As sector watchers will be aware, this outperformance was largely down to yield compression leading to net asset value upgrades as investors continued to warm to the merits of holding property as an investment class while the world’s leading central banks pursue ultra easy monetary policy. It’s therefore worth considering the likely course of economic events in 2015 to determine whether this key factor is likely to continue to support share prices of UK property companies.
Risks to another year of gains
Bearing this in mind, the greatest perceived risk by many is the most obvious: a change in monetary policy by the Bank of England and the start of a rate tightening cycle. It’s almost six years now since the Bank base rate was cut to a record low of 0.5 per cent and with the UK economy recovering strongly – unemployment has dropped to 6 per cent of the working population for the first time since the start of the global financial crisis and those in employment are a record level – then it’s fair to say that the point at which the economy hits escape velocity is far nearer now than it was 12 months ago.
True, the Bank of England rate setters will be keeping a close eye on inflation too – at 1 per cent, and falling due to the decline in energy prices, the consumer price index (CPI) is well below the central bank's 2 per cent target rate, so there would appear no urgent need to raise rates now. Indeed, some economists believe that the first hike will be in the final quarter of 2015 at the earliest. However, this misses the point that the factors that have driven down inflation – the oil price and food prices – are more than likely to be temporary. Indeed, strip these out and the adjusted inflation figure is nearer 1.6 per cent, something worth considering in 12 months time when the deflationary effects of the sharp oil price decline in the second half this year drops out of inflation calculations.
It’s worth pointing out too that there is increasing evidence of tightness in the labour market – at the latest count there were 690,000 job vacancies nationwide, the highest level for 13 years. In addition, for the first time in years consumers will be enjoying real pay rises as hard as that is to swallow for those working in the budget constrained public sector. But public workers only account for 17 per cent of the UK labour force and far more important are the annual wage settlements in the all-important private sector accouning for 83 per cent of the UK labour force. There is clear upward pressure here, a point acknowledged by two of the nine members of the Bank of England's rate setting Monetary Policy Committee who voted for a rate rise at last month’s meeting.
Impact of rate rises on property yields
That said, irrespective of when interest rates rise – and it’s my own view that investors banking on an increase at the end of next year are being far too complacent given the possibility of rising wage inflation emerging in the first half of 2015 – this is unlikely to impact property yields. That's because according to real estate analysts at broking house Liberum Capital “property yields have historically shown little correlation to base rates, and have tended to compress for the first 12-18 months of rate tightening cycles”. Interestingly, analysts Kieran Lee and Jon Stewart also point out that “rental growth is accelerating in late-cycle sectors, something that has historically coincided with yield compression.” They also note that in the rampant London market, rental growth has stabilised at double-digit annualised rates.
Another factor pointing to further yield compression is that, London aside, in most segments of the property market property yields are still above their historic lows. And with 10-year UK gilts yielding only 1.83 per cent – the lowest level since May 2013 – and the 30-year UK government bond yields trading at a record low of 2.5 per cent, the back drop is still favourable for investment flows into higher yielding property assets as investors continue to hunt for yield. As Mr Lee and Mr Stewart rightly point out it is very rare indeed for the real estate sector to underperform when property yields are falling which, given the current environment, increases the chances of the sector outperforming the wider market again.
Risks on the horizon
Admittedly, there are risks on the horizon, the primary one being the forthcoming general election in five months time. That’s because the UK-listed real estate sector has traditionally performed badly in the immediate aftermath of general elections. That said, the average 7 per cent drop in the first four months after polling day has been “typically reversed quickly”, according to research carried out by Liberum. The timing of the election also neatly coincides with the well known 'sell in May' equities strategy, reflecting the historic lacklustre performance of the UK stock market over the summer months and into early autumn.
It’s easy to see how investors could get spooked by a Labour-led government, albeit in a hung parliament. The introduction of a mansion tax, higher levels of stamp duty and capital gains tax on foreign buyers of high-end residential property are the three risks that Liberum feel the London residential developers face. And even a Conservative coalition poses risks as it “raises the possibility of Britain leaving the EU which would be a negative for sectors such as London offices, as constitutional uncertainty would likely lead to a slowing of business investment and employment growth.”
That said, having assessed the risks I feel that for the coming quarter maintaining exposure to my UK real estate plays is the right strategy. Each one has a specific catalyst for their ongoing share price re-ratings to continue, and with share price momentum positive, I feel running with our bumper profits is the right way to go.
A smart vulture fund
Shares in Aim-traded property vulture fund Conygar (CIC: 189p) are closing in on my conservative fair value target price of 200p (‘Clear road for gains’, 30 October 2014) and are showing a decent gain since I initiated coverage a year ago at 131p ('Shrewd insider buying at property play', 30 September 2013).
Importantly, full-year results announced a few weeks ago are very supportive of further gains. In the financial year to end September 2014, the company’s net asset value (NAV) increased 13 per cent to 197p a share, buoyed by a 10.4 per cent like-for-like uplift in the investment portfolio to £158m. The property book was valued by surveyors Jones Lang LaSalle on an equivalent yield of 8.33 per cent, a 66 basis points tightening on 12 months earlier, and it’s worth noting that every further 50 basis points contraction in yield equates to a valuation uplift of almost 7 per cent.
There were also hefty gains from the company’s development portfolio, worth £36.9m, after the company booked an £11.5m profit by selling a 9.6 acre land parcel to supermarket group Sainsbury at its Haverfordwest site. Expect further gains as the site has planning for 726 residential properties and, even after factoring in infrastructure spend, each plot will only have cost around £13,000. Expect large land parcel sales to housebuilders to crystallise value.
Conygar has been doing some smart deals elsewhere including the acquisition of an industrial park at Colwyn Bay, North Wales, comprising 191,000 square feet of modern industrial space and located close to the A55 between Holyhead and Chester. Around 45,000 sq ft of space is let to three tenants paying a rent of £167,000 and Conygar is upgrading and redeveloping the empty 146,000 sq ft. Having paid just £15 per sq ft for the property, which has suffered from underinvestment, there should be significant upside here in due course once redeveloped. And because the company’s gearing is less than 10 per cent, and it has total cash on its balance sheet of £71m, Conygar has ample firepower for further deals too. Add to that net asset value accretive share buy backs, and a progressive dividend policy – the full-year payout was raised 16 per cent to 1.75p – and the shares are worth buying at 189p. Buy.
Making friends in the north
Shares in shares in Town Centre Securities (TCSC: 265p), the Leeds-based property investor and car park operator which also has interests in Manchester, Edinburgh and Glasgow, got within pennies of hitting my 290p target price before profit taking set in. I first advised buying when the price was 198p in February 2013 ('A high yield play in the north', 18 Feb 2013) and last updated the investment case when the price was 252p (‘High yield play with growth potential’, 1 October 2014).
Like Conygar, the company has been reporting bumper gains on its portfolio, announcing a 10 per cent like-for-like increase in the financial year to end June 2014. That mainly reflected an 80 basis point contraction in the initial yield on the portfolio to 6.4 per cent which helped increase NAV per share by 15 per cent to 308p. But the shares still offer value priced on a 22 per cent discount to brokerage Oriel Securities’ June 2015 year-end NAV estimate of 341p a share. Add to that a maintained payout of 10.44p a share, and a dividend yield of 3.9 per cent is highly supportive too.
The company remains well financed – the majority of its borrowings are funded by a debenture with 17 years to run – and has a low average cost of debt of 4.2 per cent. So with further yield compression likely, I believe that Oriel’s NAV estimate is likely to prove too conservative. That's because it factors in 2 per cent income growth across the book of mainly retail and office space, but only a 20 basis point further contraction in the initial yield. Buy.
A mid-cap winner
FTSE 250 listed Daejan Holdings (DJAN: 5,700p) is closing in on my 5,800p target price, a price level dating back to March 2007 and one I outlined in my analysis three months ago ('Revaluation to drive re-rating', 9 October 2014). However, I still think that there is a decent chance of a move towards the December 2006 all-time high of 6,600p, or double my recommended buy-in price of 3,300p ('Buy the breakout', 14 February 2013).
The fundamentals certainly support another leg to this re-rating after the company reported a 10 per cent rise in NAV per share to 7,504p in the first half to end September 2014, buoyed by gains in London commercial (mainly office), UK residential property and also in the US. Half of the UK book, worth £1.2bn, is in commercial space, and Daejan has some prime assets including the fully let Grade II-listed Africa House near the Aldwich, London, a property offering 118,000 sq ft of prime London West End. The southern bias – three quarters of the UK book is based in London and the south east – also means that the company is operating in a sweet spot in the market right now, and one continuing to attract investment flows for both residential and commercial property. Further gains on the US book aside, mainly in New York and Boston, there should also be a windfall valuation gain on translation resulting from the ongoing weakening of sterling against the greenback. Add to that a decent dividend – the shares yield 1.6 per cent – and I would run your profits.
Please note that on I have also published two column on European Politics, Economics and Markets ('Europe's plight weakens...but that's good', 19 December 2014) and on the financial implications of monetary policy being pursued in Japan and Europe ('Fireworks to set markets alight', 19 December 2014).
I also discussed these features with the editor John Hughman in our free podcast, available here.
■ Subject to availability and until 31 December, Simon Thompson's book Stock Picking for Profit is available to purchase at a special discounted price of £10.99, plus £2.75 postage and packaging, for all internet orders placed at www.ypdbooks.com. The book is priced at £14.99, plus £2.75 postage and packaging, for all telephone orders placed with YPDBooks (01904 431 213). Simon has published an article outlining the content: 'Secrets to successful stockpicking'
