The equivalent yield on prime commercial property rose further to 5.9% in the first quarter and is now 110 basis points above its recent trough, according to CB Richard Ellis. The yield remains below its average of 6.4% over 1972-2007 but this may be a poor guide to “fair value”, for two reasons.

First, rents fluctuate significantly with the economic cycle. A high yield may not indicate that property is cheap if rents have been boosted above a sustainable level by a buoyant economy. Conversely, it may be right to invest when yields are low if rents are below trend and likely to benefit from future strong economic growth.

Secondly, any judgement about valuation must take account of returns on competing assets. The rental yield is often compared with yields on conventional gilts but this is invalid because bond interest is fixed while rents rise with inflation over the long run. In other words, the rental yield should be compared with real not nominal interest rates.

The chart shows a measure of valuation that incorporates these considerations – the gap between the normalised or cyclically-adjusted rental yield and real yields on long-term index-linked gilts. The normalised yield is currently lower than the actual yield (5.6% versus 5.9%) because rents are estimated to be 4% above trend, reflecting the economy’s recent strength. (There were much greater deviations in the early 1970s and late 1980s, when rents overshot by 30-40%.)

A below-average normalised yield is, however, counterbalanced by the low level of yields on long-term index-linked gilts. The gap between the two has surged from 3.1% in last year’s second quarter to 4.7% currently – the highest since 2004 and well above a long-term average of 3.6%.

Tight credit conditions and a slowing economy will restrain demand for property space but current valuations already discount much gloom. Property should outperform government bonds over the medium term.