A YEAR into the commercial property downturn, investors and developers are asking the same question: is the worst over? The answer, unfortunately for them, is almost certainly not, writes Daniel Thomas.

The market value of listed British property companies has almost halved over 12 months but analysts and property professionals warn there could be at least another year of pain before the sector emerges from the lowest point of its downturn.

The extent of the initial phase of the downturn was made clear in financial results for the year ended in March, with many of the UK's biggest property investors and developers forced to write off hundreds of millions of pounds from the value of their assets.

The two biggest, Land Securities and British Land, saw £900m (€1.139 billion) and £1.6 billion (€2.025 billion) wiped from the value of their respective portfolios. In total, about £18.2 billion (€23 billion) has been knocked off the market capitalisation of the FTSE 350 real estate index during the period.

The property market peaked at the beginning of 2007, coinciding with the introduction of UK real estate investment trusts.

At the time, growth appeared unstoppable but overheated values suffered a sharp reversal last summer.

After that point, total returns for commercial property fell by 17 per cent in the period up to April this year, reflecting a fall in capital values of about 24 per cent.

However, even with the devaluation of property factored in over the past year the property sector is still trading at a considerable discount to asset value. The average discount is about 25 per cent, with some companies trading at far higher levels.

Current share prices predict another fall in capital values of about 26 per cent, according to Credit Suisse, on top of the 18 per cent fall since last June. Shares appear discounted to reflect an "almost-Armageddon" scenario, according to Patrick Sumner, head of property equities at Henderson Global Investors.

Chief executives are incredulous on how the market values their companies. Hammerson's John Richards says it is almost impossible to imagine a scenario where his firm's inherent value will fall as low as its market price.

Nevertheless, Sumner says the market has been proved right so far in its gloomier predictions, though he questions whether the negative expectations still apply to all companies.

A short bear rally took place in the market in January, but otherwise the trend has been downwards. And in the past month, those who had been hoping for a short-lived downturn have become resigned to a more profound slump.

This has been reflected in a wave of analyst downgrades. Last week, Lehman Brothers, Morgan Stanley and Credit Suisse posted bearish notes, warning rental growth and values remained under threat.

The most recent, by Credit Suisse, warned share prices could fall another 26 per cent. It appears inevitable that property values will be affected by a decline in rent-based income, with tenants likely to struggle in the economic downturn.

Robert Houston, chief executive of ING Real Estate, says his initial expectation that the market will recover this year has proven incorrect. "It's probably worse than we thought and we can't see the light at the end of the tunnel yet."

Mike Slade, Helical Bar's outspoken chief executive, expects a "double dip" downturn, with the drop in rental income leading to a secondary hit on property values.

And Tim Wheeler, Brixton's chief executive, believes the stock exchange reflects accurately where asset values are headed. He says, however, that the market could rally towards the end of the year.

In the meantime, says Wheeler, it is a case of waiting things out.

In Brixton's case, this means stopping all new development until the market becomes clearer.

Industry executives and shareholders draw some comfort from an absence so far of large-scale bankruptcies or breaches of debt covenants, though there are expectations that these will be inevitable. Property is entirely dependent on the cost of capital.

The biggest question for investors is how near companies are to breaching banking covenants as the value of assets falls in relation to the debt used to buy them. For some, the break point has been getting worryingly close, though most companies are better financed and less heavily geared than during the last big recession.

The return of the property sector is also linked inextricably to debt markets; as long as debt remains expensive and scarce, property will struggle. But the good news is that while debt remains a problem, equity seems to be abundant, with tens of billions of pounds already raised to invest in the British sector.

When those funds start buying - and they will need to at some point - it will have a profound effect on the timing of a property market recovery.

For the listed sector, there will probably be a drip feed of bad news for the rest of 2008, but share prices are already very low.

Sumner, for one, believes the sector has never been as cheap, while dividend income remains attractive.

For some, it seems, certain parts of the market are priced low enough to make them attractive, but the risk-averse will remain wary.

- (Financial Times)