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OPINION

Calling the commercial property cycle

Calling the commercial property cycle
April 25, 2014
Calling the commercial property cycle

There will be a point, however, when it will become increasingly prudent for landlords to de-risk their portfolios. Carrying too much debt is an obvious subject that needs addressing, although debt in itself is not a problem, as rental income usually covers the cost of servicing the debt. The problem comes when the portfolio is marked down so that loan-to-value covenants are breached - during the last recession, the sheer scale of such loans carried by the banks usually resulted in much of the debt on breached covenants being rolled over. Calling in a loan in these circumstances would lead to a big write-down by the bank and a real-estate company forced into becoming a distressed seller in a falling market. Hardly ideal for anyone, save perhaps for a well-heeled US fund looking for a bargain to hold for the long term.

This time around property companies aren't taking any chances, and the current cycle has seen a good number of fundraising exercises achieved through raising equity instead. Shaftesbury (SHB) for example, raised £157m at just a 5 per cent discount to its share price at the time, while student house operator Unite (UTG) issued shares to raise £100m. This was priced at a 9 per cent discount to the share price but 7 per cent above net asset value (NAV). There are exceptions. St Modwen Properties (SMP) took a slightly different approach by raising £100m through the issue of senior, unsecured guaranteed convertible bonds with a five-year maturity. With a modest 2.875 per cent coupon rate, the bonds can be converted into preference shares and then into ordinary shares, with an initial conversion price around 35 per cent above the share price and a mouth-watering 90 per cent premium to the last reported NAV. It's worth pointing out, though, that NAV is forecast to grow by 35 per cent in the next two years alone. Other real-estate companies taking advantage of the healthy level of interest in property include NewRiver Retail (NRR), raising £75m through a share placing, and Safestore (SAFE), which issued shares worth £32.5m. And most recently, Intu Properties (INTU) launched a two-for-seven rights issue to raise around £500m at a daunting 42.5 per cent discount to the previous close.

The second trap to avoid is having a long arm of development projects just when the tide starts to go out. Previously, some real-estate companies have been left with properties in the development stage just when rents were collapsing and construction costs were still rising.

Not surprisingly, timing is everything. Great Portland Estates (GPOR), for example, has bought over half its existing portfolio since 2009, and gearing levels are relatively low. Selling part of the existing portfolio is the most obvious way of reducing risk, but it would be premature to assume that selling off sites is a sign that the late-cycle environment has arrived. Some properties bought for redevelopment have been sold to desperate buyers - typically a hedge fund looking for a base - at a price that enables crystallisation of all the embedded value without having to go through all the hard work of redevelopment.

Key factors that allow companies to make a decent stab at identifying the top of the cycle include the pace of economic growth and employment levels. In fact, rental performance in the West End of London, for example, has a very high correlation with employment trends, which are currently in an up phase.

But while demand for property investments and office space shows no signs of abating just yet, there are still ways that landlords can be caught out. One of the inevitable consequences of a revival in demand for construction contractors, whether it be for refurbishment or building from scratch, is pressure on costs, and real-estate companies spend a lot of time monitoring contractors and their sub-contractors to ensure that sufficient margins are built in to take into account rising costs, such as the current dearth of electricians. Trouble at or the insolvency of a sub-contractor is not the end of the world, but development delays inevitably cost money.

For now, the impetus in place looks to be strong enough to overcome such eventualities, and certainly in the West End, the existing real-estate operators have the market pretty well sown up, with high barrier levels of entry, not least of which is the essential prerequisite of having an established and trusted relationship with local planning authorities - who are usually overworked and under-resourced coping with an area that includes at least 13,000 buildings with listing restrictions.

So calling time now on the property boom would indeed be premature. There are of course several key factors that could influence the timetable, notably next year's general election and the possibility of a Labour-led government imposing fresh taxes. Ultimately, though, it's probably better to remember that when riding the rollercoaster real-estate sector, it's easier to stay out of trouble than get out of trouble - a mantra that, for now at least, the UK's listed property companies appear to be heeding.