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    Default Opportunity knocks in difficult times

    THIS is a difficult period for commercial property. Prices are falling, yields blowing out, valuations lagging, and markets not clearing.

    We know that prices will fall further over the next year and there's difficulty ahead for the leasing market.

    Has the investment market overreacted? Are yields too high?

    Many think the financial crisis has caused an overreaction in property markets, and current low prices present an opportunity to buy cheaply. In a sense, in some markets, that's true. But it's a little more complicated.

    We need to shift our focus from the downturn to understanding the extent to which markets overreacted in the preceding boom. This is the correction we had to have.

    It's not the financial crisis-induced shock to yields that's the aberration. It was the six-year financial engineering-driven boom that preceded it that took prices to unrealistically high levels.

    The inflow of funds became self-fulfilling as the weight of money drove a process of "yield compression" -- don't you love it when they make a name for it -- with the associated capital growth attracting a further inflow of funds.

    Initially, the logic of financial engineering was for investments that "washed their faces" in the sense that yields were higher than interest costs, with high gearing improving the return on equity. The listed property trusts and investment banks made their money by taking a fee on the way in and a fee on the way through.

    Through all this, there was a bias towards investments with higher returns, towards "yield accretive" (another name) properties, towards higher-yielding industrial property and favouring secondary, relative to premium property. Once again the inflow of funds caused a compression of relative yields. After a while, the yield compression was such that investments no longer washed their faces.

    But firming yields and capital growth still underwrote substantial returns. So the logic subtly shifted to total returns, implicitly assuming that capital growth would continue.

    What they forgot was that high gearing also meant higher risk. Yields were too low. And the compression in relative yields between sectors no longer reflected property risk. The boom had gone too far. Investment markets were riding for a fall.

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