In the US, office markets are facing their second year with more rental space dumped on the market than tenants are taking up.
This negative net absorption, unprecedented even through the previous and much more severe property recession of the early 1990s, has produced an interesting reaction from real estate securities analysts at Lehman Brothers: they have lowered their calculated capitalisation rates - or yields to European investors - on the property portfolios of most companies they track. In effect, the Lehman analysts have concluded property is becoming more valuable, even as vacancy rates are rising and rents are softening. Moreover, this perverse state of affairs is replicated in Europe.
Researchers at Knight Frank, looking at the UK market, point out that office performance is deteriorating. Rental growth on a one-, three- and six-month basis has been negative and getting worse. Voids within the office sector have more than doubled within the past five months to 16.3 per cent.
Nevertheless, total returns on property - the highest of any asset class on a six- or 12-month view - are rising, hitting 7.9 per cent in the 12 months through May, up from 7.1 per cent in March. Here, too, property is becoming more valuable as its underlying fundamentals weaken.
Knight Frank does not view this trend in a completely benign light. 'An intensification of investment activity and a reduction in yields, at a time when occupier demand is weakening must, however, be cause for concern,' the analysts say.
Lehman Brothers sounds an equally worried note in its latest Net Asset Value handbook for the US Real Estate Investment Trust sector. 'We caution that when cap rates are lowered to reflect weakening operating conditions, they will necessarily be raised as occupancies and rental rates increase . . .' the analysts note. 'Moreover, lower cap rates beget more supply and that, in turn, weakens the operating environment,' they say, pointing to continued construction of apartments despite falling rents and rising vacancies in that sector.
Lehman is urging REIT managements to take advantage of falling cap rates, selling into strength. 'Buying at low-cap rates will penalise returns for years to come,' the analysts warn. By continuing to buy in current conditions, property investors are saying that they are prepared to pay more in a falling market than they were when conditions looked more hopeful.
In trying to explain this phenomenon, Karen Sierecki, a professor of land economics and a consultant to the property advisers, BH2, points to collapsing equities markets. 'The answer,' she says, 'is that investors are lowering the risk premium they are demanding for investing in property.'
The equity risk premium is broadly defined as the additional amount of yield that investors expect to receive over that available on risk-free bonds to compensate them for the uncertainties of buying shares.
A similar premium, in theory can be applied to property purchases and is represented by the differential between the initial yield and short-term Treasury bills. And although property yields historically traded below those of gilts, the pattern has since been reversed. Arguably, gilt yields now reflect low inflationary expectations and, at last, those expectations have been priced into property in the form of higher initial yields demanded by investors. But how much more yield should investors expect from property than from Treasury notes and how does this compare with changing expectations on equities?
Profs Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School, in their book Triumph of the Optimists: 101 Years of Global Investment Returns, concluded that over the past century, equities had not yielded anything like what investors had believed.
Once historical data on yields had been stripped clean of various biases, they turned out to have delivered far less than the risks justified.
Moreover, Ms Sierecki says, investors are dubious about even whether the current equity markets are priced too high for the ris