Pension funds can look forward to 1998 with some optimism and back on 1997 with some relief, as far as the UK property market is concerned. According to provisional figures from performance measurement consultancy The WM Company, pension funds' property holdings showed average returns of 12.4% last year. This was a considerable improvement on 1996's 8.6% and well above the long-term (20-year) average of 10.7%. But there is always a fly in the ointment. Property was completely overshadowed by the 22% average return on UK equities. The UK property industry, in selling its merits to fund asset allocation committees, has more problems in downplaying the relative attractions of equities than in boosting the merits of property.

But at least the UK pension funds do not appear to have been running down their net property holdings in 1997 as they were in 1996. After net investment in property of only £28m in the first half of 1997, the figure for the third quarter jumped to £145m. However, property still accounts for only 4.9% of UK pension fund assets according to WM, up only marginally from the previous year.

1997 was important for UK commercial property as it marked the first occasion since the slump of 1990-93 that property had produced respectable returns based on its intrinsic merits. In other words, for the first time since the crash at the start of the decade, the increase in values was underpinned by rising rents. Good property returns were seen in 1993 and 1994, but this was mainly the result of a yield play: as bond yields dropped, investors moved into property for higher returns and thus forced capital values up. Rises in capital value that result from rising rents are far more soundly based.

Most of the forecasters are predicting another good year for UK property investment in 1998. The country is now at the point in the property cycle where demand is good, rents for good-quality space are rising and there is little yet in the way of speculative development of new space to ease the pressure on rents. The banks, which have been reluctant since the crash to finance speculative property development, are now talking more of the possibility. But even if talk turns rapidly into action it will be 18 months to two years before new space becomes available and perhaps slows the growth in rents.

The property industry will thus be watching very closely for evidence of renewed speculative development, as this could dominate prospects for growth in values from 2000 onwards.

Analysing last year's performance of institutionally-held property, Investment Property Databank (IPD) puts total returns at 15.5% - rather higher than WM's figure for the pension funds alone. Rental values grew on average by 5.6% over the year for the three main classes of business property, with offices making the largest contribution at 7.1% growth. Capital growth of 6.6% for all classes of property was a little higher than rental growth, thanks to a modest reduction in average yields, but rising rents were clearly the dominant factor.

The IPD figures underline the fact that most of the growth was in London and the south east. This pattern could well persist through 1998. Investors are likely to concentrate on quality, both by property type and location.

In the words of Peter Evans of agents DTZ Debenham Thorpe, the drivers of demand look good for the next three or four years with a shortage of the types of space that are most in demand. And as an additional technical factor, he points out that the average yield on property is again above the average yield on medium-dated UK government bonds. Commercial property in the UK has income attractions as well as growth possibilities.