As we approach the last quarter of 2006 there still appears to be no end in sight to the relentless investor appetite for freehold commercial property.

The media is keen to point to the strength of the market particularly highlighting growth in capital values. Although this is true, as demand continues to outstrip supply boosting values, it doesn’t take account of the full market picture, which is more complex and hides a less positive reality for some highly geared investors.

Rental incomes have failed to keep pace with capital values and with stagnant rents and high values can come poor yields. Some private investors with highly geared portfolios are facing real difficulties particularly after the latest quarter point rise in interest rates. For example a 100% geared investment with an interest only loan at around 1% above the current base rate, is rewarded with yields at their peak of less than 5%. As a result, banks are increasingly keen to review and even call in some commercial property loans.

However many institutional investors and cash purchasers continue to see commercial property as a must have investment, as even yields of 4.5% are better than basic bank rates at around 2%.Many shrewd investments are also being made in improvement opportunities, where value can be added to a property to boost value for resale or to strengthen asset value, rather than an investment which is just pursuing rental growth. One recent client was able to purchase and transform a run down West Midlands office development with moderate refurbishment, attracting new occupants and therefore increased rental and service charge incomes, which covered double the cost of refurbishment. The resulting asset was then resold 12 months later with a more secure tenant base and a greatly enhanced capital value, which generated a £1.5m profit for the client.

By being selective about investments there are still many excellent deals to be done, but it is a more treacherous market that favours those taking professional advice. It is proving very easy for even experienced investors to get it wrong, spurred on by the strength of capital values and forced to take whatever becomes available as supply is still so limited. There is then a very real danger of paying an over inflated price or selecting a poor long term investment.

For example the trend of many blue chip organisations like banks opting for sale and leaseback arrangements for their property assets has thrown up investment opportunities. A property with a secure 10 year covenant in the form of a major high street bank as tenant may seem a sound investment. However with an inhouse team of property experts they will hotly contest any rental increase at the 5 year review and some will even use the accepted argument that the property, most of which have a hard frontage, is less appealing because of this hard frontage and should therefore have a lower rent. There is also then the question of what you do with this asset in the future. Although banks are keen to demonstrate an end to branch closures in the current climate, in a decades time when we have more IT literate generations of customers we may see another u-turn, leaving the owner with a property asset that is largely limited to bar or nightclub use!