On 8 October Land Securities (LAND) and British Land (BLND), the country's two largest listed property companies, announced the sale of their jointly-owned shopping centre in Aberdeen to the property arm of F&C for £189m. Having secured £142m of debt from two specialist lenders, F&C funded the purchase with just £47m of its clients' equity - a deposit of 25 per cent.
Such a high loan-to-value deal would have been impossible even six months earlier, when lingering talk of a triple-dip recession made investors and lenders alike deeply wary of committing funds to property outside London, whatever the price. Last Christmas we alerted investors to an "age of extremes", when provincial real estate was cheaper than it ever had been relative to London. This year will go down in business history as the year when those extremes finally showed signs of converging.
The best indication of the turnaround is in the IPD Quarterly index, which is based on revaluations of a broad basket of commercial buildings. Compared with the previous quarter, capital values for the three months to September were up across every one of the index sub-sectors. Offices and industrial estates in south-east England (outside London) were the stand-out performers, marked up 2.5 and 2.0 per cent respectively. Neil Blake, head of UK and European research at property broker CBRE, reckons the fourth-quarter numbers, due to be released in February, will be even stronger.
One reason for the sudden turnaround has been investor sentiment. Positive news on the wider UK economy, which ultimately drives demand for commercial real estate, has prompted institutional investors, from both London and the US, to bet that occupiers will honour and even renew lease obligations. Another important reason is a thaw in the credit freeze: although net bank lending to commercial property remains negative, property companies report that finding debt is getting easier, both from banks and the variety of alternative sources that have sprung up in recent years. "Twelve months ago there was a theoretical arbitrage between rental yields at 10 per cent and bank debt at 4 per cent - but you couldn't actually access it. Now you can do the trade," explains Mike Brown of Max Property. As a result, he reports, "the market outside London is moving very quickly indeed".
Do the deal now
The question now is whether investors have got over-excited. Even in recovery hotspots such as Maidenhead and Reading, office rents are not yet growing. Indeed, commercial rents outside London as a whole, which includes the embattled retail sector, continued to fall in the third quarter – albeit by only 0.1 per cent, according to the IPD index. Yet bulls point out that this is invariably the case in a recovery scenario: just as stock-pickers will pile into a stock market well before profits start growing again, property investors will start buying property well before rents pick up. "It's not that people are getting ahead of themselves - it's just that you've got to do the deal now, while debt is still cheap," points out Mr Brown.
London, as an example, offers evidence of the lag between the so-called investment and occupier markets. Last year £15.4bn-worth of central London offices changed hands, calculates Jones Lang LaSalle - a figure exceeded only twice since the broker's records began in the 1980s (in 2006 and 2007). But tenants only signed up to 7.2m sq ft of space in 2012, well below the 10-year average of 9.3m, causing rents to stagnate. This year, however, both the investment and occupier markets have been roaring. Leases covering 8.3m sq ft had already been signed by the end of the third quarter. Rents are rising strongly, particularly in the West End.
How to gain entry
So what does a strengthening property market, both in London and the provinces, mean for private investors? The only kind of commercial property the vast majority of investors can feasibly own directly is a high-street shop, but owning one of these remains risky. National retail chains are consolidating their store portfolios around major shopping hubs, putting pressure on rents elsewhere. They are also increasingly reluctant to sign long leases – the average length of new leases signed in the past year is less than five years. The disruptive impact of e-commerce, which is bound to take further sales away from stores, probably means these problems will outlive the current cyclical trend of falling real wages. Without expert knowledge of a fast-evolving market and the resources to build a diversified portfolio, investors could end up with a vacant shop on their hands - and business rates make vacant shops extremely costly.
It makes much more sense for private investors to buy into the real-estate recovery via a listed property company or fund. Open-ended funds offer the chance to buy property at book value, which is welcome now that valuations are lagging a fast-recovering market. But open-ended funds carry significant cash to manage redemptions, which is one big drag on the yield; another is that they are barred from taking on debt. Those with income needs are better off looking to the stock market.
It was an excellent year for all but the largest property stocks. After a poor 2012, developers, agents and smaller investment companies rocketed in value as the regional market bottomed out. Meanwhile, shares in the blue-chip and London players, which already re-rated dramatically in 2012, have been range-bound ever since Federal Reserve chairman Ben Bernanke made his comments about the "tapering" of quantitative easing in May.
The result is that the sector no longer looks conspicuously cheap. Big discounts to book value are much scarcer than a year ago, although they persist among some developers - check out Development Securities (DSC), Conygar (CIC) or Macau Property (MPO). But don't ignore expensive-looking shares: those on a premium to historic book may still offer value if the underlying portfolio is valued at a cyclical trough. Max Property's stock, for example, trades at a 3 per cent premium to book value as reported for 30 September. Yet its portfolio, including developments, is valued on the basis of a rental yield of 7.2 per cent - or 9.5 per cent if you mark rents to market and assume it can fill its vacancies (the 'reversionary yield'). That suggests substantial scope for portfolio growth - and hence share price gains.
As the UK recovery entrenches, investors' attention may well turn to the risks associated with the end of quantitative easing and other unprecedented forms of monetary laxity. "The patient has been on the heroin of free money for too long and will find it very difficult to wean itself off," frets Marcus Phayre-Mudge, manager of TR Property, a listed portfolio of European property shares. The impact of tapering is even harder to predict than that of more familiar economic phenomena, but it seems likely that bond proxies - prime properties with weak rental growth prospects - will suffer most. That's why shares in mall landlord Intu, long an Investors Chronicle sell tip (341p, 16 September 2011), have performed so poorly this year.
The other prime landlords don't have the recovery prospects of their smaller peers - but there is now a valuation-based case for buying their stock. Shares in Land Securities and British Land trade at around book value even though the companies should deliver meaningful development profits next year. Hammerson's (HMSO) shares trade at a 10 per cent discount to book, which - we reasoned in a recent buy tip (522p, 21 November 2013) - looks unwarranted given its scope for profit growth.
That said, small property companies have historically outperformed large ones by a huge degree (see graph). Alex Ross, who runs the Premier Pan-European Property fund, cites three reasons: active management can make a bigger difference in small, more concentrated portfolios; smaller portfolios are more liquid, giving managers flexibility to time the cycle; and small-company executives are often significant shareholders. This relationship broke down in 2009 as global investors flocked to the safe havens of London offices and prime shopping malls – the domain of the large-caps. Yet it reappeared this year. If the spell of this long slump is broken, and history is any guide, now is an excellent time to be buying into small-cap property.
