The Irish property market is currently enjoying its sixth year of strong growth, and in 1998, property experienced its best ever performance with a total return, according to the SCS-IPD index, of 38 per cent. The total return for 1999 will not match the spectacular growth of 1998. It should nevertheless be about 25 per cent.
No cycle, however, lasts forever. Given that the last "bull" property market extended for no more than four years, and given that interest rates are rising, it is timely now to assess the medium-term prospects for the Irish commercial property market.
One approach to determining the likely future prospects for the market is to identify those key factors which drive it. The fundamental forces which drive the property market are: the economic cycle, which ultimately determines the demand for property from business occupiers; the development cycle, which ultimately determines the supply of property; and the capital market, which determines the supply of cash - which allows the property market to function.
The success story of the Irish property market over the past six years had been determined by strong economic growth boosting the demand for property and coinciding with a level of development activity which has ensured that the market has not become oversupplied, and by the availability of relatively cheap money. The question which must be addressed in assessing the future outlook for the market is: how robust are each of these key drivers going forward?
Economic cycle
THE Irish economy continues to enjoy high growth, with GDP likely to be up 8 per cent in 1999. The latest projection for 2000 indicates a moderation in the rate of growth to 6.5 per cent due to domestic resource constraints and also to the natural tendency to revert back to the long-term growth trend.
Few economists venture projections for 2001 and beyond. The ESRI, however, has forecast average GDP growth for the Irish economy of 5 per cent per annum for the period 2000 to 2005. On balance, therefore, it is likely that the domestic real economy should continue to underpin the demand for property from occupiers for 2000 and (probably) 2001. It is this fundamental demand which is the engine driving the investment market.
The prospects for demand on a sectoral basis are as follows:
Office Market
MOST of the employment growth at present is in the service sector and most service employment is in office accommodation. Future demand for offices depends on growth in existing business and on the continued inflow of new projects. If the generally positive economic scenario projected for 2000/2001 remains intact, then demand for offices should remain strong, particularly from the expansion of existing business such as professional and financial services.
The flow of new, incoming projects, fuelling demand for offices in Dublin, is likely, however, to ease over time due to factors such as constraints on the number of new projects qualifying for the 10 per cent corporation tax rate, the likely general slowdown in new IDA-sponsored projects coming into Ireland and re-direction of some projects away from Dublin.
It is difficult at present to see this scenario turning negative in the short/medium term, given the rapid move towards 12.5 per cent corporation tax rate, as well as the momentum generated in areas such as software development and international financial services.
Retail Market
DEMAND for retail space depends on the response of retailers to the growth (or fall) in retail sales. Prospects in this regard appear to be good, with retail sales up around 13 per cent in the year to March, 1999. Continued low retail interest rates, coupled with the likely further cuts in personal tax rates, should ensure that consumer expenditure remains strong in 2000 also.
Industrial market
AS with the office market, demand for industrial space is coming from a combination of the expansion in existing enterprises and the large inflow of new IDA sponsored projects. As with offices, demand is likely to be maintained in respect of growth in existing businesses, spurred by continued economic expansion. Future growth from incoming new projects is likely, however, to ease somewhat from its current unprecedented level.
In general, demand in 1999 will probably match last year's total of 3.7 million sq ft, and for the moment at least, there is no sign that this level of activity will ease next year.
Development cycle
ONE of the traditional early warning signals of an overheating property market is the volume of new speculative office, retail and industrial space under construction.
In general, the amount of speculative development activity is not, as yet, excessive, as developers have been more disciplined than in the past. The picture on a sectoral basis is as follows.
Offices
THE Dublin office market is historically highly cyclical, with scarcity of space sparking building booms which ultimately oversupply the market.
The current situation in the city is one where the vacancy rate has dropped to below 2 per cent, while demand for space is very strong, with over 2.4 million sq ft taken up in 1998. Rental growth is accelerating, and with the standard 12 to 18-month time lag in actually completing new space, growth should continue for some time. The volume of new office development has been increasing with about 2.6 million sq ft of speculative space currently under construction. Most of this space is due for completion in 2000.
Almost all of the space due for completion during 1999 has been pre-let and so it is possible to project a continuing scarcity of space, at least into 2000. Beyond 2000, the supply picture is likely to change, with a continuation in the trend of rising development activity coupled with a number of new locations focusing on office development.
Areas such as the Docklands, Sandyford and at Citywest could see a major increase in new development activity. Many of the larger schemes will be developed built on a phased basis, so that developers can match supply with demand. Large scale new supply in Docklands could take many years to materialise due to delays in the planning process and infrastructural issues.
Supply of suitable sites in the traditional office core in Dublin 2 and 4 will remain extremely limited and this will underpin values. Where sites are available and planning permission forthcoming, unbridled speculative development activity is a potential threat, although as noted earlier, most developers to date have not undertaken large scale speculative development, preferring to await at least partial pre-lets before starting on site.
Retail
THE retail development cycle is a little less pronounced than the office cycle. Most retail development takes the form of shopping centres, which are usually very large in terms of floor area and lot size. The time lag from conception to completion for shopping centres can in some cases take many decades. In general, however, new schemes require a minimum of two to three years.
A large number of schemes are in the pipeline but most have run into various planning difficulties. In particular, the 1998 ministerial directive banning new food stores of 34,000 sq ft or more put a temporary halt on many new projects, given that such food stores are the traditional anchors for new shopping centres. A Department of Environment review is now underway on the impact of out-of-town retailing.
One element of the review is the degree to which economic and population growth in a stated area is sufficient to absorb this new supply without serious damage being done to existing retail centres. It is likely that the review will not be complete until 2000 and the directive will not be relaxed before then (if at all). While the outcome of the review is uncertain, trends in the UK and the Continent are against large, out-of-town schemes.
Notwithstanding the directive, over 2.2 million sq ft of retail space is in the development pipeline and likely to come on to the market over the next two to three years. Most projects will proceed once the planning hurdles have been overcome, no doubt with the food store element down-sized.
Industrial Market
THERE is about 1.6 million sq ft of industrial space under construction, approximately 77 per cent of which is pre-let or presold.
The lead time for building new industrial space is much shorter than office or retail, and the ready availability of development land means that supply responds relatively quickly to a pick-up in values. This elasticity in supply is likely to ensure that new speculative development does not outstrip take-up in a major way.
Capital market
THE technical situation on the Irish property investment market has been positive for some time with a significant weight of money chasing a limited supply. A detailed consideration of the likely trends in this situation is an important ingredient in assessing prospects for the investment market.
The key factors are as follows:
Loan finance availability
A LARGE proportion of the cash available for property since 1994 has been funded by lending institutions as private/corporate investors have acquired up to 70 per cent of investments. Is this scenario likely to change over the next few years and if so, how?
The easy availability of loan finance for investors in commercial property has been driven by factors such as:
Competition for business among the traditional lenders.
Entry of new players including the building societies and foreign, especially German, banks.
Basic attractiveness of this type of lending when secure rent-roll exceeds borrowing costs and security is asset backed.
There have been suggestions that prudent lenders are becoming more selective in advancing loans as the credit cycle matures. As a general proposition, it is likely that the prime end of the commercial property investment market will benefit from such a "switch to quality".
Properties let to good covenants on long leases with upward-only rent reviews are highly secure from a banking perspective. Thus lenders, redirected away from more speculative or unsecured business are likely to compete for commercial property investment. The main risk to this scenario is that a serious credit squeeze causes lenders to withdraw from all business for a time.
Loan finance cost
THE cost of borrowing has fallen sharply as interest rates have declined and as competition has forced lenders to trim margins.
This has been the single most important factor in driving Irish property investment yields from their high of 8.5 per cent in 1993 to 5.8 per cent now.
Interest rates have however, started to trend upwards again. In particular, five-year fixed rate money is now available on the Interbank market at 5.2 per cent, up from 3.5 per cent at the beginning of the year. Property yields are unlikely to fall much further against this background. Obviously, if there were to be a significant further increase in interest rates, this would remove a major underpinning of the Irish property bull market.
Institutional cash flow
INSTITUTIONAL demand for Irish property has been unexciting for most of the 1990s (see table). This is due to the fact that many institutions have allowed the property component of their portfolios mark time. With equity markets under pressure at present and little prospect of major upside in bonds it is quite possible that institutional cash flow for property will grow in the short-medium term.
There are a small number of major funds with substantial cash earmarked for property investment, but there is no indication that managers are under pressure to invest. The UK property market has acted as a form of safety valve diverting excess liquidity.
Little work has been undertaken to assess the likely impact of EMU on the Irish property market. In the short term, the impact is likely to be slight, as national property markets in Europe vary considerably in terms of legislation, tax and structure. This situation will, no doubt, change in time and is one to watch.
Supply of investments
SUPPLY of investment stock is limited due to the relatively modest amount of development under way and to the fact that low relative interest rates have encouraged owners to hold and occupiers to buy rather than rent.
This scenario will change if/when the relative value position becomes eroded due to further decline in property yields and/or a further rise in interest rates.
John Bruder is head of property, AIB Investment Managers.
