Value under Development

The theme of recovery is an enduring one in the commercial property market and property developer Development Securities (Dev Secs) is well placed to build on this sentiment.

Over the last 15 years, the company's strategy has always been to forward-fund large commercial development projects with institutional equity, typically from pension funds like Aviva and Standard Life which have an appetite for direct property exposure. The company's flagship development is Paddington Central in West London, where it has developed and leased high quality office buildings and a hotel. The majority of its projects are concentrated in London and major regional cities.

Because it seldom owns the projects it is actively developing, Dev Secs makes its money from project management fees (which generated £1.4m of income in 2008) and a profit share when developments are completed. Typically, this is calculated on a sliding scale - the sooner a building is leased, the greater Dev Sec's share. Its strong track record of developing and letting major schemes is attractive to both funding partners and potential occupiers.

In the last financial year, the group booked development profits of £22.9m, though this was overshadowed by a £66.4m valuation loss on its investment and development portfolios.

Nevertheless, de-risking development projects by working with joint venture partners (rather than taking on high levels of bank debt) has protected its balance sheet. Unlike the more highly leveraged real estate investment trusts (Reits), Dev Secs is modestly geared and at full year results in March, confirmed that it was not in danger of breaching its loan-to-value covenants. Of course, property values are still falling, but with £61m cash on the balance sheet, management is confident it can "cure" any potential breaches before they occur by injecting more equity and thus will not need to resort to a rights issue.

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Going forward, the group is looking to build on its track record of developing schemes in conjunction with equity partners. Discussions are progressing with traditional UK and European funding partners, as well as a broader group of overseas investors (thought to include US private equity funds) who are keen to buy into the UK's recovery story and also benefit from the weak pound.

Thus far into the downturn, the group has remained on the sidelines as the market continues to fall. However, its veteran management team believes that the time for re-entry is getting closer.

"We have a tactical advantage over our competitors because we don't use bank finance," says chief executive Michael Marx. "We are beginning to identify new projects in central London and explore JV partners, but it is a very complex process."

Shares have picked up in the last six weeks, in anticipation of deals being announced, but are still trading at 21 per cent below forecast NAV for 2009.

Dev Secs also has a small investment portfolio which provides valuable cash flow to cover operational expenses, and is actively looking for opportunities to grab assets on the cheap in the current market. In 2008, the total rent roll was £3m. The portfolio is nearly two-thirds retail, which could be regarded as the sector at greatest risk of tenant failure, but most of the properties are supermarket-anchored schemes let to quality covenants such as Waitrose and ASDA.

The abortive sale of the Oriental City shopping centre in Colindale, north London is one blot on its copy book. Its private investor buyer was unable to raise £52m of finance needed to complete the transaction, agreed in 2007, and Dev Secs is now repossessing the vacant property. It will retain a £16m deposit and the property is held at £25m on the balance sheet.

As it is not a Reit, there is no imperative to distribute rental income as a dividend, but given the lumpy nature of development profits, this company has never been regarded by investors as a dividend stock. We note that the full-year dividend was cut, but are also encouraged by management's decision to take the knife to their own pay packets, with the executive team taking a voluntary 10 per cent pay cut in January.