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08 Feb, 2008

Published: 07:00 Friday 08 February 2008
By: Dylan Lobo, Investment News Editor

M&G Investments property head John Cartwright has noted a marked improvement in the commercial property market this year after the firm's M&G Property Portfolio slashed its exposure to prime London office space in the last quarter.

John Cartwright, who is head of retail and institutional funds at M&G Investments' property fund management subsidiary PRUPIM, said: 'We have been selling central London office property as we are still concerned about growth prospects and the balance between occupant demand and supply.

'The M&G Property portfolio has been a long term holder of central London property but we are now running a significant underweight and we expect to keep this for at least three years. We feel there were better opportunities elsewhere.'

Cartwright has identified three areas of the market which look attractive: retail, office space outside London and industrial sites.

While Cartwright said there were signs conditions in the commercial property market had improved, he warned the correction is substantially ahead of the one indicated in the Investment Property Databank (IPD) index.

Last month's IPD showed commercial property returns recorded their largest ever fall in December, slumping by 3.7%. This was marginally worse than the 3.6% fall of the previous month.

A separate report released this week from the Association of Real Estate funds showed a record £1.65 billion of redemptions from property funds in the final quarter. This is double the level of withdrawals for the whole of 2006.

Cartwright said the IPD is distorted by the fact not all funds represented in the index have moved to fortnightly pricing, particularly those in the closed ended space. He pointed out these types of funds are unlikely to have been transacting to the same extent as open-ended funds, which were forced to sell property to meet redemptions.

'Asset yields for the fund [M&G Property Portfolio] have risen at a faster pace than indicated by the index. Our understanding is that a similar pattern is evident also in competing direct property funds.'

As a consequence, he said, the aggregated market yield is somewhere between 5.75 and 6%, rather than the 5.5% indicated on the latest IPD.

But he does not draw parallels between now and the early 1990s when rising yields and declining property valuations sparked a crash in property.

Cartwright said the economy is in much better nick today than it was in the early 1990s. He highlights back then inflation stood at 10.9% and interest rates were 15%. More importantly average rents had grown to an 'unsustainably' high rate of 18.8% per year.

This time around though inflation is 4.1%, interest rates are at 5.5% rental growth has been stable at 3.6% per annum in the last two year. Additionally unemployment is around one million less.

'Overall, this evidence suggests strongly to us that, whilst not without risks, the economic outlook is far healthier now than in the early 1990s, and hence much more supportive to the commercial property market.' he said.

Cartwright also points out vacancy rates in the City stood at 15% in September 1990, while they stand at just 5.2% today. He also draws comfort from the fact rental income, which in his view is the biggest driver in the commercial property market, is far more stable now than in it was in the early 1990s.

'We are now seeing a clear pick-up in the number of property transactions driven by increasingly attractive market prices,' Cartwright said.

'From our own transactions activity, we have seen clear evidence of good levels of investment demand, particularly from overseas buyers who are especially attracted by the relative value offered by the UK market in a global context.'

'The market correction has clearly been sharper than we thought in the early month of last year, but we now believe it will also be shorter. So whilst this is a painful period to go through, in the longer-term it is also very healthy for the market.'

Cartwright admits a UK recession would have negative implications on property, but he does not see this is a likely scenario.

His overriding view is that yields will stabilise earlier rather than later this year and by the second half of the year capital values should no longer be eroding income returns.

'There clearly risks to this outlook - principally that the current economic slowdown may escalate into a full-blown recession, with potentially negative implications for prospective rental growth. Overall, however, the market seems to regard that as a less likely scenario, and the central view seems now to be one of cautious optimism.'

In November the offshore M&G Property fund was forced to apply a 90-day notice period on withdrawals by institutional investors because it could no longer meet redemptions on a daily basis.

But Cartwright said that is unlikely a similar moved would be employed on the open-ended M&G Property Portfolio, which holds £995 million in assets. 'We have sold a handful of properties and liquidity is at 10%. We are comfortable where we are, particular at this point in the cycle.'

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