Property tips from Grainger

"If you buy well, maintain properties properly and do the right things to them before you sell, you should outperform the index." So says Andrew Cunningham, the mild-mannered chief executive of Grainger , Britain's largest listed residential landlord.

This advice is less obvious than it sounds. For a start, by "buying well" he doesn’t mean buying at auction. Quite the opposite - he thinks auction buyers tend to overpay, a phenomenon familiar to behavioural economists as the "winner's curse". If the value of the auctioned object can only be estimated - as is the case with houses - the winner is the bidder who has the highest estimate. But this is unlikely to be the real value of the house, which is probably closer to the average estimate. By the same logic, it is the seller who actually wins. It's no surprise Grainger is a familiar name in auction house catalogues.

It's also slightly counter-intuitive that "doing the right things before you sell" doesn't include a paint job: Grainger typically sells properties unmodernised. Mr Cunningham says the company only makes improvements where they unambiguously speed up the sale process - such as damp-proofing, without which buyers cannot get a mortgage. "If you put in a kitchen, it can cost £20,000. Are you really going to get a £20,000 valuation uplift? People want their own kitchen when they move into a house," he reasons.

Grainger does undertake larger-scale refurbishments. It recently built and sold off a penthouse on top of freehold building in Bayswater, for example, and it is also reconfiguring a block of flats in Islington. The works in Islington will add an extra 120 square feet to each flat, as well as improving the communal areas and general appearance. Mr Cunningham says major works like these have a better chance of making money than changing the odd fitting.

The test of his advice is the performance of Grainger's £1.9bn UK portfolio. Sure enough, this has been strong - particularly since house prices stagnated in 2010. The portfolio was marked up 2.8 per cent for the six months to 31 March, when the Halifax and Nationwide indices were both marginally down. And over the full year to Sep 30 it rose 3.8 per cent, again compared to declines for both major indices. The company usually sells at healthy premia to book value, so its valuations aren't overly bullish.

This strength can partly be explained by the portfolio's bias towards London and the South East, which account for about three quarters of its value. But house prices in Greater London only grew by 2 per cent over the year to September, according to the Halifax, and in the South East they fell. So Mr Cunningham's team must be doing something right.

Unfortunately, Grainger's share price has not given them much credit for it - it's down 15 per cent since October 2010, whereas the FTSE 250 is roughly flat. Landlords can draw a lesson here, too, albeit a much harder one: operational excellence is only part of the business of being a landlord.

The most obvious explanation for Grainger's underperformance is debt. The group's loan-to-value (LTV) ratio - debt as a share of gross assets - was 59 per cent in March, higher than most lenders and investors feel comfortable with. That debt is expensive, too, at an average rate of 6 per cent, and is proving hard to reduce (though not to refinance, mercifully). The situation would be desperate but for a deeply-discounted rescue rights issue in 2009.

Private landlords have neither the luxury of equity financing nor the broad access to international lenders available to FTSE 250 companies. If they get in trouble, they have little choice but to sell their best assets at the bottom of the cycle - a sure-fire way of destroying returns. The lesson, which is always worth repeating, is that property is a cyclical business. That makes anticipating corrections essential. Throughout the last crisis, Grainger blithely repeated its mantra about UK house-prices benefiting from a long-term demand-supply imbalance. But in a cyclical industry the long-term is not always the term that matters.

To be fair to Grainger, few big property companies did any better. British Land , which reported its annual results this week, boasted that it had outperformed the IPD commercial property index over five years "at a portfolio level". True, but irrelevant - investors buy into a company, not a portfolio, and at the geared company level British Land has massively underperformed the index. Likewise, adjusted for the rights issue Grainger's book value per share has fallen by 40 per cent over five years, whereas Nationwide's average house is worth only 7 per cent less. Strong portfolio management has been obliterated by poor balance-sheet management.

Property executives like to think that success is about doing good deals and repositioning assets. But the big money in property is made and lost by anticipating the cycle - just as the big money in investment is made and lost in asset allocation, not stock picking. Buy well and improve selectively, to be sure. But don't overlook the town for the houses.

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