The recent improvement in the UK commercial property market has been dominated by the recovery of the Central London Office sector. However, historical data clearly demonstrates that this is the most volatile part of the UK market, providing investors with a high risk, high reward investment profile. For the traditional UK institutional investor it could be argued that this profile does not meet their core aspirations: asset liability matching, diversification, superior long run risk adjusted returns and a high yield backed by solid income. With this in mind, should Central London offices currently be on their radar?

The answer revolves around two key issues:
-The ability to achieve a level of return that reflects the additional risk, and
-Market timing

Assuming a core long-term target return of circa 7-8% per annum, an appropriate hurdle for a Central London investment is likely to be in the region of 12-15% pa. Given that yields are currently around 4.25% in the West End and a slightly less than 5.5% in the City, capital appreciation therefore needs to be into double digits. The question is whether the next three to five years can provide this degree of growth?

The good news is that the fundamentals for Central London offices continue to look appealing: vacancy rates are below their equilibrium levels, lack of finance will restrict future development completions and, relative to the rest of the UK, Central London has a lower economic reliance on public sector spending. Combined, these factors suggest that Central London currently provides a strong case for sustained rental growth. Moreover, whereas the IPD index suggests that rental values are only just beginning to recover (up 6-7% in 2010), data suggests that the real market has rebounded by over 30% (or by more than 40% when you factor in the rapid reductions in tenant incentives). Even without additional yield reduction, rental growth should therefore drive returns into the teens for at least the next three years.

Despite these positives, with the financial crisis still fresh in the memory and with the impact of recent events in Japan and the Middle East/North Africa still in the balance, Central London offices are certainly not without risk (albeit these events may, for an overseas investor, actually reduce the perception of the risk of investing in Central London). However, investment is all about the management of risk and, whilst timing is everything, the skilled manager should have the ability to create a balanced portfolio containing lower risk assets which will help to offset any additional risk from the Central London investments.

In conclusion, the amount of uncertainty around the globe means that now is not the time to take big risks with client capital. Despite this, we believe that Central London offices provide the best opportunity for medium-term performance. As such, we are advocating a neutral relative allocation to Central London; relative to the IPD benchmarks this would require circa 15% of a typical institutional property portfolio to be invested in the sector. Whilst a highly cautionary investor may decide against this approach, the more muted prospects for most other parts of the UK property market will mean that an absence of any Central London exposure could lead to a prolonged drag on relative performance.
(Sources: IPD, ING REIM)

Kevin Aitchison is CEO, ING Real Estate Investment Management UK

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