the influence of investor flows and, in particular, debt leveraged investors come to the fore, which is reflected in the yield impact on capital growth. There is a broadly symmetrical impact on the downside, as money flows back out of the property market and yields shift back up as values fall.

In previous property corrections, commercial banks helped to trigger a “death spiral” in the market, where the correction was exacerbated by distressed selling - when banks scrabbled to repair their balance sheets by selling off property assets, thereby depressing prices even further and worsening the situation. Rents and capital values fell further in the early 1990s correction than they did in the most recent one, although one of the principal causes was the higher level of development activity in the late 80s/early 90s boom.

The feared deluge of distressed sales did not materialise during this downturn. We have to congratulate the banks for this, because they played their hand remarkably well. It’s not in the banking sector’s interests for any bank to be selling assets into a falling market since it negatively impacts all banks and begins to impinge on even the strongest players. The preferable situation is for the banks to sit tight and “muddle through” until there is a recovery in asset prices (and their own balance sheets). Thankfully, this is what happened in the wake of the 2008 financial crisis.

One of the reasons that banks were able to muddle through was the relatively sharp recovery in prime real estate. In terms of absolute value, the banks have a significant amount of loans tied up against prime property, so the fact that these property values have recovered, pushing some ‘big ticket’ loans back above water, has made the banks more comfortable. We should also not overlook the role that has been played by government funds in terms of the banks’ ability to avoid distressed sales.

Equally, the banks themselves are heavy users of prime commercial property. This means that if they struggle during downturns (and need to let staff go), they too contribute to weakening property markets. However, the recent loss of jobs in the financial sector was not as severe as many analysts expected at the outset of the recession. Indeed, employment growth in the financial and business service sectors in centres such as central London, Paris CBD [central business district] and Stockholm CBD has been strong in 2010, as businesses have re-geared. It is this point especially that argues against the pessimism of the crowd.

There is some basis for this pessimism. According to CBRE, prime headline office rents have fallen over 10 per cent over the last two years and rental growth remains negative across the overall market. Even though this isn’t as bad as previous downturns, it has made commentators gloomy on the outlook for rental growth.

As we have seen, however, the headline numbers disguise the fact that rental prospects are rapidly improving in the major business/office centres of Northern and Western Europe. Indeed, recent analysis undertaken by our Property Research team showed that European offices can be expected to deliver rental growth of between 2.5-3.0 per cent a year over the next five years.

There will be a few star performers amongst European hubs, and these will deliver even higher yields. Those of note include London City, with an expected rental growth of 7.5 per cent a year over the next five years, London West End at 7.00 per cent, Paris CBD at 4.25 per cent, Paris La Defense at 5.25 per cent, Stockholm CBD at 5.00 per cent and Munich CBD at 3.00 per cent.

Our proprietary analysis also indicates that there is a significantly lower chance of tenant default in the office sector. The projected 12-month failure rate for UK office tenants, for example, has fallen steadily since the second quarter of 2010 and is now 1.48 per cent, compared with the UK “All Property” average of 2.89 per cent.

All in all, therefore, in prime office markets at least, “commercial property pessimism” may soon be evicted.