Looking beyond the Reits

Which UK public company owns the most property? You might be tempted to say Land Securities, London's largest real-estate investment trust (Reit), whose portfolio is worth £10.7bn. But in fact the answer is Tesco - and by a very large margin. Even valued at cost net of depreciation, rather than marked up to market prices, the grocer's property estate is worth £21.8bn.

Stock pickers who appreciate the security of property should take a serious look at companies like Tesco, which own real estate without being real-estate companies. They offer impressive levels of asset-backing - the reassurance that, if the company went bust, its properties could be sold to bail out shareholders - but without as much exposure to the cyclical vagaries of property pricing as, say, Land Securities. Tesco's enterprise value (market capitalisation plus net debt) is £36.6bn, suggesting that about 60 per cent of the business is backed by property. The equivalent figures for its smaller rivals are even higher - 80 per cent for Sainsbury's and 96 per cent for Morrison. Sainsbury's even provides an estimated market value for its properties of £11.2bn, which is 32 per cent more than its enterprise value.

This is reassuring - but not to the extent it appears. Supermarket portfolios are different from property company portfolios for the crucial reason that they are owner-occupied. Because the vacant value of commercial property is much lower than the occupied value, Sainsbury's supermarkets would be worth far less than £11.2bn if the company did not exist to occupy them. So the premise of liquidation that keeps shares in Land Securities trading near book value does not apply to the grocers, which have accumulated property more for reasons of competition - to get to a site before their rivals - than to bolster their balance sheets.

The same goes for the few non-food retailers that still own shops, though to a lesser degree. By far the largest of these is Marks and Spencer, which owns about £2.5bn-worth of high-street units. High-street units are more versatile and better located than purpose-built supermarkets, so their vacant value would be greater if even M&S went under. But they would still be hard to fill - not least because M&S is what draws foot traffic to so many smaller town centres.

There is one stock market sector where the real estate can be taken at face value: pubs. That's partly because pub companies are not always owner-occupiers - just like pure real-estate companies, they lease many of their properties to tenants who would continue to pay rent if they went bust. The other reason is that pubs often make decent residential conversions, so would attract developers if they fell vacant.

But the principle of investing in trading companies for their property makes most sense when applied to much smaller firms, which have a higher chance of going bust. For example, about half of the companies in which venture capital firm Albion Ventures has stakes are underpinned by real estate, including hospitals, hotels, cinemas, pubs, gyms and even a new for-profit school in Twickenham called Radnor House. "Setting up a school in a recession would otherwise have been too risky," says managing partner Patrick Reeve, who likes to balance asset-backed investments against riskier ventures in biomedical sciences and technology.

The same logic applies to a tiny Enterprise Investment Scheme (EIS) in a south London film studio, which I came across when visiting the 18th century granary in Rotherhithe that serves as its base during Open House, London's festival of architecture. Called Sands Films, the company makes its money these days by providing period costumes for films such as Les Misérables and Lincoln. On its own, this would be a risky proposition - although manager-owner Olivier Stockman promises dividends. Yet add in a generous dose of tax reliefs and a property that is probably worth more than the company and the investment becomes virtually loss-proof.

Sands Films launched the EIS to buy its headquarters after the previous owner tried to redevelop the old Georgian warehouse for retail and luxury flats. It needed to move fast, so it completed the £2.8m deal in May using all its spare cash, the initial proceeds of the EIS, a loan from HSBC and a special bridging loan from some shareholders. It is to pay back this bridging loan and to fund some repairs that the EIS remains open.

EIS subscribers can claim back income tax worth up to 30 per cent of their investment, and that's not the only tax benefit. One investor used the EIS to defer a tax liability he had crystallised by selling a buy-to-let property, reports Mr Stockman. But the main reason why this EIS looks safe is the latent value of the company's headquarters. Ironically, if Sands Films were to go bust, the shares might well be worth more, because the granary could then be converted into homes. Last May's purchase price works out at about £112 per square foot, compared with an average of about £400 for housing in the SE16 postcode.

So the real estate effectively removes the downside risk that the tax authorities are compensating investors so generously for taking. If you don't mind locking up your money for at least three years, it's a no-brainer.

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