Time to take property profits?

A weighted basket of large- and mid-cap Reits would have risen by 17.4 per cent so far this year. Meanwhile, the FTSE 100 index is up only 2.9 per cent. Industry fundamentals can hardly explain this stunning outperformance. Quite the opposite. Having bounced in the second half of 2009 and 2010, commercial property values followed the economy into a double-dip last autumn. On average, they now stand 2.5 per cent below their November level, according to data provider IPD.

The Reits tend to own better than average properties, with a big bias towards economically buoyant London. Nevertheless, with the notable exceptions of the West-End specialists Derwent London, Great Portland Estates and Shaftesbury, their portfolios have still been little better than flat. British Land, probably the most resilient of the large-cap Reits, saw its portfolio rise by a meagre 0.4 per cent during the six months to 31 March. Its arch rival, Land Securities, posted a slight valuation deficit for the same period.

Yet Land Securities' shares are up 23 per cent so far this year. In the absence of much good news from the company, the most plausible explanation is simply that they were too cheap after a terrible autumn in 2011. When we reviewed the sector as part of our annual FTSE 350 report in January, the shares traded on a 27 per cent discount to the company's adjusted net asset value (NAV). We noted at the time that it did not deserve such a low rating, and since then the market appears to have come to the same conclusion.

Likewise, shop landlord Hammerson was our value tip of the year in January, not because we were bullish on the retail sector (we weren't), but because its shares were trading on a 32 per cent discount to NAV. Happily, this started to reverse as soon as we published the article, and the shares are now up 25 per cent on our tip. But we cannot claim credit for the timing. As so often the case with value investing, there seemed to be few obvious catalysts for a re-rating at the time.

What happened there then?

Indeed, even with the benefit of hindsight, identifying a catalyst is hard. Various explanations have been ventured. Mike Prew at brokerage Jefferies suggests the market had been confusing the big London-oriented Reits with the wider property sector. When they reported even flat results, investors stopped discounting the worst-case scenario. It can also be argued that the Reits have meaningfully reduced their debt levels and risk profiles over the past year, by selling or pre-letting properties. News on that score, particularly from Hammerson, which has sold off most of its London offices, may have underpinned a relief rally.

But probably the most compelling rationalisation of the sector's strong performance centres on the unstoppable rise of gilts. 10-year gilt yields have fallen by over a percentage point over the past 12 months, unexpectedly prolonging a theme that has defied mortality at every turn. This reduces the sector's cost of debt, boosting profits and supporting valuations. And, even more importantly, it also reduces investors' threshold for what constitutes an acceptable return based on the industry's 'cost of equity'. Even if property prices are stagnant, prime rental yields of 4-5 per cent compare favourably with the 1.45 per cent return currently available from 10-year gilts.

So, what now? With portfolios stagnant and shares up strongly, discounts are back to around 10 per cent. Three broad scenarios present themselves. Reit shares could maintain their current trajectory, returning to being priced at NAV and possibly beyond. Only last summer, shares in British Land and Land Securities were trading at slight premia to NAV. Alternatively, they could stay at their current discounts while moving in line with portfolio performance. Finally, investors could reappraise the companies' prospects and ditch their shares as rapidly as they have bought them, or as rapidly as they ditched them this time last year. The FTSE 350 Real Estate index fell 19 per cent in August and September 2011, after a very strong first half.

Downing the Pom-Poms

Sadly, the scenario that looks least likely is the most bullish. Broking houses tend to err on the side of optimism, but it is increasingly hard to find a City analyst willing to talk up the sector. Indeed, those fund managers that did not spend August on holiday have had plenty of downgrades to digest.

Mr Prew, one of the City's most experienced property analysts, has been in the vanguard with a note entitled 'Topping Out'. Most tellingly, he revokes all his Reit buy recommendations. Michael Burt at Espirito Santo, among the most respected of the younger brokers, called the end of the rally much earlier, back in late March. He admits this was premature but reinforced his neutral view last month on the basis that growth is now necessary for returns. His key sector picks are Unite Group, Workspace and Great Portland - the first two because they offer recovery potential in reasonably strong sub-sectors and the third because it trades at an unjustified discount to the other West End specialists.

Most bearish of all is the veteran broker Alan Carter at Investec. He views the sector as "unreassuringly expensive" and notes a "definite feeling from some dedicated Reit funds that the time to take risk off and perhaps book some profits is now". At the same time, however, he admits there is "limited real commitment" for selling, because the euro crisis makes the big London Reits look like relative safe havens.

IC VIEW:

It is foolish to underestimate the enduring appeal of property, not so much for its own merits but as a medium-risk alternative to equities or bonds. Some of that appeal rubs off on the big Reits even though they are also equities. The sector is also helped by having very little exposure to continental Europe and hence the euro. All these negatives add up to a surprisingly powerful positive, particularly, perhaps, under the influence of quantitative easing.

But we would still not recommend buying at current levels. Commercial rents are unlikely to grow outside of the West End and seem bound to fall in marginal retail and office destinations. Buyers can still be found for top-quality buildings, but there isn't so much demand that prices will rise without rental growth. Developments can be profitable, but are commensurately risky; businesses continue to delay long-term decisions such as signing shop or office leases. These economic considerations might be irrelevant if the shares had performed poorly, but they haven't. Expect volatile share prices as sentiment continues to flip-flop, with long-term returns flowing mainly from dividends.