A Financial Stability Analysis of the Irish Commercial Property Market by Maria Woods

8/9/2019 A Financial Stability Analysis of the Irish Commercial Property Market by Maria Woods

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A Financial Stability Analysis of the Irish Commercial

Property Market

by Maria Woods1

ABSTRACT

While most research and analysis have tended to focus on the Irish residential market, it could be argued that developments in

the commercial property market have greater consequences for the stability of the Irish financial system. This may be especially

true in the light of international experience regarding recent financial crises in developed economies, the results of stress-testing

exercises and the current historically high share of commercial property-related lending to private non-financial corporates.

Over the period 2003 to 2006, there was a large increase in capital values in the Irish commercial property market without a

correspondingly large increase in rents. Consequently, income yields on all types of commercial property reached very low levels

in 2006. Of additional concern, from a financial stability perspective has been the rapid rates of increase in lending for commercial

property-related purposes during the same period. This paper investigates whether these trends are unique to Ireland, and considers

the extent to which the growth in commercial property values can be explained by fundamental factors. It addresses these issues

by examining recent trends in capital values and income yields on Irish commercial property on a historical and international basis

and finds that nominal income yields have followed a general downward trend since the mid-1990s. In common with the Irish

experience, robust capital growth combined with relatively static rental growth has been a feature of other commercial

property markets up to 2006. Additionally, over the last decade, yields on European commercial property have declined

significantly.

The occurrence of very low-income yields is puzzling in light of developments in property market fundamentals, such as vacancy

rates and rental values. The application of some simple discounted cash-flow techniques suggests that capital values may not be

fully explained by fundamental factors. It is possible however, that other factors, both domestic and global, have created a new

regime of lower income yields by increasing the pool of investors and increasing investor demand generally. This paper also

discusses a number of these factors.

1. Introduction

While most research and analysis have tended to focus

on the Irish residential market, it could be argued that

developments in the commercial property market have

greater consequences for the stability of the Irish

financial system. This may be especially true in the light

of international experience regarding recent financial

crises in developed economies, the results of stress-

testing exercises and the current historically high share

of commercial property-related lending to private non-

financial corporates.

Over the period 2003 to 2006, there was a large

increase in capital values in the Irish commercialproperty market. There was not, however, a

correspondingly large increase in rents. Furthermore,

apart from a brief interlude in 2001 and 2002 nominal

income yields on all types of Irish commercial property

1 The author is an economist in the Monetary Policy & Financial Stability Department. The views expressed in this paper are the personal responsibility

of the author and are not necessarily held by the Central Bank & Financial Services Authority of Ireland or by the ESCB. All remaining errors and

omissions are the authors. The author would like to thank colleagues within the CBFSAI for invaluable assistance in completing this paper.

Financial Stability Report 2007 75

have followed a general downward trend since the mid-

1990s. More recently, momentum in the rate of growth

in capital values on Irish commercial property has eased,

albeit not to the same extent as is occurring in the

residential market. Commercial property prices across all

sectors remained brisk in 2007, ranging from 9 per cent

to 11 per cent in the third quarter.

If a large increase in capital values such as occurred

in the Irish commercial property market between 2003

and 2006 cannot be justified by fundamental variables,

there exists the prospect of a future correction to more

sustainable levels. A disorderly correction or sharp

decline in prices would lead to a deterioration in banks

asset quality, increasing expenses for bad loans, erosion

of capital and a decrease in future lending capacity. An

orderly correction would conversely avoid such adverse

developments. In addition to heightening the risk of a

disorderly correction, a persistent misalignment of capital


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values from levels that could be justified by economic

and market-based fundamentals distorts the efficient

allocation of resources within the economy, indicating

over-investment in that asset class. It is extremely difficult

to correctly approximate a fundamentally-warranted

capital value; it requires rigorous statistical analysis that

is outside the scope of this paper. Instead, descriptive

analysis of long-run yields and the application of simple

discounted cash-flow methods are used in this paper to

shed light on the sustainability of recent trends in the

Irish market.

The aim is to provide a broad assessment of the

commercial property market from a financial stability

perspective by addressing a number of issues. In Section2, the links between the Irish banking sector and

commercial property are examined. An abrupt

correction in capital values could lead to a deterioration

in banks asset quality and declines in their income and

profitability. This section also outlines two financial crises

during the early-1990s in developed economies, where

real estate price adjustments were an important causal

factor. Their experience suggests that declines in

commercial property prices had greater implications for

the banking sector than decreases in residential house

prices. To further explore the relative risks posed by the

differing sub-sectors of the Irish property market the

results of the latest bottom-up stress-testing exercises for

the Irish banking sector are examined in this section.

Section 3 examines recent trends in capital values andincome yields on Irish commercial property on a

historical and international basis. In a first attempt to

uncover any indications of misalignment in capital

values, some overvaluation models that have been

developed for the residential markets are applied to the

commercial property market in Section 4. Bearing in

mind the limitations of these techniques, additional

driving forces that lie outside the scope of these models

are also outlined in this section.

2. The Importance of Commercial Propertyfor Financial Stability

2.1 Importance of Commercial Property for Irish

Banks2

One of the risks highlighted in the Financial Stability

Report 2006 was the concentration of the Irish loan

book in property-related lending. This currently accounts

for 62.4 per cent of the total lending to the private sector

2 The following analysis is based on Irish banks activities within the state.3 It is conceded that loans to the construction sector may also represent lending for residential activities. Therefore figures in the above analysis

correspond to the broadest measure of commercial property-related loans.4 Private-sector credit figures include securitisations.

76 Financial Stability Report 2007

and is growing at a brisk pace (24 per cent). To put these

figures in context, in September 2001 the equivalent

share was approximately 38 per cent.

A decomposition of total property-related lending

indicates that in 2006 commercial loans, broadly defined

as construction and real estate activities3, accounted for

42 per cent of the total while residential mortgages

comprised the remainder. A closer examination of

commercial property-related lending reveals that

advances for real estate activities have significantly

dominated this category since 2001. During 2006, at

least half of all commercial property loans were

extended for projects that were already pre-let or pre-

sold.

0

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25

30

As a percentage of PSC (LHS)

07Q20605040302011999Q4

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70

Annual percentage change (RHS)

annual percentage

change

Source: CBFSAIN ot e : P r i v a t e - s ec t o r c r ed i t f i gu re s i nc lud esecuritisations.

Chart 1: Commercial Property-Related

Lending Irelandpercentage

Although commercial property makes up a smaller

component of total property-related lending than

residential, this component is growing at a relatively fast

pace. In 2006, loans secured by commercial property

increased by an average annual rate of approximately 60

per cent (Chart 1) compared with 25 per cent for

residential mortgages. In early-2007, annual rates of

increase in commercial property-related lending beganto decelerate, albeit remaining at relatively robust rates.

As a percentage of outstanding private-sector credit,

commercial property loans have increased from 8 per

cent in 1999 Q4 to almost 27 per cent in 2007 Q2 4.


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Furthermore, according to Kearns & Woods (2006), the

share of residential mortgages in total property loans has

been declining slowly since the 1990s, indicating some

diversification away from the residential market and into

the commercial sector.

0

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4

6

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12

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18

ESNOLVPTIE*ITZADECAUKPL

Source: IMF and author's calculationsNote: * Commerical property figures are estimated forIreland. Figures include lending to both resident and non-resident sectors. Lending to the public sector is also included.

Chart 2: Ratio of Commerical Property-Related

Loans to Total Loans 2005percentage of total loans

It is extremely difficult to benchmark Irish banks

exposure to commercial property-related lending against

international comparators, as definitions of commercialproperty loans vary greatly between countries. However,

Chart 2 makes an attempt by drawing upon the

International Monetary Funds Financial Soundness

Indicators, which were compiled for end-2005. This chart

ranks countries according to the share of total loans to

both resident and non-resident sectors that can be

attributed to commercial property-related advances in

2005. Among this grouping, Ireland is estimated to be in

fifth position5. Since 2005, Irelands ratio has continued

to grow, reaching approximately 12 per cent in the first

quarter of 2007.

While property-related lending is important for all banks,

the focus of such lending can vary by bank. Only a small

number of institutions however, have a significantproportion of their property-related loans tied to the

commercial property market. The majority of Irish

mortgage lenders have a property loan portfolio

that is more equally distributed between residential

5 This is the broadest measure of Irish commercial property loans, as data on the sub category real estate activities were not available. It was proxied

by the category real estate and business activities.6 Taken from the Bank of England statistical release Analysis of bank deposits to and lending from UK residents. To compare with Irish results,

commercial property loans are defined as the sum of advances for construction and real estate.


mortgages and loans for commercial property.

Furthermore, this category of mixed focus lenders

accounts for over two-thirds of the banking sectors

total assets.

0

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30

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60

70

Q2070605040302011999Q4

Source: CBFSAINote: Refers to all credit institutions.

percentage

Chart 3: Commerical Property-Related Loans as a

Percentage of Loans to PNFCs-Ireland

A sectoral decomposition of private-sector credit shows

that lending to Private Non-Financial Corporates (PNFCs)

currently comprises the largest component of totalprivate-sector credit. The majority of this lending to

PNFCs is for commercial property-related purposes.

Additionally, between 1999 and 2007, the share of

PNFC loans extended for commercial property purposes

has more than doubled (Chart 3). By 2007 Q2, the

exposure to commercial property reached almost 70 per

cent of PNFC loans, while the equivalent share in the

United Kingdom was approximately 42 per cent6.

Moreover, commercial property-related lending has

been the main driving force behind the recent robust

annual growth in lending to Irish PNFCs. Although the

international trend has been for a decline in bank debt as

a major source of funding to PNFCs, Irish non-financial

corporates remain reliant on bank loan funding as non-

bank financial markets are not well developed. Between2001 and 2005, loans accounted for approximately 30

per cent on average of total liabilities for Irish non-

financial corporates (CSO, 2007).


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2.2 CBFSAI Bottom-Up Stress-Testing Results

In its mandate to maintain financial stability, the CBFSAI

and the Irish banking sector have conducted bottom-up

stress-testing exercises since 1999. These exercises

involve Irish retail banks evaluating the impact of

hypothetical recessions on their financial positions. The

last exercise took place in 20067. The limitations and

caveats of these exercises notwithstanding, they provide

a useful indication of the relative risks posed by the

differing sub-sectors of the Irish property market. The

results of the last bottom-up stress-testing exercise

suggest that commercial property-related lending poses

a greater credit risk to Irish banks in comparison with

residential mortgages.

In the shock scenario there is a greater deterioration in

asset quality for commercial property-related lending

than for residential mortgages (Chart 4). Asset quality is

measured as the rate of outstanding loans that are non-

performing. This rate rises to 2 per cent for commercial

loans during the hypothetical recession compared with

approximately 1 per cent for mortgages. Moreover, asset

quality is also higher for mortgages in the baseline

scenario.

0.0

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1.0

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2.0

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Commercial

Mortgage

ShockBase

Source: Kearns et al., 2006Note: Data are weighted average over period 2006 to 2008.

per cent

Chart 4: Asset Quality

7 For full results of the 2006 exercise see Kearns et al (2006). In this exercise banks were asked to assess their balance sheets in the context of

economic projections over the period 2006 to 2008. At the time of the exercise, these projections were based on forecasts contained in the CBFSAIs

Quarterly Bulletin No.1 2006 and extended to 2008. The results from these projections formed the baseline scenario. Two hypothetical adverse

shocks one severe and the other milder in nature were also applied to the baseline results.8 The cover ratio is the value of provisions to non-performing assets.


An additional measure of credit risk is the loss-given-

default rate and using this measure, commercial property

loans also pose the greatest risk, even in normal times

(Chart 5). This rate captures the percentage of an

outstanding loan that must be written off in the event of

default and is proxied by the cover ratio 8. In the baseline

scenario, Irish retail banks assume that they will lose 60

per cent of gross commercial loans that fall into arrears

compared with 18 per cent of non-performing residential

mortgages. It should also be noted that these rates are

strongly dependent upon an estimated recoverable

value of collateral, which may not be realised in the

event of a severe downward adjustment in capital

values.

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60

70

Commercial

Mortgage

ShockBase

Source: Kearns et al., 2006Note: Data are weighted average over period 2006-2008.Data are cover ratios-the value of provisions to the value ofnon-performing assets.

per cent

Chart 5: Loss-Given Default Rates

2.3 International Experience

Booms and busts in the real estate sector, both

residential and commercial, have played a major role in

recent financial crises in a number of developed

economies, most notably in the Nordic countries in the

early-1990s and in East Asia in the latter part of that

decade. In the majority of instances, sharp corrections in

commercial property prices tended to create relativelygreater losses for the financial system during times of

stress. There are two possible explanations for this

occurrence. First, default rates and subsequent credit


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losses may be lower for households compared with non-

financial corporates during times of crises. Secondly,

commercial capital values tend to be more volatile and

track the economic cycle with greater amplitude than

residential house prices. Although the macroeconomic

environment is vastly different from that which prevailed

in the early-1990s, and accepting that financial

innovation has increased the scope for hedging risks, it

is still important to review such episodes. There are two

illustrative examples the Nordic financial crises of the

early-1990s and the UK small banks crisis of the same

period.

During the 1980s the Nordic countries underwent

significant financial liberalisation. Prior to deregulation,the existence of interest-rate ceilings, quantitative

lending restrictions and foreign-exchange controls had

promoted an environment of excess demand for credit

(Drees and Pazarbasioglu, 1998). Lack of competition

within the banking sectors in these countries in the

1970s and early-1980s had also contributed to credit

rationing as banks were highly selective when assessing

credit risk, relying primarily on long-term relationships

between borrower and lender.

Financial liberalisation increased competition within the

Nordic banking sectors and credit standards were

subsequently loosened to gain market share. In an

environment of pent-up credit demand and a tax system

biased towards borrowing, the coincidence of robusteconomic growth and financial deregulation led to asset

and credit booms in these countries in the 1980s. A

significant proportion of this increase in credit was

extended to investors in both residential and commercial

property, which created a concentration of credit risk in

the property market. Adverse macroeconomic

Table 1: Non-performing loans (as a percentage of total non-performing loans)

Norway Sweden Finland

1988 1992 1991 1993 1991 1993

Firms 80 77 84 75 59 58

of which:

Construction 5 8 13 14Real estate business 16 30 75 50 16 12

Households 15 20 7 11 21 25

Source: Drees and Pazarbasiouglu (1998).

9 Over the course of the crisis, the share of non-performing loans that could be attributed to the real estate sector fell. A possible reason suggested

by the authors is that some of these non-performing loans may have been converted into real estate holdings by banks.


developments in the late-1980s, in conjunction with tax

reforms and monetary tightening, ended the boom in the

Nordic countries. Lower income growth and declining

asset prices created considerable credit losses for the

banking sector. In Sweden, property prices fell by more

than 50 per cent over 18 months (Andersson and

Viotti, 1999).

In common with other Nordic countries that suffered

similar crises in the early-1990s, the majority of loan

losses incurred by Swedish banks were property-related.

According to Drees et al. (1998), real estate losses

accounted for approximately 75 per cent of total loan

losses in 1991 and about 50 per cent in 19939.

Examining a sectoral breakdown of loan losses during

the crisis shows that losses on household loans

comprised only 11 per cent of losses in 1993, while non-

financial corporate loans accounted for 75 per cent

(Table 1). Nyberg (2005) believes that this outcome is to

be expected as a property investor generally funds

interest repayments with rental income and if the

building is left vacant, the investor may face difficulty

in meeting its debt-servicing obligations, increasing the

probability of default. Conversely, households may be

able to cover their interest payments with income from

different sources and are thus able to cope with short

periods of financial stress created by rises in interest rates

and short-term loss of income.

Although the deterioration in asset quality arising from

commercial property-related loans was not as marked in

Finland and Norway, real estate losses were still

significant. In 1992, 38 per cent of loan losses incurred

by the Norwegian banking sector resulted from defaults

on corporate loans that were extended for construction


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and real estate activities. Although households

accounted for a significant proportion of non-performing

loans in Finland, only 1 per cent of total households

loans were written off as credit losses. By contrast,

almost 50 per cent of Finnish banks exposures to the

real estate sector had to be either booked as non-

performing or written off (Drees et al., 1998).

Downward adjustments in commercial property prices

also caused huge financial disruption during the United

Kingdoms small banks crisis of the early-1990s. During

this crisis 25 banks failed and many more got into severe

financial difficulty (Logan, 2000). It was also necessary

for the Bank of England to extend liquidity to a few small

banks to prevent a widespread loss of confidence in the

banking sector. Previously, in the economic upturn in the

late-1980s, a number of small banks expanded rapidly,

extending credit as output and asset prices, particularly

commercial and residential property prices, increased.

Therefore, a big increase in property-related loans by

these banks led to a severely concentrated loan book.

Finally in the early-1990s, more restrictive monetary

policy conditions and a recession were accompanied by

a severe correction in property prices. Consequently the

small banks that were heavily exposed got into financial

difficulties. During the downturn, commercial property

prices suffered relatively greater cyclical deterioration

falling by 27 per cent (peak to trough) compared with a

14 per cent decline in residential house prices.

2.4 Financial Stability and Commercial Property

Abrupt changes in commercial property prices may

affect the financial health of banks through many

different channels. Specifically, sharp declines can lead

to a deterioration in asset quality and a decline in income

and profitability. International experience and results of

the Irish stress-testing exercises highlighted that the

reduction in asset quality was relatively greater for

commercial property loans compared with residential

mortgages, during times of severe financial stress.

A sharp decrease in capital values may increase the

probability of default on commercial property-related

loans for a number of reasons. During a period of bothrobust capital appreciation and accommodative lending

conditions, developers face perverse incentives which

may lead to greater risk taking (Herring and Wachter,

1999). Developers tend to be highly leveraged when

investing in commercial property, preferring to minimise

their capital exposure in each project so as to maximise

the amount of risk borne by the lender. Therefore, banks

require low loan-to-value ratios, more stringent loan


covenants, guarantees and some pre-selling on a

proportion of the project, when extending such

advances. During an economic upturn however,

increased competition may lead to a loosening in

lending standards and consequently covenants become

weaker. Also, commercial property projects are difficult

and costly to monitor by banks. Therefore, this

combination of asymmetric information and high gearing

provides developers with an opportunity to increase the

risk profile of their projects to maximise return during an

upturn. In this context, developers become more

vulnerable to default if there is an abrupt reversal in

capital values.

Moreover, if capital values decline significantly before a

developer completes a project, reduced collateral values

may obstruct the raising of bank funding necessary to

finish (Zhu, 2003). Such credit constraints increase the

possibility of non-performing loans. In this instance, if the

project is also near default the developer may not be

interested in contributing further capital to rescue the

project as the creditors may gain the benefits (Herring

and Wachter, 1999). Households, by contrast may have

a greater incentive to avoid default, as housing is both a

consumption and investment good for this sector.

Although commercial property loans usually have a

lower loan-to-value ratio than residential mortgages, it is

possible that in the event of a severe downturn, these

may prove insufficient if the market value was

determined at an exceptionally robust phase of the

property cycle. As previously mentioned, capital values

tend to exhibit relatively greater cyclical deterioration

than residential property prices. Therefore, sharp

declines in capital values will erode the value of

collateral securing these loans.

In addition to deteriorating asset quality, sharp declines

in commercial property prices may also indirectly impact

banks income and profitability, especially if banks are

highly dependent upon commercial property loans (Zhu,

2003). A downward adjustment in property prices may

lead to a smaller capital base and a decline in the value

of the banks own fixed assets thereby reducing future

lending capacity. Furthermore, a higher incidence of

non-performing loans requires increased provisions

resulting in a decline in profitability.

3. Recent Trends in Commercial Property Domestic and Global

Over the period 2003 to 2006, there was a large

increase in capital values in the Irish commercial


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property market. More recently, momentum in the rate

of growth of capital values on Irish commercial property

has eased, albeit not to the same extent as is occurring

in the residential market. Annual growth rates across all

sectors remained brisk in 2007, ranging from 9 per cent

to 11 per cent in the third quarter. The continued modest

recovery in rental values implies that the scale of the

divergence between the two series, which had been

growing since 2003, declined significantly in 2007.

Income yields across all sectors, remain however, at

low levels.

3.1 Long-Run Trends in Aggregate Capital Values

From 1970 to 2006, the average annual increase incapital values was approximately 9.3 per cent (Chart 6).

Capital values increased by a maximum of 28.9 per cent

in 1978 while the steepest decline was in 1975 (minus

8.8 per cent). Such summary statistics conceal the

significant swings in values during this time, which

created many local peaks and troughs. After a relatively

shallow correction in 2001 and 2002, the cumulative

growth in capital values over the period 2003 to 2006

was approximately 46 per cent. Annual growth in capital

values peaked in 2006 at around 24 per cent. While this

figure represents robust appreciation, Chart 7 highlights

that it is not exceptional by historical standards. Local

peaks in 1973, 1978 and 1999 exceeded this rate of

increase.

Furthermore, charting the period 1971 to 2006 highlights

the extreme cyclical volatility of the Irish commercial

property market (Chart 7). Relatively higher volatility

combined with cyclical deterioration implies that credit

risk may be higher on loans secured by commercial

property. Gavin (2000) finds that, in comparison with the

residential property market, the commercial property

market is much more volatile and follows the economic

cycle with greater amplitude. During the economic

slowdown that followed the first oil price shocks in 1973,

real capital values fell by almost 30 per cent in 1975.

Residential property prices by contrast, fell to a low of

minus 0.6 per cent during these years. Although the

divergence between the two sectors has not been asmarked since that period, capital values generally tend

to correct by greater amounts during a downturn.

Furthermore, the coefficient of variation10 for the

commercial sector was 6.0 between 1971 and 2006

compared with an equivalent figure of 1.8 for the

residential market.

10 The coefficient of variation is the standard deviation adjusted by the mean. Higher values imply greater variation.


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35Rental valuesCapital values

0602989490868278741970

Source: Jones Lang LaSalleNote: Data are quarterly averages.

Chart 6: Annual Percentage Change in Capital

and Rental Values Ireland

annual percentage

change

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Real GDP

0604019895928986838077741971

Real capital values Real new residential

Source: Jones Lang LaSalle, CSO, DoEHLG and author'scalculations

per cent

Chart 7: Real GDP and Real Growth in Residential

and Commercial Property Prices-Ireland

In recent years, there has been robust growth in

commercial capital values in many countries. As can be

seen from Chart 8, Ireland significantly outperformed its

European counterparts in terms of capital growth across

all commercial property sectors in 2006. In Ireland,


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IEFRSEUKDKESNONLPTFIITATCHDE

Source: Investment Property DatabaseNote: Derived from ungeared property returns measured ineuros.

annual percentage

change

Chart 8: Capital Growth on All Commercial

Property 2006

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OfficeRetail

IESEFRUKESDKPTNLFINOITATDKCH

Source: Investment Property DatabaseNote: Derived from ungeared property returns measured ineuros. Countries are ranked in ascending order according tocapital growth in the retail sector.

Chart 9: Capital Growth in the Retail and Office

Sectors 2006annual percentagechange

capital values increased by 21.9 per cent11 compared

with France and Spain, which recorded annual rates in

the region of 15 per cent and 11 per cent, respectively.

11 Figures are taken from the Investment Property Database and therefore 2006 capital growth for Ireland will differ from section 3.1, which is based

on Jones Lang LaSalle data.12 This divergence has been confirmed by another key source of data for the Irish commercial property market-the Society of Chartered Surveyors

and Investment Property Database (SCS/IPD) Ireland Index. However, using the SCS/IPD Ireland index this differential emerged slightly earlier, in

late-2002. In 2006, total capital values increased by 21.9 per cent while aggregate rental values grew by 4.7 per cent.


Not all European countries, however, experienced rates

of increase in capital values in 2006. In Germany and

Switzerland, capital values declined by 3.1 and 2.4 per

cent, respectively.

A sectoral examination of capital appreciation shows

that Ireland outranked all other countries in this grouping

across both the retail and office sectors in 2006 (Chart

10). In 2006, capital values in the Irish retail sector

increased by 22.8 per cent while in the United Kingdom

the equivalent figure reached 12.3 per cent. Sweden and

France also enjoyed buoyant market conditions in the

retail sector, as capital appreciation reached 16.9 per

cent and 16.6 per cent, respectively. With regard to the

office sector, only the United Kingdom experienced a

similar rate of capital growth as Ireland.

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25

Q307050301999793891985

Source: Jones Lang LaSalleNote: Data are bi-annual from 1985 through 1996 andquarterly from 1997 to date.

percentage points

Chart 10: Differential Between Annual Growth in

Capital and Rental Values-Ireland

3.2 Trends in Rental Growth and Income Yields

Although Irish capital values have grown strongly

between 2003 and 2006, there has not been a

correspondingly large increase in rental values. Over this

period, the cumulative growth in rental values on all

commercial property was just 7.4 per cent compared

with 46.2 per cent for capital values. Further, as can be

seen in Chart 10, apart from a brief interlude between

2001 and 2003, capital appreciation has outpaced rentalgrowth since late-1993, with the greatest absolute

differential between capital growth and rental growth

occurring in mid-200612. It was noted above that the


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historical time series show that capital growth and rental

growth tend to move broadly in tandem over time (Chart

6). This result is broadly consistent with the dividend

discount model, assuming a constant discount rate over

time. Although there have been brief periods of

deviation between the two series, since late-2003 there

has been a marked widening in the differential. The gap

between annual rates of increase in capital and rental

values increased significantly between 2005 Q2 and

2006 Q3 (Chart 10). Over this period, annual growth in

capital values averaged 20.5 per cent, while the mean

annual growth rate recorded for rental values was 3.3

per cent.

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10Initial yieldEquivalent yield

06040200989694929088861984

per cent

Chart 11: Equivalent and Initial Yield onIrish Commerical Property

Source: SCS/IPD and Jones Lang LaSalle

More recently, a moderation in annual rates of capital

appreciation which began in late-2006, combined with

the continued modest recovery in rental values, has

reduced the gap between the two series. By September

2007, the absolute divergence between capital growth

and rental growth has fallen significantly to 3.4

percentage points.

As a result of this divergence, yields on Irish commercial

property are currently at low levels regardless of which

definition is used (Chart 11). Furthermore, yields have

been following a downward trend since the mid-1990s.

The equivalent yield on Irish commercial property

reached historic lows in 2006. The equivalent yield is

defined as the rate at which the expected future income

13 These yields may be slightly misleading, especially if set during a boom phase. Although rent levels used are still subject to review, the fact that

rents are generally sticky downward implies that in a subsequent downturn, initial yields may be above market yields.


stream accruing to a property is discounted to current

gross capital value (IPD, 2007). Apart from a brief

upward movement between 2000 Q3 and 2002 Q4, the

equivalent yield on Irish commercial property has

followed a general downward trend over the last decade

and, over the years 1995 to 2006, declined to almost

half its earlier value - the yield shift has been

approximately 4 12 percentage points over this period. In

2006, the initial yield as calculated by Jones Lang LaSalle

reached a level last seen in the final quarter of 2000 and,

at 3.7 per cent, was below the historical average of 5.4

per cent. Initial yields are a measure of current return.

They are analogous to the dividend yield in equity

markets and are calculated as the net income (rental

income less management costs) divided by gross capital

value13. Even allowing for inflation, Chart 13 shows that

yields have reached low levels in 2006.

-4

-2

0

2

4

6

8

Real initial yield

Real equivalent yield

06040200989694929088861984

per cent

Source: SCS/IPD, Jones Lang LaSalle and CSO

Chart 12: Real Yields on Irish Commercial

Property

Unfortunately both of these measures of income yields

cover a very short time frame. During this time, Ireland

underwent significant economic transformation - from

the very depressed 1980s to exceptional growth during

the 1990s. Therefore, a longer time series of yields isnecessary to benchmark current levels. Chart 13 looks

at the prime yield on all commercial property between

1969 and 2007. The long-run average over this time is

5.8 per cent. Since 1998, Irish yields have fallen below

this average.


10/16

2

3

4

5

6

7

8

Long-run average (1969-2007)

07 Q30503019997959391898785838179777573711969

per cent

Chart 13: Prime Yield for Irish Commercial

Property

Source: Author's calculationsNote: Based on prices in the Dublin market. To obtain anaggregate price level, the representative price for each sectorwas weighted according to share of investment turnover.

The divergence between capital growth and rental

growth in total commercial property is also reflected

across all three sub-sectors (i.e., office, retail and

industrial). As with total commercial property, yields

across all three sectors are currently at low levels. Since

1980, initial yields on industrial property have been

consistently greater than yields in the other two sectors

(Chart 14). In the third quarter of 2007, the initial yield

on industrial property was approximately 5.1 per cent,

comparable to levels last seen in mid-2006. Since 2002,

there has been a significant difference in levels between

initial yields in the office and retail sectors, despite

moving closely together in the past. The initial yields on

office and retail sectors are currently 3.7 per cent and

2.9 per cent, respectively.

The occurrence of low yields on Irish commercial

property reflects an international trend. Over the last

decade, yields on European commercial property have

also declined significantly (BOIPB, 2007). In 2006, robust

capital growth combined with relatively static rental

growth was also a common feature of other internationalcommercial property markets. In its Financial Stability

Report 2006(2), Swedens Riksbank highlighted the

possibility of increased investment risk in the commercial

property market. Real property prices were rising rapidly

in 2006 Q1 but without a corresponding increase in

rents or a decline in vacancy rates. A rising risk-free long-

term rate in conjunction with a lower required yield

implied that the risk premium on Swedish property may


have fallen in line with other asset markets. The Riksbank

questioned this lower required yield (Chart 15), in view

of the fact that, to date, neither economic growth nor

increased employment growth had impacted rental

levels to any significant degree.

0

2

4

6

8

10

12

14

Industrial

Retail

Office

Q307060504030201009998969492908886841980

Source: Jones Lang LaSalleNote: Net income as a percentage of gross value. Data are bi-annual from 1980 through 1997 and quarterly from 1998 todate.

per cent

Chart 14: Initial Yields Ireland

82

0

2

4

6

8

10

12

14

Malm

Gteborg

Stockholm

0704019895928986831980

Source: Newssec ABNote: Data annex to Riksbank FSR 2007:1.

per cent

Chart 15: Average Direct Yield Required for

Centrally Located Office Premises Sweden


11/16

Data up to end-2006 for the commercial property

market in the United Kingdom also reveal a recent

divergence between trends in capital growth and rental

growth (Chart 16). From 2002, the annual rate of

increase in capital values has outpaced rental growth.

Capital growth averaged 8.5 per cent compared with a

mean of 1.2 per cent for rental growth over this period.

Strong growth in UK capital values has driven yields on

commercial property to historic lows of 5.5 per cent. This

yield is nearly half the rate experienced in the early-

1990s (Jenkinson, 2007). In common with Ireland, the

equivalent yield on total commercial property in the

United Kingdom has also been trending downwards in

recent times (Chart 17).

-20

-15

-10

-5

0

5

10

15

20

25Rental valuesCapital values

0604019895928986831980

Chart 16: Annual Percentage Change in Capital and

Rental Values-United Kingdom

Source: Investment Property Database.

annual percentage

change

Table 2: Comparison of European commercial property markets 2007Q1

Office Retail Warehousing

Average prime yield 4.90 4.69 6.39

Dublin 3.70 2.40 4.75

Average vacancy rate 8.16

Dublin 11.5

Source: Key Market Indicators 2007 Q1, Jones Lang LaSalle and authors calculations.

Note: 29 major European cities were used. Cities were chosen that had information covering both yields and vacancy rates.

The prime net initial yield is used and is defined as the initial net income at the date of purchase, as percentage of the purchase cost (including

both acquisition costs and transfer taxes).


0

2

4

6

8

10

12

14

All propertyIndustrialRetailOffice

060503019997959391898785831981

per cent

Chart 17: Equivalent Yields on UK Commercial

Property

Source: Investment Property Database

Even though trends in the Irish commercial property

market mirror those experienced in other international

markets, it is important to benchmark these

developments. Table 2 compares prime yields across

three commercial property sub-sectors in Dublin with the

European average as at 2007 Q1. This European average

is constructed using data on major European cities from

Jones Lang LaSalle in 2007 Q1. As can be seen from the

table, prime yields in Dublin are significantly lower than

the European average across all three categories. At 2.4per cent, the prime yield on retail property in Dublin is

the lowest among its European counterparts. Lisbon has

the highest yield in the European retail sector at 7 per

cent. Dublin also scored the lowest yield in the

warehousing sector. With respect to the office sector,

Dublin is outranked only by London (3.5 per cent) with

the lowest yield.


12/16

Jones Lang LaSalle also provides data on vacancy rates

for the office sector across major European cities.

Vacancy rates represent vacant floor space as a

percentage of the total stock. A low vacancy rate is

usually the result of robust employment growth

combined with an insufficient supply of adequate

leasable premises. Table 2 shows that the vacancy rate

in Dublin was high and exceeded the European average

in 2007 Q1. However, the highest vacancy rate was in

Frankfurt-am-Main (15.2 per cent) in Germany.

As was noted in Part 1 of the Report, the vacancy rate

in the Dublin office market has declined since 2002

based on data from CB Richard Ellis Gunne. The current

vacancy rate however, remains above the long-run

average.

4. Are Low Yields of Concern?

At present, such low yields in Ireland reflect strong

investor demand and suggest that these investors must

at present be either anticipating high future rental growth

or continued capital appreciation. Given that capital

growth rates have begun to ease of late, albeit still

maintaining a brisk pace and, although the economic

outlook remains positive which may support the recent

recovery in rents, the continued acceptance of such

yields may be questionable14. While low yields are not,

in themselves, conclusive evidence of a misalignment

within the commercial property market, it does raise

concerns about recent trends. If this recent large

increase in capital values cannot be justified by

fundamental variables within the economy, then a

misalignment may exist within the commercial sector. A

persistent misalignment of capital values from levels that

could be justified by economic and market-based

fundamentals distorts the efficient allocation of resources

within the economy, indicating possible overinvestment

in that asset class. A disorderly correction or sharp

decline in prices would lead to a deterioration in banks

asset quality, increasing expenses for bad loans, erosion

of capital and a decrease in future lending capacity. An

orderly correction in capital values to more sustainable

levels would conversely avoid such adverse

developments.

4.1 Applying Models from the Residential Market

Similar to other asset classes, commercial capital values

may be determined by the discounted future income

stream accruing to the property. Movements in the

expected future rental growth and the required rate of

return, which itself can be decomposed into long-term

interest rates and the property risk premium can exert

14 It is conceded that yields may not be fully representative of the true return on a property. Other features such as capital allowances, development

potential or a fixed rental term and lease structure may also come into play.


an influence on capital value dynamics (Zhu, 2003).

There are many difficulties associated with the correct

estimation of this relationship, as there are many

unobservable variables such as the property risk

premium and the expected future cash flow (Hordahl

and Packer, 2007). An estimation of the property risk

premium requires assumptions concerning investor

preferences and the degree of risk associated with

commercial property. The precise estimation of a

fundamental capital value, therefore, is subjective and

there are many proposed models. The more complicated

approaches are beyond the scope of this paper. The

approach here uses two simple variants of the

discounted present value model, which have already

been used to analyse prices in the Irish residential market(FSR, 2004). There are many caveats associated with

these models and therefore any conclusions of

misalignments are highly tentative.

First, the fundamental capital value is estimated as the

discounted present value of future rents over a period of

20 years. In the absence of data on forecasts of rental

values, it is assumed that investors are basing their

decisions on historical rates of growth. Based on data up

to 2007 Q3 and a 10-year Government bond yield of

4.38 per cent, this model shows that current capital

values may be broadly in line with fundamentals across

all three commercial property sectors. This version of the

discounted present value model, however, assumes that

the term structure of interest rates remains flat and the

level of estimated over- or under-valuation is extremely

sensitive to the discount factor chosen.

To correct for this shortcoming, a second approach

adjusts for the equilibrium relationship between the

price-earnings ratio (P/E ratio) and the long-term interest

rates drawing on the Gordon growth model. Chart 18

displays a scatter plot of the P/E ratio and the interest

rate for the retail sector. The gold line corresponds to

the equilibrium relationship between the 10-year

Government bond yield and the P/E ratio. Bounding this

estimated equilibrium relationship are the upper and

lower 95 per cent confidence bands. The extent to which

current levels of P/E ratios exceed these bands

represents a statistically significant misalignment of

actual P/E ratio from its equilibrium level. Based on data

up to 2007 Q3, this model suggests a statistically

significant misalignment in the region of 11 per cent for

the retail sector, 15 per cent for the industrial sector and

8 per cent for the office sector. However, a low

goodness-of-fit for this specification implies that a more

encompassing model needs to be developed.


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0

2

4

6

8

10

12

14

16

18

20

22

24

26

28

20 4 6 8 10 12 14 16

Bond yield

P/E ratio2007Q3

2006Q1

2003Q3

Equilibrium level

Upper bound (95 per cent)

Lower bound (95 per cent)

P/E ratio

Chart 18: P/E Ratio and 10-Year GovernmentBond Yield Irish Retail Sector

Source: Author's calculations

The limitations of the above models preclude drawing

conclusive evidence of a misalignment. Moreover, in

common with the residential market, the commercial

property market has some unique characteristics, which

may also explain why capital values may deviate from

fundamental values in the short run. First, an important

point to note is that the estimation of an index for capital

values is derived from valuations of standing investment

properties15 and is not based on actual transactions. Due

to the low level of transactions in the commercial

property market it is therefore difficult to assess if these

valuations correctly represent actual market values

(Whitley and Windram, 2003). Second, the supply

process may also only respond with a considerable lag

to changes in demand requirements. Information

transmission is also not very efficient in the commercial

property market. It is very costly to gather and is heavily

dependent on local knowledge, increasing the possibility

of errors by investors and developers (Zhu, 2003). Other

features specific to property markets and which differ

from equity markets are high transaction costs, the

inability to short-sell and lack of a common market place

(Hendershott et al, 2005).

4.2 Other Possible Driving Forces within the

Domestic Market

4.2.1 Liquidity ConstraintsThe availability of bank financing plays an important role

in determining property prices and may not be fully

taken into account in discounted cash-flow models. This

15 Standing investment properties as defined by the IPD are completed and lettable properties, [which] exclude the financial performance of properties

at the time when they are purchased, sold or in the course of development. This is to ensure that the indices only reflect market values and are

not influenced by abnormal profits/losses which may be generated through active management. These [properties] have at least two valuations

during the year.16 See FSR 2004 and Browne, Gavin and Reilly (2003) for further details.


may be especially relevant for capital values in the Irish

commercial property market, as some corporates may

not have access to capital markets. Lack of access to

credit would obstruct the purchase of land for

development, prevent the financing of construction

projects and inhibit the realisation of investor demand.

As has been noted in research on house prices, a

number of developments such as financial liberalisation

and membership of Economic and Monetary Union

(EMU) have increased the elasticity of loan supply to the

private sector16. Over the course of the 1980s and

1990s, the Irish financial system underwent a number of

very important liberalising measures. Some examples of

these measures are: the removal of sectoral guidelines

for the extension of loans, reductions in interest-rate

ceilings and falls in the primary liquidity ratios. Such

measures served to increase the supply of credit to the

private sector. Furthermore, by promoting the

integration of interbank money markets, EMU also

allowed Irish banks access to cheap sources of funding

enabling them to extend credit in response to

demand.

As the loan supply schedule becomes more elastic, any

increase in demand would lead to a bigger increase in

the volume of loans made available. A loosening of

liquidity constraints for formerly credit-rationed

corporates may have increased the number of Irish

investors. For a given number of opportunities in the Irish

commercial property market and in the context of a

favourable macroeconomic environment, an increased

pool of investors will lead to an increase in capital values.

In combination with the recent low growth in rental

values, this development would have driven income

yields to low levels.

4.2.2 Fiscal Incentives

Changes in fiscal policies may also play an important role

in the dynamics of capital values and may not be

captured by the discounted present value approach.

Capital allowances and a reduction in stamp duty may

heighten investor demand in certain commercial

property projects, which in turn drives capital

appreciation in these sectors. At present, the top rate of

stamp duty levied on non-residential property is 9 per


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cent17 compared with 6 per cent in 199718. Furthermore,

according to Gavin (2000), a number of tax-based

incentives on commercial property were introduced in

Ireland in recent years, to promote investment and

development in certain sectors of the property market

and in specifically designated areas. Some examples of

these schemes are the urban/rural and town renewal

schemes. Relief was also extended to the development

of multi-storey car parks, private hospitals and hotels in

certain areas and seaside resorts. Tax incentives were

also offered for companies operating in the IFSC and the

Dublin Docklands Area. Such incentives include capital

allowances, owner-occupier relief, double rent

deductions and deductions for depreciation on

qualifying developments.

In 2005, the Department of Finance commissioned two

consultancy reports to undertake a review of these

schemes19. With regard to the area-based schemes, one

report concluded that the three schemes should be

discontinued. More specifically, the urban renewal

scheme was found to be successful in promoting

regeneration in the targeted areas but in terms of

producing benefits for the community, it was less

successful, as there was a higher take-up by investors

than by owner-occupiers. Further, the rural renewal

scheme was found to have little impact on industrial or

commercial activity and there was very little take-up

under the town renewal scheme. Regarding the tax relief

schemes offered on hotels, those were found to havegreatly increased investment in this sector, increasing the

quality of hotel stock, but may have resulted in a

potential oversupply of accommodation. Also, no

Table 3: Asset Portfolio Performance (1989 to 2006)

Equiti es Equit ies Commercial Commercia l Res identia l Res idential Government

(incl. property property property property 10-year

dividends) (incl. (incl. rental bonds

income) income

Average annual

return (%) 13.672 16.755 10.209 17.174 10.40 19.60 6.440

Variance 523.094 554.794 142.533 148.336 46.62 59.59 4.922

Sharpe ratio 0.014 0.019 0.026 0.072 0.085 0.221

Source: Investment Property Databank, Irish Stock Exchange and authors calculations.

17 This applies to projects over \150,000.18 This rate applied to projects over 60,000.19 Information on both reports taken from the Department of F inances Tax Strategy Groups Paper No. 05/18.

http://www.finance.irlgov.ie/documents/tsg/2006/tg1805.pdf.


economic justification for offering incentives to build

multi-storey car parks was found. Both reports concluded

that the property-based tax incentive schemes were not

tax efficient, with most of the benefits accruing to high-

income individuals. It was concluded, for example, that

the reliefs under the urban renewal scheme were

enjoyed mainly by landlords and by private and

corporate investors. Budget 2006 confirmed the

discontinuation of various renewal schemes and those

on multi-storey car parks and hotels, with reliefs gradually

being phased out between December 2006 and July

2008.

4.2.3 Commercial Property as an Investment Asset

In terms of risk-adjusted returns, commercial property

appears to be a more attractive investment when

compared solely with Irish equities over the period 1989

to 2006 (Table 3). With respect to capital gains, equities

outperformed both property sectors and long-dated

Government bonds. However, if income returns are

included, the average annual return on residential

property over the years 1989 to 2006 exceeded the

equivalent figures for the other three asset classes in this

comparison. This result also holds if returns are adjusted

for risk by the Sharpe ratio over the sample period. The

Sharpe ratio normalises the return of an asset on a

measure of risk the higher the ratio, the greaterexpected return on that asset for a given level of risk.

Moreover, the Sharpe ratio for both property sectors

surpasses the ratio for equities.


15/16

To allow for the income return accruing to commercial

property in addition to capital gains, total returns as

calculated by SCS/IPD are included. In 2006, total

returns on Irish commercial property also outperformed

their international counterparts (Chart 19). This may be

a possible reason why Irish commercial property

investors may have preference for domestic investments.

0

5

10

15

20

25

30

IEZAFRCAUKNZDKNOESAUSEKR*NLPTFIITDE

Source: Investment Property DatabaseNote: * Consultative index. Data are based on nationalindices.

percentage

Chart 19: Total Returns on Commercial

Property 2006

4.3 Global Factors

As was noted in Section 3 the low level of yields in

Ireland reflects an international trend, suggesting some

global factors may be exerting an influence on yield

dynamics in commercial property markets. First, financial

innovation in the form of Real Estate Investment Trusts

(REITs) has increased the pool of investors and

transformed an illiquid asset such as commercial

property into a possible source of indirect investment. In

the 2006 Financial Stability Report, the Reserve Bank of

Australia suggests that the increase in investor demand

may be due to pension funds, which have been attracted

to a long-term income stream with high yields. REITs

have made indirect investment in commercial property

possible for these institutional investors. Jenkinson(2007) believes that such financial innovation is a

positive development for financial stability as it increases

diversification of risk.

Secondly, the global decline in yields on bonds may have

played a role in decreasing the required rates of return

on commercial property. Assuming a constant risk

premium, a decrease in the risk-free rate and in turn a


lower discount factor, will increase expected future cash

flows and may be stimulating investor demand and

increasing capital values. Furthermore, a decline in the

yield on bonds may have encouraged investors to invest

in riskier assets to find a higher nominal return. This

search for yield phenomenon has lead to an increase

in asset prices globally.

5. Summary and Conclusions

This paper aims to provide a broad assessment of Irish

commercial property from a financial stability

perspective. An investigation of the links between Irish

banks and commercial property shows that commercial

property loans make up a significant proportion of loansextended to the non-financial corporate sector.

Furthermore, commercial property-related loans are also

growing faster than residential mortgages. Additionally,

although much research has tended to focus on the risks

arising from the residential market, results of the bottom-

up stress-testing exercises and international experience

suggest that, in times of financial stress, it is exposure to

the commercial property market that causes the greatest

credit losses for the banking sector. Possible

explanations for this occurrence are relatively greater

incidences of defaults on commercial property-related

loans and the fact that commercial property prices tend

to exhibit greater cyclical volatility.

A statistical overview of recent trends shows that overthe period 2003 to 2006, there was a large increase in

capital values in the Irish commercial property market.

There was not, however, a correspondingly large

increase in rents. Furthermore, apart from a brief

interlude in 2001 and 2002 nominal income yields on all

types of Irish commercial property have followed a

general downward trend since the mid-1990s. Some

international markets have also mirrored this trend of

robust appreciation in capital values, indicating that

some global factors may be exerting a common

influence on investor demand for commercial property.

In common with the Irish experience, robust capital

growth combined with relatively static rental growth

featured in other commercial property markets up to

2006. Additionally, over the last decade, yields onEuropean commercial property have declined

significantly.

The occurrence and persistence of very low, nominal

and real income yields is puzzling in l ight of

developments in property market fundamentals such as

vacancy rates and rental values. Vacancy rates, while

declining, are high and rental growth remains low.


16/16

Additionally, the application of some simple discounted

cash-flow techniques suggests that capital values may

not be fully explained by fundamental factors. It is

possible however, that other factors, both domestic and

global have created a new regime of lower income yields

by increasing the pool of investors and increasing

investor demand generally. This paper discusses a

number of these factors. Further more rigorous research

is required to accurately assess the sustainability of low

yields.

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A Financial Stability Analysis of the Irish Commercial Property Market by Maria Woods

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