A Financial Stability Analysis of the Irish Commercial

Property Market
by Maria Woods1

ABSTRACT

While most research and analysis have tended to focus on the Irish residential market, it could be argued that developments in
the commercial property market have greater consequences for the stability of the Irish financial system. This may be especially
true in the light of international experience regarding recent financial crises in developed economies, the results of stress-testing
exercises and the current historically high share of commercial property-related lending to private non-financial corporates.

Over the period 2003 to 2006, there was a large increase in capital values in the Irish commercial property market without a
correspondingly large increase in rents. Consequently, income yields on all types of commercial property reached very low levels
in 2006. Of additional concern, from a financial stability perspective has been the rapid rates of increase in lending for commercial
property-related purposes during the same period. This paper investigates whether these trends are unique to Ireland, and considers
the extent to which the growth in commercial property values can be explained by fundamental factors. It addresses these issues
by examining recent trends in capital values and income yields on Irish commercial property on a historical and international basis
and finds that nominal income yields have followed a general downward trend since the mid-1990s. In common with the Irish
experience, robust capital growth combined with relatively static rental growth has been a feature of other commercial
property markets up to 2006. Additionally, over the last decade, yields on European commercial property have declined
significantly.

The occurrence of very low-income yields is puzzling in light of developments in property market fundamentals, such as vacancy
rates and rental values. The application of some simple discounted cash-flow techniques suggests that capital values may not be
fully explained by fundamental factors. It is possible however, that other factors, both domestic and global, have created a new
regime of lower income yields by increasing the pool of investors and increasing investor demand generally. This paper also
discusses a number of these factors.

1. Introduction have followed a general downward trend since the mid-

While most research and analysis have tended to focus
on the Irish residential market, it could be argued that
developments in the commercial property market have
greater consequences for the stability of the Irish
financial system. This may be especially true in the light
of international experience regarding recent financial
crises in developed economies, the results of stress-
testing exercises and the current historically high share
of commercial property-related lending to private non-
financial corporates.
Over the period 2003 to 2006, there was a large
increase in capital values in the Irish commercial
property market. There was not, however, a
correspondingly large increase in rents. Furthermore,
apart from a brief interlude in 2001 and 2002 nominal
income yields on all types of Irish commercial property
1990s. More recently, momentum in the rate of growth
in capital values on Irish commercial property has eased,
albeit not to the same extent as is occurring in the
residential market. Commercial property prices across all
sectors remained brisk in 2007, ranging from 9 per cent
to 11 per cent in the third quarter.
If a large increase in capital values — such as occurred
in the Irish commercial property market between 2003
and 2006 — cannot be justified by fundamental variables,
there exists the prospect of a future correction to more
sustainable levels. A disorderly correction or sharp
decline in prices would lead to a deterioration in banks’
asset quality, increasing expenses for bad loans, erosion
of capital and a decrease in future lending capacity. An
orderly correction would conversely avoid such adverse
developments. In addition to heightening the risk of a
disorderly correction, a persistent misalignment of capital

1
The author is an economist in the Monetary Policy & Financial Stability Department. The views expressed in this paper are the personal responsibility
of the author and are not necessarily held by the Central Bank & Financial Services Authority of Ireland or by the ESCB. All remaining errors and
omissions are the author’s. The author would like to thank colleagues within the CBFSAI for invaluable assistance in completing this paper.

Financial Stability Report 2007 75

values from levels that could be justified by economic
and market-based fundamentals distorts the efficient
allocation of resources within the economy, indicating
over-investment in that asset class. It is extremely difficult
to correctly approximate a fundamentally-warranted
capital value; it requires rigorous statistical analysis that
is outside the scope of this paper. Instead, descriptive
analysis of long-run yields and the application of simple
discounted cash-flow methods are used in this paper to
shed light on the sustainability of recent trends in the
Irish market.
The aim is to provide a broad assessment of the
commercial property market from a financial stability
perspective by addressing a number of issues. In Section
2, the links between the Irish banking sector and
commercial property are examined. An abrupt
correction in capital values could lead to a deterioration
and is growing at a brisk pace (24 per cent). To put these
figures in context, in September 2001 the equivalent
share was approximately 38 per cent.
A decomposition of total property-related lending
indicates that in 2006 commercial loans, broadly defined
as construction and real estate activities3, accounted for
42 per cent of the total while residential mortgages
comprised the remainder. A closer examination of
commercial property-related lending reveals that
advances for real estate activities have significantly
dominated this category since 2001. During 2006, at
least half of all commercial property loans were
extended for projects that were already pre-let or pre-
sold.
Chart 1: Commercial Property-Related
Lending — Ireland
30 70
percentage annual percentage
change

in banks’ asset quality and declines in their income and

60
profitability. This section also outlines two financial crises 25

during the early-1990s in developed economies, where

50
real estate price adjustments were an important causal
20
factor. Their experience suggests that declines in
commercial property prices had greater implications for 40

the banking sector than decreases in residential house 15

prices. To further explore the relative risks posed by the 30

differing sub-sectors of the Irish property market the
10
results of the latest bottom-up stress-testing exercises for 20
the Irish banking sector are examined in this section.
Section 3 examines recent trends in capital values and 5 As a percentage of PSC (LHS)
10
income yields on Irish commercial property on a Annual percentage change (RHS)

historical and international basis. In a first attempt to

0 0
uncover any indications of misalignment in capital
1999Q4 01 02 03 04 05 06 07Q2
values, some overvaluation models that have been
Source: CBFSAI
developed for the residential markets are applied to the Note: Private-sector credit figures include
commercial property market in Section 4. Bearing in securitisations.
mind the limitations of these techniques, additional
driving forces that lie outside the scope of these models Although commercial property makes up a smaller
are also outlined in this section. component of total property-related lending than
residential, this component is growing at a relatively fast
2. The Importance of Commercial Property pace. In 2006, loans secured by commercial property
for Financial Stability increased by an average annual rate of approximately 60
per cent (Chart 1) compared with 25 per cent for
2.1 Importance of Commercial Property for Irish
residential mortgages. In early-2007, annual rates of
Banks2
increase in commercial property-related lending began
One of the risks highlighted in the Financial Stability to decelerate, albeit remaining at relatively robust rates.
Report 2006 was the concentration of the Irish loan As a percentage of outstanding private-sector credit,
book in property-related lending. This currently accounts commercial property loans have increased from 8 per
for 62.4 per cent of the total lending to the private sector cent in 1999 Q4 to almost 27 per cent in 2007 Q24.
2
The following analysis is based on Irish banks’ activities within the state.
3
It is conceded that loans to the construction sector may also represent lending for residential activities. Therefore figures in the above analysis
correspond to the broadest measure of commercial property-related loans.
4
Private-sector credit figures include securitisations.

76 Financial Stability Report 2007

Furthermore, according to Kearns & Woods (2006), the
share of residential mortgages in total property loans has
been declining slowly since the 1990s, indicating some
diversification away from the residential market and into
the commercial sector.
Chart 2: Ratio of Commerical Property-Related
Loans to Total Loans — 2005
percentage of total loans
PL UK CA DE ZA IT IE* PT LV NO
Source: IMF and author's calculations
Note: * Commerical property figures are estimated for
Ireland. Figures include lending to both resident and non-
resident sectors. Lending to the public sector is also included.
It is extremely difficult to benchmark Irish banks’
exposure to commercial property-related lending against
international comparators, as definitions of commercial
property loans vary greatly between countries. However,
Chart 2 makes an attempt by drawing upon the
International Monetary Fund’s Financial Soundness
Indicators, which were compiled for end-2005. This chart
ranks countries according to the share of total loans to
both resident and non-resident sectors that can be
attributed to commercial property-related advances in
2005. Among this grouping, Ireland is estimated to be in
fifth position5. Since 2005, Ireland’s ratio has continued
to grow, reaching approximately 12 per cent in the first
quarter of 2007.
While property-related lending is important for all banks,
the focus of such lending can vary by bank. Only a small
number of institutions however, have a significant
proportion of their property-related loans tied to the
commercial property market. The majority of Irish
mortgage lenders have a property loan portfolio
that is more equally distributed between residential
5
This is the broadest measure of Irish commercial property loans, as data on the sub category real estate activities were not available. It was proxied
by the category real estate and business activities.
6
Taken from the Bank of England statistical release ‘‘Analysis of bank deposits to and lending from UK residents’’. To compare with Irish results,
commercial property loans are defined as the sum of advances for construction and real estate.
mortgages and loans for commercial property.
Furthermore, this category of ‘‘mixed focus’’ lenders
accounts for over two-thirds of the banking sector’s
total assets.
Chart 3: Commerical Property-Related Loans as a
Percentage of Loans to PNFCs-Ireland
18 70
percentage
16
60
14
50
12
10 40
8
30
6
20
4
2 10
0 0
ES 1999Q4 01 02 03 04 05 06 07Q2
Source: CBFSAI
Note: Refers to all credit institutions.
A sectoral decomposition of private-sector credit shows
that lending to Private Non-Financial Corporates (PNFCs)
currently comprises the largest component of total
private-sector credit. The majority of this lending to
PNFCs is for commercial property-related purposes.
Additionally, between 1999 and 2007, the share of
PNFC loans extended for commercial property purposes
has more than doubled (Chart 3). By 2007 Q2, the
exposure to commercial property reached almost 70 per
cent of PNFC loans, while the equivalent share in the
United Kingdom was approximately 42 per cent6.
Moreover, commercial property-related lending has
been the main driving force behind the recent robust
annual growth in lending to Irish PNFCs. Although the
international trend has been for a decline in bank debt as
a major source of funding to PNFC’s, Irish non-financial
corporates remain reliant on bank loan funding as non-
bank financial markets are not well developed. Between
2001 and 2005, loans accounted for approximately 30
per cent on average of total liabilities for Irish non-
financial corporates (CSO, 2007).
Financial Stability Report 2007 77
2.2 CBFSAI Bottom-Up Stress-Testing Results An additional measure of credit risk is the loss-given-
default rate and using this measure, commercial property
In its mandate to maintain financial stability, the CBFSAI
loans also pose the greatest risk, even in normal times
and the Irish banking sector have conducted bottom-up
(Chart 5). This rate captures the percentage of an
stress-testing exercises since 1999. These exercises
outstanding loan that must be written off in the event of
involve Irish retail banks evaluating the impact of
default and is proxied by the cover ratio8. In the baseline
hypothetical recessions on their financial positions. The
scenario, Irish retail banks assume that they will lose 60
last exercise took place in 20067. The limitations and
per cent of gross commercial loans that fall into arrears
caveats of these exercises notwithstanding, they provide
compared with 18 per cent of non-performing residential
a useful indication of the relative risks posed by the
mortgages. It should also be noted that these rates are
differing sub-sectors of the Irish property market. The
strongly dependent upon an estimated recoverable
results of the last bottom-up stress-testing exercise
value of collateral, which may not be realised in the
suggest that commercial property-related lending poses
event of a severe downward adjustment in capital
a greater credit risk to Irish banks in comparison with
values.
residential mortgages.
Chart 5: Loss-Given Default Rates
In the shock scenario there is a greater deterioration in per cent 70

asset quality for commercial property-related lending Mortgage

60
than for residential mortgages (Chart 4). Asset quality is Commercial
measured as the rate of outstanding loans that are non-
50
performing. This rate rises to 2 per cent for commercial
loans during the hypothetical recession compared with
40
approximately 1 per cent for mortgages. Moreover, asset
quality is also higher for mortgages in the baseline
30
scenario.
20

Chart 4: Asset Quality 10

per cent 2.5

0
Base Shock

Mortgage
2.0 Source: Kearns et al., 2006
Note: Data are weighted average over period 2006-2008.
Commercial Data are cover ratios-the value of provisions to the value of
non-performing assets.
1.5

2.3 International Experience

1.0
Booms and busts in the real estate sector, both
residential and commercial, have played a major role in
recent financial crises in a number of developed
0.5
economies, most notably in the Nordic countries in the
early-1990s and in East Asia in the latter part of that
0.0 decade. In the majority of instances, sharp corrections in
Base Shock commercial property prices tended to create relatively
Source: Kearns et al., 2006 greater losses for the financial system during times of
Note: Data are weighted average over period 2006 to 2008. stress. There are two possible explanations for this
occurrence. First, default rates and subsequent credit

7
For full results of the 2006 exercise see Kearns et al (2006). In this exercise banks were asked to assess their balance sheets in the context of
economic projections over the period 2006 to 2008. At the time of the exercise, these projections were based on forecasts contained in the CBFSAI’s
Quarterly Bulletin No.1 2006 and extended to 2008. The results from these projections formed the baseline scenario. Two hypothetical adverse
shocks — one severe and the other milder in nature — were also applied to the baseline results.
8
The cover ratio is the value of provisions to non-performing assets.

78 Financial Stability Report 2007

losses may be lower for households compared with non-
financial corporates during times of crises. Secondly,
commercial capital values tend to be more volatile and
track the economic cycle with greater amplitude than
residential house prices. Although the macroeconomic
environment is vastly different from that which prevailed
in the early-1990s, and accepting that financial
innovation has increased the scope for hedging risks, it
is still important to review such episodes. There are two
illustrative examples — the Nordic financial crises of the
early-1990s and the UK small banks’ crisis of the same
period.
During the 1980s the Nordic countries underwent
significant financial liberalisation. Prior to deregulation,
the existence of interest-rate ceilings, quantitative
lending restrictions and foreign-exchange controls had
promoted an environment of excess demand for credit
(Drees and Pazarbasioglu, 1998). Lack of competition
within the banking sectors in these countries in the
1970s and early-1980s had also contributed to credit
rationing as banks were highly selective when assessing
credit risk, relying primarily on long-term relationships
between borrower and lender.
Financial liberalisation increased competition within the
Nordic banking sectors and credit standards were
subsequently loosened to gain market share. In an
environment of pent-up credit demand and a tax system
biased towards borrowing, the coincidence of robust
economic growth and financial deregulation led to asset
and credit booms in these countries in the 1980s. A
significant proportion of this increase in credit was
extended to investors in both residential and commercial
property, which created a concentration of credit risk in
the property market. Adverse macroeconomic
Table 1: Non-performing loans (as a percentage of total non-performing loans)
Norway
1988 1992
Firms 80 77
of which:
—Construction 5 8
—Real estate business 16 30
Households 15 20
Source: Drees and Pazarbasiouglu (1998).
9
Over the course of the crisis, the share of non-performing loans that could be attributed to the real estate sector fell. A possible reason suggested
by the authors is that some of these non-performing loans may have been converted into real estate holdings by banks.
developments in the late-1980s, in conjunction with tax
reforms and monetary tightening, ended the boom in the
Nordic countries. Lower income growth and declining
asset prices created considerable credit losses for the
banking sector. In Sweden, property prices fell by more
than 50 per cent over 18 months (Andersson and
Viotti, 1999).
In common with other Nordic countries that suffered
similar crises in the early-1990s, the majority of loan
losses incurred by Swedish banks were property-related.
According to Drees et al. (1998), real estate losses
accounted for approximately 75 per cent of total loan
losses in 1991 and about 50 per cent in 19939.
Examining a sectoral breakdown of loan losses during
the crisis shows that losses on household loans
comprised only 11 per cent of losses in 1993, while non-
financial corporate loans accounted for 75 per cent
(Table 1). Nyberg (2005) believes that this outcome is to
be expected as a property investor generally funds
interest repayments with rental income and if the
building is left vacant, the investor may face difficulty
in meeting its debt-servicing obligations, increasing the
probability of default. Conversely, households may be
able to cover their interest payments with income from
different sources and are thus able to cope with short
periods of financial stress created by rises in interest rates
and short-term loss of income.
Although the deterioration in asset quality arising from
commercial property-related loans was not as marked in
Finland and Norway, real estate losses were still
significant. In 1992, 38 per cent of loan losses incurred
by the Norwegian banking sector resulted from defaults
on corporate loans that were extended for construction
Sweden Finland
1991 1993 1991 1993
84 75 59 58
— — 13 14
75 50 16 12
7 11 21 25
Financial Stability Report 2007 79
and real estate activities. Although households
accounted for a significant proportion of non-performing
loans in Finland, only 1 per cent of total households
loans were written off as credit losses. By contrast,
almost 50 per cent of Finnish banks’ exposures to the
real estate sector had to be either booked as non-
performing or written off (Drees et al., 1998).
Downward adjustments in commercial property prices
also caused huge financial disruption during the United
Kingdom’s small banks’ crisis of the early-1990s. During
this crisis 25 banks failed and many more got into severe
financial difficulty (Logan, 2000). It was also necessary
for the Bank of England to extend liquidity to a few small
banks to prevent a widespread loss of confidence in the
banking sector. Previously, in the economic upturn in the
late-1980s, a number of small banks expanded rapidly,
extending credit as output and asset prices, particularly
commercial and residential property prices, increased.
Therefore, a big increase in property-related loans by
these banks led to a severely concentrated loan book.
Finally in the early-1990s, more restrictive monetary
policy conditions and a recession were accompanied by
a severe correction in property prices. Consequently the
small banks that were heavily exposed got into financial
difficulties. During the downturn, commercial property
prices suffered relatively greater cyclical deterioration
falling by 27 per cent (peak to trough) compared with a
14 per cent decline in residential house prices.
2.4 Financial Stability and Commercial Property
Abrupt changes in commercial property prices may
affect the financial health of banks through many
different channels. Specifically, sharp declines can lead
to a deterioration in asset quality and a decline in income
and profitability. International experience and results of
the Irish stress-testing exercises highlighted that the
reduction in asset quality was relatively greater for
commercial property loans compared with residential
mortgages, during times of severe financial stress.
A sharp decrease in capital values may increase the
probability of default on commercial property-related
loans for a number of reasons. During a period of both
robust capital appreciation and accommodative lending
conditions, developers face ‘‘perverse incentives’’ which
may lead to greater risk taking (Herring and Wachter,
1999). Developers tend to be highly leveraged when
investing in commercial property, preferring to minimise
their capital exposure in each project so as to maximise
the amount of risk borne by the lender. Therefore, banks
require low loan-to-value ratios, more stringent loan
80 Financial Stability Report 2007
covenants, guarantees and some pre-selling on a
proportion of the project, when extending such
advances. During an economic upturn however,
increased competition may lead to a loosening in
lending standards and consequently covenants become
weaker. Also, commercial property projects are difficult
and costly to monitor by banks. Therefore, this
combination of asymmetric information and high gearing
provides developers with an opportunity to increase the
risk profile of their projects to maximise return during an
upturn. In this context, developers become more
vulnerable to default if there is an abrupt reversal in
capital values.
Moreover, if capital values decline significantly before a
developer completes a project, reduced collateral values
may obstruct the raising of bank funding necessary to
finish (Zhu, 2003). Such credit constraints increase the
possibility of non-performing loans. In this instance, if the
project is also near default the developer may not be
interested in contributing further capital to rescue the
project as the creditors may gain the benefits (Herring
and Wachter, 1999). Households, by contrast may have
a greater incentive to avoid default, as housing is both a
consumption and investment good for this sector.
Although commercial property loans usually have a
lower loan-to-value ratio than residential mortgages, it is
possible that in the event of a severe downturn, these
may prove insufficient if the market value was
determined at an exceptionally robust phase of the
property cycle. As previously mentioned, capital values
tend to exhibit relatively greater cyclical deterioration
than residential property prices. Therefore, sharp
declines in capital values will erode the value of
collateral securing these loans.
In addition to deteriorating asset quality, sharp declines
in commercial property prices may also indirectly impact
banks’ income and profitability, especially if banks are
highly dependent upon commercial property loans (Zhu,
2003). A downward adjustment in property prices may
lead to a smaller capital base and a decline in the value
of the banks’ own fixed assets thereby reducing future
lending capacity. Furthermore, a higher incidence of
non-performing loans requires increased provisions
resulting in a decline in profitability.
3. Recent Trends in Commercial Property —
Domestic and Global
Over the period 2003 to 2006, there was a large
increase in capital values in the Irish commercial
property market. More recently, momentum in the rate
of growth of capital values on Irish commercial property Chart 6: Annual Percentage Change in Capital
has eased, albeit not to the same extent as is occurring and Rental Values — Ireland
in the residential market. Annual growth rates across all annual percentage 35
sectors remained brisk in 2007, ranging from 9 per cent Capital values Rental values change
30
to 11 per cent in the third quarter. The continued modest
recovery in rental values implies that the scale of the 25

divergence between the two series, which had been 20

growing since 2003, declined significantly in 2007.
15
Income yields across all sectors, remain however, at
low levels. 10

5
3.1 Long-Run Trends in Aggregate Capital Values
0
From 1970 to 2006, the average annual increase in
-5
capital values was approximately 9.3 per cent (Chart 6).
Capital values increased by a maximum of 28.9 per cent -10

in 1978 while the steepest decline was in 1975 (minus -15

8.8 per cent). Such summary statistics conceal the 1970 74 78 82 86 90 94 98 02 06
significant swings in values during this time, which
Source: Jones Lang LaSalle
created many local peaks and troughs. After a relatively Note: Data are quarterly averages.
shallow correction in 2001 and 2002, the cumulative
growth in capital values over the period 2003 to 2006
was approximately 46 per cent. Annual growth in capital Chart 7: Real GDP and Real Growth in Residential
values peaked in 2006 at around 24 per cent. While this and Commercial Property Prices-Ireland
figure represents robust appreciation, Chart 7 highlights
per cent 30
that it is not exceptional by historical standards. Local
25
peaks in 1973, 1978 and 1999 exceeded this rate of
20
increase.
15

10
Furthermore, charting the period 1971 to 2006 highlights
5
the extreme cyclical volatility of the Irish commercial
0
property market (Chart 7). Relatively higher volatility
-5
combined with cyclical deterioration implies that credit
-10
risk may be higher on loans secured by commercial
-15
property. Gavin (2000) finds that, in comparison with the
-20
residential property market, the commercial property
-25
market is much more volatile and follows the economic
Real GDP Real capital values Real new residential -30
cycle with greater amplitude. During the economic
-35
slowdown that followed the first oil price shocks in 1973,
1971 74 77 80 83 86 89 92 95 98 01 04 06
real capital values fell by almost 30 per cent in 1975.
Source: Jones Lang LaSalle, CSO, DoEHLG and author's
Residential property prices by contrast, fell to a low of calculations
minus 0.6 per cent during these years. Although the
divergence between the two sectors has not been as
marked since that period, capital values generally tend
to correct by greater amounts during a downturn. In recent years, there has been robust growth in
Furthermore, the coefficient of variation10 for the commercial capital values in many countries. As can be
commercial sector was 6.0 between 1971 and 2006 seen from Chart 8, Ireland significantly outperformed its
compared with an equivalent figure of 1.8 for the European counterparts in terms of capital growth across
residential market. all commercial property sectors in 2006. In Ireland,

10
The coefficient of variation is the standard deviation adjusted by the mean. Higher values imply greater variation.

Financial Stability Report 2007 81


Chart 8: Capital Growth on All Commercial
Property — 2006
annual percentage 25
change
Not all European countries, however, experienced rates
of increase in capital values in 2006. In Germany and
Switzerland, capital values declined by 3.1 and 2.4 per
cent, respectively.

A sectoral examination of capital appreciation shows

20
that Ireland outranked all other countries in this grouping
across both the retail and office sectors in 2006 (Chart
15 10). In 2006, capital values in the Irish retail sector
increased by 22.8 per cent while in the United Kingdom
10 the equivalent figure reached 12.3 per cent. Sweden and
France also enjoyed buoyant market conditions in the
retail sector, as capital appreciation reached 16.9 per
5
cent and 16.6 per cent, respectively. With regard to the
office sector, only the United Kingdom experienced a
0
similar rate of capital growth as Ireland.

Chart 10: Differential Between Annual Growth in

-5
Capital and Rental Values-Ireland
DE CH AT IT FI PT NL NO ES DK UK SE FR IE percentage points 25

Source: Investment Property Database

Note: Derived from ungeared property returns measured in 20
euros.

15

Chart 9: Capital Growth in the Retail and Office

10
Sectors — 2006
annual percentage 25
change 5
Retail Office

20
0

15
-5

10
-10
1985 89 93 97 99 01 03 05 07 Q3
5
Source: Jones Lang LaSalle
Note: Data are bi-annual from 1985 through 1996 and
quarterly from 1997 to date.
0

3.2 Trends in Rental Growth and Income Yields

-5
Although Irish capital values have grown strongly
-10 between 2003 and 2006, there has not been a
CH DK AT IT NO FI NL PT DK ES UK FR SE IE correspondingly large increase in rental values. Over this
Source: Investment Property Database period, the cumulative growth in rental values on all
Note: Derived from ungeared property returns measured in
euros. Countries are ranked in ascending order according to commercial property was just 7.4 per cent compared
capital growth in the retail sector. with 46.2 per cent for capital values. Further, as can be
seen in Chart 10, apart from a brief interlude between
2001 and 2003, capital appreciation has outpaced rental
capital values increased by 21.9 per cent11 compared growth since late-1993, with the greatest absolute
with France and Spain, which recorded annual rates in differential between capital growth and rental growth
the region of 15 per cent and 11 per cent, respectively. occurring in mid-200612. It was noted above that the
11
Figures are taken from the Investment Property Database and therefore 2006 capital growth for Ireland will differ from section 3.1, which is based
on Jones Lang LaSalle data.
12
This divergence has been confirmed by another key source of data for the Irish commercial property market-the Society of Chartered Surveyors
and Investment Property Database (SCS/IPD) Ireland Index. However, using the SCS/IPD Ireland index this differential emerged slightly earlier, in
late-2002. In 2006, total capital values increased by 21.9 per cent while aggregate rental values grew by 4.7 per cent.

82 Financial Stability Report 2007

historical time series show that capital growth and rental
growth tend to move broadly in tandem over time (Chart
6). This result is broadly consistent with the dividend
discount model, assuming a constant discount rate over
time. Although there have been brief periods of
deviation between the two series, since late-2003 there
has been a marked widening in the differential. The gap
between annual rates of increase in capital and rental
values increased significantly between 2005 Q2 and
2006 Q3 (Chart 10). Over this period, annual growth in
capital values averaged 20.5 per cent, while the mean
annual growth rate recorded for rental values was 3.3
per cent.
Chart 11: Equivalent and Initial Yield on
Irish Commerical Property
Equivalent yield Initial yield
1984 86 88 90 92 94 96 98 00
Source: SCS/IPD and Jones Lang LaSalle
More recently, a moderation in annual rates of capital
appreciation which began in late-2006, combined with
the continued modest recovery in rental values, has
reduced the gap between the two series. By September
2007, the absolute divergence between capital growth
and rental growth has fallen significantly to 3.4
percentage points.
As a result of this divergence, yields on Irish commercial
property are currently at low levels regardless of which
definition is used (Chart 11). Furthermore, yields have
been following a downward trend since the mid-1990s.
The equivalent yield on Irish commercial property
reached historic lows in 2006. The equivalent yield is
defined as the rate at which the expected future income
13
These yields may be slightly misleading, especially if set during a boom phase. Although rent levels used are still subject to review, the fact that
rents are generally sticky downward implies that in a subsequent downturn, initial yields may be above market yields.
stream accruing to a property is discounted to current
gross capital value (IPD, 2007). Apart from a brief
upward movement between 2000 Q3 and 2002 Q4, the
equivalent yield on Irish commercial property has
followed a general downward trend over the last decade
and, over the years 1995 to 2006, declined to almost
half its earlier value - the yield shift has been
approximately 4 1⁄2 percentage points over this period. In
2006, the initial yield as calculated by Jones Lang LaSalle
reached a level last seen in the final quarter of 2000 and,
at 3.7 per cent, was below the historical average of 5.4
per cent. Initial yields are a measure of current return.
They are analogous to the dividend yield in equity
markets and are calculated as the net income (rental
income less management costs) divided by gross capital
value13. Even allowing for inflation, Chart 13 shows that
per cent 10 yields have reached low levels in 2006.
9
Chart 12: Real Yields on Irish Commercial
8 Property
7 per cent 8
5 6
4
4
3
2 2
0 0
02 04 06
Real equivalent yield
Real initial yield -2
-4
1984 86 88 90 92 94 96 98 00 02 04 06
Source: SCS/IPD, Jones Lang LaSalle and CSO
Unfortunately both of these measures of income yields
cover a very short time frame. During this time, Ireland
underwent significant economic transformation - from
the very depressed 1980s to exceptional growth during
the 1990s. Therefore, a longer time series of yields is
necessary to benchmark current levels. Chart 13 looks
at the prime yield on all commercial property between
1969 and 2007. The long-run average over this time is
5.8 per cent. Since 1998, Irish yields have fallen below
this average.
Financial Stability Report 2007 83
 have fallen in line with other asset markets. The Riksbank
Chart 13: Prime Yield for Irish Commercial questioned this lower required yield (Chart 15), in view
Property of the fact that, to date, neither economic growth nor
per cent 8
increased employment growth had impacted rental
levels to any significant degree.
7

Chart 14: Initial Yields — Ireland

6

Long-run average (1969-2007)

per cent 14
5 Office
Retail
Industrial 12

4
10

3
8

2
6
1969 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Q3

Source: Author's calculations

4
Note: Based on prices in the Dublin market. To obtain an
aggregate price level, the representative price for each sector
was weighted according to share of investment turnover.
2

The divergence between capital growth and rental 0

growth in total commercial property is also reflected
across all three sub-sectors (i.e., office, retail and
industrial). As with total commercial property, yields
across all three sectors are currently at low levels. Since
1980, initial yields on industrial property have been
consistently greater than yields in the other two sectors
(Chart 14). In the third quarter of 2007, the initial yield
on industrial property was approximately 5.1 per cent,
comparable to levels last seen in mid-2006. Since 2002,
there has been a significant difference in levels between
1980 82 84 86 88 90 92 94 96 98 99 00 01 02 03 04 05 06 07 Q3
Source: Jones Lang LaSalle
Note: Net income as a percentage of gross value. Data are bi-
annual from 1980 through 1997 and quarterly from 1998 to
date.
Chart 15: Average Direct Yield Required for
Centrally Located Office Premises — Sweden
per cent 14

initial yields in the office and retail sectors, despite

Stockholm
moving closely together in the past. The initial yields on 12
Göteborg
office and retail sectors are currently 3.7 per cent and Malmö
2.9 per cent, respectively. 10

8
The occurrence of low yields on Irish commercial
property reflects an international trend. Over the last 6
decade, yields on European commercial property have
also declined significantly (BOIPB, 2007). In 2006, robust 4
capital growth combined with relatively static rental
growth was also a common feature of other international 2
commercial property markets. In its Financial Stability
Report 2006(2), Sweden’s Riksbank highlighted the 0
possibility of increased investment risk in the commercial 1980 83 86 89 92 95 98 01 04 07

property market. Real property prices were rising rapidly

Source: Newssec AB
in 2006 Q1 but without a corresponding increase in Note: Data annex to Riksbank FSR 2007:1.
rents or a decline in vacancy rates. A rising risk-free long-
term rate in conjunction with a lower required yield
implied that the risk premium on Swedish property may

84 Financial Stability Report 2007

Data up to end-2006 for the commercial property Chart 17: Equivalent Yields on UK Commercial
Property
market in the United Kingdom also reveal a recent
divergence between trends in capital growth and rental per cent 14
growth (Chart 16). From 2002, the annual rate of Office Retail Industrial All property
increase in capital values has outpaced rental growth. 12

Capital growth averaged 8.5 per cent compared with a

mean of 1.2 per cent for rental growth over this period. 10

Strong growth in UK capital values has driven yields on

commercial property to historic lows of 5.5 per cent. This 8

yield is nearly half the rate experienced in the early-

6
1990s (Jenkinson, 2007). In common with Ireland, the
equivalent yield on total commercial property in the
4
United Kingdom has also been trending downwards in
recent times (Chart 17).
2

Chart 16: Annual Percentage Change in Capital and 0

Rental Values-United Kingdom 1981 83 85 87 89 91 93 95 97 99 01 03 05 06

Source: Investment Property Database

Capital values Rental values annual percentage 25
change
20 Even though trends in the Irish commercial property
market mirror those experienced in other international
15
markets, it is important to benchmark these
10 developments. Table 2 compares prime yields across
three commercial property sub-sectors in Dublin with the
5
European average as at 2007 Q1. This European average
0 is constructed using data on major European cities from
Jones Lang LaSalle in 2007 Q1. As can be seen from the
-5
table, prime yields in Dublin are significantly lower than
-10 the European average across all three categories. At 2.4
per cent, the prime yield on retail property in Dublin is
-15
the lowest among its European counterparts. Lisbon has
-20 the highest yield in the European retail sector at 7 per
1980 83 86 89 92 95 98 01 04 06 cent. Dublin also scored the lowest yield in the
Source: Investment Property Database.
warehousing sector. With respect to the office sector,
Dublin is outranked only by London (3.5 per cent) with
the lowest yield.

Table 2: Comparison of European commercial property markets 2007Q1

Office Retail Warehousing

Average prime yield 4.90 4.69 6.39

Dublin 3.70 2.40 4.75

Average vacancy rate 8.16 — —

Dublin 11.5 — —

Source: Key Market Indicators 2007 Q1, Jones Lang LaSalle and author’s calculations.
Note: 29 major European cities were used. Cities were chosen that had information covering both yields and vacancy rates.
The prime net initial yield is used and is defined as the initial net income at the date of purchase, as percentage of the purchase cost (including
both acquisition costs and transfer taxes).

Financial Stability Report 2007 85

Jones Lang LaSalle also provides data on vacancy rates
for the office sector across major European cities.
Vacancy rates represent vacant floor space as a
percentage of the total stock. A low vacancy rate is
usually the result of robust employment growth
combined with an insufficient supply of adequate
leasable premises. Table 2 shows that the vacancy rate
in Dublin was high and exceeded the European average
in 2007 Q1. However, the highest vacancy rate was in
Frankfurt-am-Main (15.2 per cent) in Germany.
As was noted in Part 1 of the Report, the vacancy rate
in the Dublin office market has declined since 2002
based on data from CB Richard Ellis Gunne. The current
vacancy rate however, remains above the long-run
average.
4. Are Low Yields of Concern?
At present, such low yields in Ireland reflect strong
investor demand and suggest that these investors must
at present be either anticipating high future rental growth
or continued capital appreciation. Given that capital
growth rates have begun to ease of late, albeit still
maintaining a brisk pace and, although the economic
outlook remains positive which may support the recent
recovery in rents, the continued acceptance of such
yields may be questionable14. While low yields are not,
in themselves, conclusive evidence of a misalignment
within the commercial property market, it does raise
concerns about recent trends. If this recent large
increase in capital values cannot be justified by
fundamental variables within the economy, then a
misalignment may exist within the commercial sector. A
persistent misalignment of capital values from levels that
could be justified by economic and market-based
fundamentals distorts the efficient allocation of resources
within the economy, indicating possible overinvestment
in that asset class. A disorderly correction or sharp
decline in prices would lead to a deterioration in banks’
asset quality, increasing expenses for bad loans, erosion
of capital and a decrease in future lending capacity. An
orderly correction in capital values to more sustainable
levels would conversely avoid such adverse
developments.
4.1 Applying Models from the Residential Market
Similar to other asset classes, commercial capital values
may be determined by the discounted future income
stream accruing to the property. Movements in the
expected future rental growth and the required rate of
return, which itself can be decomposed into long-term
interest rates and the property risk premium can exert
14
It is conceded that yields may not be fully representative of the true return on a property. Other features such as capital allowances, development
potential or a fixed rental term and lease structure may also come into play.
86 Financial Stability Report 2007
an influence on capital value dynamics (Zhu, 2003).
There are many difficulties associated with the correct
estimation of this relationship, as there are many
unobservable variables such as the property risk
premium and the expected future cash flow (Hordähl
and Packer, 2007). An estimation of the property risk
premium requires assumptions concerning investor
preferences and the degree of risk associated with
commercial property. The precise estimation of a
fundamental capital value, therefore, is subjective and
there are many proposed models. The more complicated
approaches are beyond the scope of this paper. The
approach here uses two simple variants of the
discounted present value model, which have already
been used to analyse prices in the Irish residential market
(FSR, 2004). There are many caveats associated with
these models and therefore any conclusions of
misalignments are highly tentative.
First, the fundamental capital value is estimated as the
discounted present value of future rents over a period of
20 years. In the absence of data on forecasts of rental
values, it is assumed that investors are basing their
decisions on historical rates of growth. Based on data up
to 2007 Q3 and a 10-year Government bond yield of
4.38 per cent, this model shows that current capital
values may be broadly in line with fundamentals across
all three commercial property sectors. This version of the
discounted present value model, however, assumes that
the term structure of interest rates remains flat and the
level of estimated over- or under-valuation is extremely
sensitive to the discount factor chosen.
To correct for this shortcoming, a second approach
adjusts for the equilibrium relationship between the
price-earnings ratio (P/E ratio) and the long-term interest
rates drawing on the Gordon growth model. Chart 18
displays a scatter plot of the P/E ratio and the interest
rate for the retail sector. The gold line corresponds to
the equilibrium relationship between the 10-year
Government bond yield and the P/E ratio. Bounding this
estimated equilibrium relationship are the upper and
lower 95 per cent confidence bands. The extent to which
current levels of P/E ratios exceed these bands
represents a statistically significant misalignment of
actual P/E ratio from its equilibrium level. Based on data
up to 2007 Q3, this model suggests a statistically
significant misalignment in the region of 11 per cent for
the retail sector, 15 per cent for the industrial sector and
8 per cent for the office sector. However, a low
goodness-of-fit for this specification implies that a more
encompassing model needs to be developed.
 Chart 18: P/E Ratio and 10-Year Government
Bond Yield — Irish Retail Sector
2007Q3 Equilibrium level
Upper bound (95 per cent)
Lower bound (95 per cent)
2006Q1 P/E ratio
2003Q3
Bond yield
0 2 4 6 8 10 12
Source: Author's calculations
The limitations of the above models preclude drawing
conclusive evidence of a misalignment. Moreover, in
common with the residential market, the commercial
property market has some unique characteristics, which
may also explain why capital values may deviate from
fundamental values in the short run. First, an important
point to note is that the estimation of an index for capital
values is derived from valuations of standing investment
properties15 and is not based on actual transactions. Due
to the low level of transactions in the commercial
property market it is therefore difficult to assess if these
valuations correctly represent actual market values
(Whitley and Windram, 2003). Second, the supply
process may also only respond with a considerable lag
to changes in demand requirements. Information
transmission is also not very efficient in the commercial
property market. It is very costly to gather and is heavily
dependent on local knowledge, increasing the possibility
of errors by investors and developers (Zhu, 2003). Other
features specific to property markets and which differ
from equity markets are high transaction costs, the
inability to short-sell and lack of a common market place
(Hendershott et al, 2005).
4.2 Other Possible Driving Forces within the
Domestic Market
4.2.1 Liquidity Constraints
The availability of bank financing plays an important role
in determining property prices and may not be fully
taken into account in discounted cash-flow models. This
15
Standing investment properties as defined by the IPD are ‘‘completed and lettable properties, [which] exclude the financial performance of properties
at the time when they are purchased, sold or in the course of development. This is to ensure that the indices only reflect market values and are
not influenced by abnormal profits/losses which may be generated through active management. These [properties] have at least two valuations
during the year.’’
16
See FSR 2004 and Browne, Gavin and Reilly (2003) for further details.
may be especially relevant for capital values in the Irish
commercial property market, as some corporates may
not have access to capital markets. Lack of access to
P/E ratio 28
credit would obstruct the purchase of land for
26 development, prevent the financing of construction
24 projects and inhibit the realisation of investor demand.
22
As has been noted in research on house prices, a
20
18
number of developments such as financial liberalisation
16 and membership of Economic and Monetary Union
14 (EMU) have increased the elasticity of loan supply to the
12
10
private sector16. Over the course of the 1980s and
8 1990s, the Irish financial system underwent a number of
6 very important liberalising measures. Some examples of
4
these measures are: the removal of sectoral guidelines
2
0
for the extension of loans, reductions in interest-rate
14 16 ceilings and falls in the primary liquidity ratios. Such
measures served to increase the supply of credit to the
private sector. Furthermore, by promoting the
integration of interbank money markets, EMU also
allowed Irish banks access to cheap sources of funding
enabling them to extend credit in response to
demand.
As the loan supply schedule becomes more elastic, any
increase in demand would lead to a bigger increase in
the volume of loans made available. A loosening of
liquidity constraints for formerly credit-rationed
corporates may have increased the number of Irish
investors. For a given number of opportunities in the Irish
commercial property market and in the context of a
favourable macroeconomic environment, an increased
pool of investors will lead to an increase in capital values.
In combination with the recent low growth in rental
values, this development would have driven income
yields to low levels.
4.2.2 Fiscal Incentives
Changes in fiscal policies may also play an important role
in the dynamics of capital values and may not be
captured by the discounted present value approach.
Capital allowances and a reduction in stamp duty may
heighten investor demand in certain commercial
property projects, which in turn drives capital
appreciation in these sectors. At present, the top rate of
stamp duty levied on non-residential property is 9 per
Financial Stability Report 2007 87
cent17 compared with 6 per cent in 199718. Furthermore,
according to Gavin (2000), a number of tax-based
incentives on commercial property were introduced in
Ireland in recent years, to promote investment and
development in certain sectors of the property market
and in specifically designated areas. Some examples of
these schemes are the urban/rural and town renewal
schemes. Relief was also extended to the development
of multi-storey car parks, private hospitals and hotels in
certain areas and seaside resorts. Tax incentives were
also offered for companies operating in the IFSC and the
Dublin Docklands Area. Such incentives include capital
allowances, owner-occupier relief, double rent
deductions and deductions for depreciation on
qualifying developments.
In 2005, the Department of Finance commissioned two
consultancy reports to undertake a review of these
schemes19. With regard to the area-based schemes, one
report concluded that the three schemes should be
discontinued. More specifically, the urban renewal
scheme was found to be successful in promoting
regeneration in the targeted areas but in terms of
producing benefits for the community, it was less
successful, as there was a higher take-up by investors
than by owner-occupiers. Further, the rural renewal
scheme was found to have little impact on industrial or
commercial activity and there was very little take-up
under the town renewal scheme. Regarding the tax relief
schemes offered on hotels, those were found to have
greatly increased investment in this sector, increasing the
quality of hotel stock, but may have resulted in a
‘‘potential oversupply of accommodation’’. Also, no
economic justification for offering incentives to build
multi-storey car parks was found. Both reports concluded
that the property-based tax incentive schemes were not
tax efficient, with most of the benefits accruing to high-
income individuals. It was concluded, for example, that
the reliefs under the urban renewal scheme were
enjoyed mainly by landlords and by private and
corporate investors. Budget 2006 confirmed the
discontinuation of various renewal schemes and those
on multi-storey car parks and hotels, with reliefs gradually
being phased out between December 2006 and July
2008.
4.2.3 Commercial Property as an Investment Asset
In terms of risk-adjusted returns, commercial property
appears to be a more attractive investment when
compared solely with Irish equities over the period 1989
to 2006 (Table 3). With respect to capital gains, equities
outperformed both property sectors and long-dated
Government bonds. However, if income returns are
included, the average annual return on residential
property over the years 1989 to 2006 exceeded the
equivalent figures for the other three asset classes in this
comparison. This result also holds if returns are adjusted
for risk by the Sharpe ratio over the sample period. The
Sharpe ratio normalises the return of an asset on a
measure of risk — the higher the ratio, the greater
expected return on that asset for a given level of risk.
Moreover, the Sharpe ratio for both property sectors
surpasses the ratio for equities.

Table 3: Asset Portfolio Performance (1989 to 2006)

Equities Equities Commercial Commercial Residential Residential Government

(incl. property property property property 10-year
dividends) (incl. (incl. rental bonds
income) income

Average annual
return (%) 13.672 16.755 10.209 17.174 10.40 19.60 6.440
Variance 523.094 554.794 142.533 148.336 46.62 59.59 4.922
Sharpe ratio 0.014 0.019 0.026 0.072 0.085 0.221 —

Source: Investment Property Databank, Irish Stock Exchange and author’s calculations.

17
This applies to projects over \150,000.
18
This rate applied to projects over £60,000.
19
Information on both reports taken from the Department of Finance‘s Tax Strategy Group‘s Paper No. 05/18.
http://www.finance.irlgov.ie/documents/tsg/2006/tg1805.pdf.

88 Financial Stability Report 2007

To allow for the income return accruing to commercial
property in addition to capital gains, total returns as
calculated by SCS/IPD are included. In 2006, total
returns on Irish commercial property also outperformed
their international counterparts (Chart 19). This may be
a possible reason why Irish commercial property
investors may have preference for domestic investments.
Chart 19: Total Returns on Commercial
Property — 2006
percentage
DE IT FI PT NL KR* SE AU ES NO DK NZ UK CA FR ZA IE
Source: Investment Property Database
Note: * Consultative index. Data are based on national
indices.
4.3 Global Factors
As was noted in Section 3 the low level of yields in
Ireland reflects an international trend, suggesting some
global factors may be exerting an influence on yield
dynamics in commercial property markets. First, financial
innovation in the form of Real Estate Investment Trusts
(REITs) has increased the pool of investors and
transformed an illiquid asset such as commercial
property into a possible source of indirect investment. In
the 2006 Financial Stability Report, the Reserve Bank of
Australia suggests that the increase in investor demand
may be due to pension funds, which have been attracted
to a ‘‘long-term income stream with high yields’’. REITs
have made indirect investment in commercial property
possible for these institutional investors. Jenkinson
(2007) believes that such financial innovation is a
positive development for financial stability as it increases
diversification of risk.
Secondly, the global decline in yields on bonds may have
played a role in decreasing the required rates of return
on commercial property. Assuming a constant risk
premium, a decrease in the risk-free rate and in turn a
lower discount factor, will increase expected future cash
flows and may be stimulating investor demand and
increasing capital values. Furthermore, a decline in the
yield on bonds may have encouraged investors to invest
in riskier assets to find a higher nominal return. This
‘‘search for yield’’ phenomenon has lead to an increase
in asset prices globally.
5. Summary and Conclusions
30 This paper aims to provide a broad assessment of Irish
commercial property from a financial stability
25 perspective. An investigation of the links between Irish
banks and commercial property shows that commercial
property loans make up a significant proportion of loans
20
extended to the non-financial corporate sector.
Furthermore, commercial property-related loans are also
15
growing faster than residential mortgages. Additionally,
although much research has tended to focus on the risks
10 arising from the residential market, results of the bottom-
up stress-testing exercises and international experience
5
suggest that, in times of financial stress, it is exposure to
the commercial property market that causes the greatest
credit losses for the banking sector. Possible
0
explanations for this occurrence are relatively greater
incidences of defaults on commercial property-related
loans and the fact that commercial property prices tend
to exhibit greater cyclical volatility.
A statistical overview of recent trends shows that over
the period 2003 to 2006, there was a large increase in
capital values in the Irish commercial property market.
There was not, however, a correspondingly large
increase in rents. Furthermore, apart from a brief
interlude in 2001 and 2002 nominal income yields on all
types of Irish commercial property have followed a
general downward trend since the mid-1990s. Some
international markets have also mirrored this trend of
robust appreciation in capital values, indicating that
some global factors may be exerting a common
influence on investor demand for commercial property.
In common with the Irish experience, robust capital
growth combined with relatively static rental growth
featured in other commercial property markets up to
2006. Additionally, over the last decade, yields on
European commercial property have declined
significantly.
The occurrence and persistence of very low, nominal
and real income yields is puzzling in light of
developments in property market fundamentals such as
vacancy rates and rental values. Vacancy rates, while
declining, are high and rental growth remains low.
Financial Stability Report 2007 89
Additionally, the application of some simple discounted
cash-flow techniques suggests that capital values may
not be fully explained by fundamental factors. It is
possible however, that other factors, both domestic and
global have created a new regime of lower income yields
by increasing the pool of investors and increasing
investor demand generally. This paper discusses a
number of these factors. Further more rigorous research
is required to accurately assess the sustainability of low
yields.
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