Property rebound running out of steam as economy remains on the cool side

They have rebounded recently, though, and the bounce back has been rapid. In the autumn of last year, prices were looking very cheap by historic standards and investors with money to spend re-entered the market with gusto. This activity drove prices up once again, resulting in a 15.6 per cent increase in just 13 months.

Buyers have been mainly interested in prime properties, such as quality buildings in prime locations. The quality of the income stream has been equally important, however, with investors exhibiting a strong preference for secure long-term leases. As the market started to move rapidly, though, investors moved up the risk curve, buying more secondary properties.

Overseas investors were some of the most active participants, particularly in the central London markets. The weakness of the pound was an additional bonus, making UK assets look even cheaper to euro and dollar investors. Direct property funds have also been keen buyers, seeing large cash inflows that they were keen to place in the market.

Since early summer, however, the rebound has been running out of steam and prices remain well below their peak in mid-2007. Figures from the investment property databank (IPD) released on Tuesday show values were up only 0.1 per cent over the month of August, in comparison to an average increase of 1.2 per cent in each of the first four months of the year.

Long-term investors will know that the bounce-back is reminiscent of the rise in property prices that occurred after the downturn in the early 90s when we had a short-term price correction before a long-term recovery got underway. The drivers of the market have been positive investor sentiment and the weight of money coming into the sector, rather than property market fundamentals (such as rental growth prospects). We feel that this has made the recovery unsustainable in the short term.

Indeed, while the economy remains fragile, and with job cuts and tax increases looming, rental growth is likely to be sluggish for some time to come.

The sharp economic slump and the subsequent lack of occupier demand have driven rental values down by 10.9 per cent since the spring of 2007. And at an all property level, rents continue to decline, although there are some hot spots at the sector level. On a long-term view, rental values increase as economic growth eventually drives up demand for space, which in turn increases property values (the term "rental value" normally refers to the rent a property could achieve in the open market).

While falling rental values have had a negative impact on the rental income from property (i.e. the rent actually received by the landlords), the effect has been muted somewhat by the length and stability of property leases in the UK. Indeed, property income declined only around 2.5 per cent from peak to trough. Preserving, monitoring and growing income from property is, therefore, of key importance for direct property fund managers.

On the upside, central London offices are seeing a return to rental growth. In the City and West End of London, the credit crunch hit occupiers hard and fast; rental levels fell and development quickly ground to a halt, with schemes stopped or put on hold. But when financial and business services started to recover, these supply restrictions meant that occupier demand began to drive rents up again.

Rents for shops and shopping centres have actually fallen less over the last few years than those for offices, but they are unlikely to recover as quickly. There is an overhang of new retail space created by a high number of new shopping centre completions, particularly in 2008, and of second-hand space released by failed retailers. Many secondary centres continue to experience high levels of vacant shops, and occupier demand for retail property remains weak across many markets. Combining this with the likely impact that government cutbacks will have on consumer confidence and spending patterns, suggests that rents are likely to be suppressed over the next couple of years. The situation could be more acute for secondary and weaker retail centres than for central London offices and some other major retail centres.

Overall, there is a risk now that rental growth will disappoint in the short term, especially if employment growth in the private sector does not compensate for the jobs expected to be lost in the public sector. The impact of this on the commercial property market is most likely to be felt in locations with high public sector employment levels that have no strong private sector to take up the slack.

When investing in diversified property funds, the ability to spread the risk across different types of asset is critical. While central London may still provide the best prospects for growth in the short term, the retail sector should reassert itself when solid rental growth is re- established in the next couple of years. Despite our short-term concerns over rental growth, we believe that direct property investment remains an attractive long-term play. With a stable and secure income - currently running at around 7 per cent - and the potential for capital growth over the longer term, there is still a lot to like.• Rachel Aird is Investment Director, Real Estate at Scottish Widows Investment Partnership