Most of the world is in economic recession. Heretofore economic recessions have resulted in property problems of greater or lesser severity. The economic recession in the UK in the early 1990s resulted in a horrendous property bust in which many property values fell by more than 50 per cent and from which the UK is still recovering. A similar situation occurred in the US in the 1980s.
Over the past five years, we in Ireland have seen property values treble and the output of the development industry more than double.
Thus if we assess the Irish commercial property market, by comparison with historical cycles, we are due a serious step down in values and property activity.
However my belief is that we will not get a property bust in 2002 for the following reasons:
High level of confidence for return to growth in late 2002
Low interest rates
Low bank lending to the development industry
High equity level in most developments
No serious stock hangover
In the remainder of this article, I look at these various factors in greater detail. I refer of course to the commercial market and not the residential market as this is my area of special knowledge.
Occupiers of buildings drive all markets. At any time they are taking on more space, sitting tight in existing space or jettisoning space.
For the past five years most business occupiers were in the mode of taking on new space. This demand for new space resulted in frenetic activity in the property industry with vacancy levels falling from 10 per cent of all stock to less than 2 per cent whilst at the same time absorbing the huge output of new space from the development industry.
Over the last six months this situation has changed dramatically. Occupiers have almost totally withdrawn from new deals. Any deals that are now being negotiated are ones that were previously embedded in organisations. As the estate agents put it "their phones have stopped ringing". Thus, the outlook on the occupation side of the equation for 2002 is not good.
On the supply side developers continue to grind out new commercial floor space at a very high rate. This is going to increase the stock of vacant property to something like 10 per cent of overall stock by the end of 2002. The development industry cannot switch "off" and "on" its output in the same way that the business sector has switched "off" its requirements for new space.
It is also important to note that there will also be a supply of floor space coming on to the market from occupiers who are rationalising their space needs and who will be subletting or assigning buildings. Organisations such as IT firms, ESB, OPW and Eircom fit into these categories.
Some development firms put projects on the back burner early in 2001, especially Dublin suburban offices, in anticipation of a possible oversupply. This appears to have been a wise decision.
Thus the supply of space in the markets by mid to late 2002 will be back to the normal levels that we experienced in the early 1990s, with perhaps some pockets of extremes.
Looking at rental growth, in the current climate there is little evidence of rental change. However where there is very little letting activity and where supply and demand is well balanced there is unlikely to be rental growth.
Prevailing rentals levels are giving a satisfactory level of profit for developers so there is no serious cost push on property prices as experienced in the early 1990s, which effectively stopped the construction of new buildings.
I would caution by noting that if there is aggressive competition between developers (which is currently being experienced within the suburban office market) or owners of existing buildings / companies rationalising, rental value erosion of as much as 15 per cent could be experienced in 2002.
Turning to investors, two different signals are coming from the investment markets. The institutional investors who have been the traditional drivers of the investment markets are virtually out of the market at the moment and may stay out of the market in 2002. This absence from the market is due to the following reasons:
A perceived overweighting in property vis-α-vis equities and gilts
Low expectations on rental growth
Negative attitudes to property by asset allocators and to prospects of value growth
In addition to the lack of new investment by institutions, some institutions are rationalising their portfolios, resulting in properties being put on the market.
However the investment market is far from dead. Private investors are very active and buying property in Ireland, particularly small lots, but at levels that I would still regard as aggressive. High net worth individuals need somewhere to put their money and many are not enamoured of investing in the stock market for various reasons.
Low interest rates and the availability of money from banks are reinforcing the demand by private investors for investment property. Never before in my career have I seen a situation that property can be bought at yields where the income more than covers the bank interest. This and an inherent faith in long-term growth in values is what are driving the private sector market. I agree with the approach but believe that much better initial yields and value growth potential are available in the UK market. For example the Ericcson deal recently announced in Clonskeagh done at 6.2 per cent by a private investor would be a 7.5 per cent deal in the UK and probably off a rent half that of the Irish rate per sq ft.
Notwithstanding the level of activity by private buyers, I believe that property values in the investment sector have fallen by about 10 per cent year on year because of the withdrawal of the institutions and the increased supply of investments. Also, vendors are willing sellers at these levels, whereas 12 months previous, they were afraid of selling for fear of missing further growth. This is probably the only active area in the Irish property market at the moment and the one which is keeping the estate agents in business.
Shortly after September 11, I believed that property values would fall a further 10 per cent making a 20 per cent year on year decline. However with the reduction in interest rates since then, this may not happen if private investors stay active in the market to make up for all or part of the hole left there by the absence of institutional investors.
The wild card in the property investment scenario is that institutional asset allocators could decide in the new year to increase property weightings in their asset mix. This could happen because of a poor outlook for equities and low bond yields coupled with higher property yield. This would result in money being thrown into a finely balanced property investment market and could result in increased demand for investment properties not just in Ireland but worldwide. An increase in property weightings from current levels of less than 7 per cent to 10 per cent or 12 per cent (which would be less than those prevailing in the 1970s) would drive the property market wild. This is very much a joker in the pack, but stranger things have happened!
On the development front, most developers have made huge money over the past five years. Whilst much of that money is tied up in projects in progress or land holdings, few developers are exposed to the market in the way that they were during previous recessions. The level of equity held by developers in most projects is very high. Prevailing low rates of interest result in developers' interest bills falling rather than increasing. It was the hike in interest rates that sparked off past property slumps.
As a result of high equity content and low interest rates, most developers are in a position to weather a period of holding buildings vacant without too much stress. However there are and always will be some developers who have gone out on a limb and are trading on the high risk basis of doubles or quits. Some of these have or will suffer, but they will be few, and I do not anticipate a market collapse caused by developer bankruptcies as happened in the UK in 1991. Also, there are developers with projects in locations where supply levels are seriously out of balance with the likely market demand and where increases in construction costs have left them exposed to negative equity situations. However, I would note that the banks are only continuing to supply funding to experienced developers for well -based schemes .The banks generally are not seriously exposed to property, provided the economy does not turn very negative in 2002 and demand disappear altogether.
Many developers are focusing on the tiger returning in 2003 and are prepared to ride out a storm in 2002. My long-term concern is that the high profits that have been made over the past five years are attracting new entrants into the game and there may soon be too many developers with big schemes. If these do go ahead we will have a serious problem sooner or later judging by the size and number of schemes currently going through the planning system. Perhaps the delays in the planning system have done us a big favour!
Having read the above, you may feel that I have ducked the issue of committing myself to forecasting the property market in Ireland in 2002. I believe it is impossible to say more than that it all depends on the economy. If we are simply having a slight pause in Celtic tiger-style growth, then it will be back to normal in late 2002, whereas if the economy does not get back to strong growth rates towards the end of 2002, then we could have some serious property problems by this time next year. 2002 could be a year when a lot of young surveyors learn what markets used to be like in the 1980s - dull and with deals hard to do.
The year 2002 will not be a year of crash, nor will it be a year of boom. My forecast is that it will a year of hibernation for the property market.
Bill Nowlan is a management consultant specialising in the property investment and development industry
