UKMarketWith the cost of borrowing in the UK at 6-6.5 per cent while yields on some prime properties are lower than 4 per cent, it may be time for Irish investors to reassess their UK investments, says Gretchen Friemann

Irish property investors are continuing to plough money into the UK market despite concerns that higher borrowing costs will trigger a slowdown in the sector.

Average funding rates are now 6-6.5 per cent while yields on some prime properties are lower than 4 per cent. This widening gap has prompted speculation that prices are likely to cool over the coming months as investors begin to bail out of the market.

Last week the Financial Times claimed the commercial property boom "has finally ended" after a Lambert Smith Hampton survey showed yields had marginally increased in late 2006. The gloomy assessment was backed up by a London-based economist who warned that returns may weaken significantly during the course of this year as the "market feels the impact of over-supply and previous big gains".

Ed Stansfield from Capital Economics, a leading economic research firm, said the "kind of returns that commercial property has delivered in all of its guises over the past few years is probably something that we are going to look back on as history rather than current". Yet this week the staggering price paid for "the Gherkin", as the iconic London skyscraper is known, seems to have shifted market sentiment onto more positive ground.

The 41-storey tower, designed by Foster and Partners, became the UK's most expensive office block after it was sold by the insurance group, Swiss Re, to German real estate group IVG Immobilien and Evans Randall, a private investment bank, for €907 million (£600 million).

30 St Mary Axe commands some of the city's highest rents and it's the prospect of strong rental growth across most sectors in the UK that has industry pundits maintaining an optimistic outlook.

According to Mike Doyle of Savills HOK, investor appetite for British property is still very strong despite the tougher financing conditions. "Investors see the performance of their asset in the rental growth although there is now careful stock selection."

Record low interest rates and comparatively high yields enabled geared Irish investors to become an established force within the UK market. But the rapid rise in borrowing costs is lifting the stakes and, for the first time in five years, the banks are beginning to show signs of nervousness.

Loan-to-value rates have been pulled back to between 65 and 75 per cent at most institutions from highs of 85 per cent just 12 months ago.

The head of commercial lending at one bank described the yield gap as "quite scary".

"It's difficult to see how you justify these acquisitions when yields have dipped to 4 per cent and the cost of financing is 6 per cent plus. The bottom line is that investors are going to be under water for some time." He claimed that banks were "not happy" with such deals but continue to fund them because they "need the business. The large institutions still have bucketfuls of cash to lend."

According to this source, some investors are reducing interest rate risk through currency hedges, either by purchasing UK property in euro or by buying up eurozone property in Swiss francs.

He claimed that the global phenomenon of converging yields and higher borrowing costs means investors have to think laterally. "Even if your yield is around 5 per cent you're still under water. The question is how do you beat the capital?"

Properties that offer a development or asset management angle in the UK are now the focus of attention for Irish investors and, according to this banking source, the smaller institutions are happy to fund such deals. "It does involve more risk and therefore more active management on the bank's part, but the lending time-frame tends to be shorter and you have some idea of where the asset is heading."

What has taken many industry pundits by surprise is the strength of demand for UK property. One source said that the rapid rise in borrowing costs had been expected to weaken investor appetite. "Our most optimistic assessment was that demand would hold steady but it has increased. I do think this level of interest stems from a herd mentality. We're not seeing the same values any more in the UK market but Irish investors are still wary about the different leasing and tax structures on the Continent."