Market Outlook: While more experienced investors will be protected by a well-balanced portfolio, new entrants may be more vulnerable to adverse movements in interest rates and a softening of rentals, writes Paul Cunningham

At the start of a new year, it is worth examining the outlook for the commercial property market in 2004 by having a look at each of the constituent sectors - retail, industrial and office - while also commenting on overseas investments.

Last year, the commercial property market in Ireland continued to perform quite strongly with total investment in retail, industrial and office property amounting to about €800 million. This is comparable to 2002 investment but it's fair to say that 2003 was a year of two halves.

The first half of the year was characterised by modest levels of activity throughout all sectors, primarily due to a slowdown in business confidence and increase in transaction costs such as stamp duty to 9 per cent. Consequently, many investors sought greener pastures abroad, mainly in the UK.

Overseas investment activity, I understand, will come in at around €2 billion for 2003, over twice the scale of the domestic investment market. This is a staggering statistic and is represented largely by "dry" UK investments on behalf of private investors, property syndicates, consortia and property funds. It is fair to say that Irish investors are now a large minority player in the UK property market.

While experienced professional investors will have the protection of a well-balanced portfolio assembled over time, new entrants are likely to be more vulnerable to adverse movements in interest rates and potential softening of rentals. Such investors should consider a more conservative investment approach in 2004 appropriate to their own financial circumstances.

The latter part of the 2003, certainly from September onwards, showed renewed activity in the domestic market, principally in the retail sector as both institutional disposals (Royal & Sun Alliance) and large corporate portfolios (Green Property) were acquired by private investors and consortia at new benchmark yield levels.

The market was also characterised by the return of the professional activists, both developers and investors of proven pedigree and experience. This will no doubt continue to be a key factor for the health of the market in 2004.

The retail sector was the strongest performer in the commercial market in 2003. Yields achieved last year at times seemed quite high (sub 3 per cent) and have consequences for continued rental growth. However, the retail property sector is likely to be active again this year as it will continue to attract both private and institutional investment.

Like most dynamics related to property, location will be one of the most important ingredients for success. Borrowers, be they developers or investors, may be wise to stress test interest rates or consider the benefits of appropriate interest rate hedging mechanisms in 2004 to counterbalance any likelihood of a rise in debt servicing costs.

Sufficient advance sales or lettings should be in place to at least ensure interest costs can be serviced and, while retail tenant demand continues to be robust, the developer/landlord's ability to attract the most beneficial tenant mix and negotiate the appropriate leases is hugely important.

In the industrial property market, demand appears to have shifted to the owner-occupiers for lot sizes of 186-465 sq m (2,000-5,000 sq ft), with less appetite from investors. Speculative industrial developments will not be a feature of the 2004 market.

The completion of various current infrastructural projects in Dublin, such as Luas, the Port Tunnel and the M50, should assist in copper-fastening industrial property values along these corridors and may present opportunities for further development. Continued efforts on public capital programmes should have a positive impact on strategically located towns and cities benefiting from new road networks.

Again, location will be critical. The low interest rate environment makes it attractive to purchase a unit for leasing purposes, as long as due caution is shown and, for developers and investors, the challenge in 2004 will be to buy in the right location at the right price with the benefit of acceptable tenants on good leases. Taken as a whole, the Dublin office market suffers from oversupply although prime yields remarkably stayed quite firm during 2003 at 5.75 per cent. I suspect this has more to do with low interest rates than market dynamics.

The suburban office market continues to be especially weak with falling rental levels and lettings on a floor-by-floor basis becoming more commonplace. It has been suggested there is approximately three years stock supply available on current vacancies.

Financing of properties without the benefit of a pre-letting agreement or sufficient alternative servicing mechanism will therefore be difficult to secure this year. Challenges may outnumber the opportunities in the office market.

Outside Dublin, we await further details on the implementation of the National Spatial Strategy and public service relocation strategy on localised supply and demand for regional property development and investment.

The overseas market will no doubt continue to attract investor interest in this year as transaction costs are lower and covenant choice and quality tends to be better. The recent increase in the UK base rate/LIBOR to 4 per cent (three-month variable) will begin to put pressure on investment yields. Irish borrowers looking to invest in the UK should be mindful of the foreign exchange entry costs, location and type of investment, as well as the impact of movements in interest rates and the timing of the proposed exit. I would like to emphasise that borrowers should be conscious of the potential for upward movements in interest rates this year and take appropriate steps to mitigate the risks involved.

In a wider economical context, the fundamentals for continued economic growth this year are solid with a low interest rate climate predicted to persist and a low level of inflation and unemployment estimates at sub 5 per cent.

On the world stage there are continuing signs of recovery in both the US and Japan and the ECB forecasts GDP growth rates for 2004 and 2005 at more encouraging levels of 1.6 per cent and 2.4 per cent respectively.

Overall, the commercial property market will continue to see considerable investment and development this year and likewise the banks will continue to play their part in supporting and assisting borrowers and helping identify the various risks involved.

• Paul Cunningham is head of property banking at Bank of Scotland (Ireland)