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Commercial property hotspots

The sub-sectors best positioned for Brexit
July 22, 2016

There was something predictably inevitable about the way that companies grouped together under the commercial property banner were tarred with the same brush in the wake of the referendum; inevitable, but somewhat crude given that the commercial property market is a pretty broad church.

For investors looking to pick through the wreckage in search of a bargain, it has to be said that the rewards are considerable, but the risk profile has increased, too. It’s all too easy to make suppositions based on the idea that one thing must inevitably lead to another. A typical example comes with the risk of financial services losing the passport that allows them to operate across the whole EU. Losing that may or may not happen, but valuations are being based on the worst-case scenario, which in itself might be a healthy or at least a sensible approach. The list of bear factors continues to include rising unemployment, falling GDP growth, a recession, increased void rates and downward pressure on rents. Yes, we’re all going to hell in a hand cart – again, so it would seem.

The question now is whether this doom-laden scenario will be acted out. There is certainly a risk that the detrimental effects of the leave vote will create a vicious circle of uncertainty, where we run the risk of simply talking ourselves into a recession. For example, some valuations have already been cut, but basing valuations on sentiment is hardly scientific and potentially misleading since the referendum there simply has not been an adequate quantity of commercial property transactions upon which to base valuations. The downside outlook adds considerable weight to the bearish view, but we have yet to see how the UK government will react. And act it almost certainly will. We have already had a few appetisers such as lower interest rates for longer, a mooted cut in corporation tax and a relaxation in banks’ reserve requirements, and there might be more to come.

However, a slowdown is impending. Investment decisions will be delayed, and not only will valuations fall, but growth in rental income will be lower than it would have been had the UK stayed in. The extent of that fall much depends on how the economy performs. Let’s put this into context. During the financial crash asset values fell by nearly a half, but this time there is no financial crisis. Banks have been pumped with money, and this is crucial because property companies need a steady credit flow. Their health this time around is much better. Leverage levels are considerably lower than they were and, while demand for space may fall, the net effect on rental income is expected to be proportionately less, simply because of the considerable reversionary element. This means that if a company has rental income of £10m, and if all rents were adjusted to current rents being charged, they would perhaps generate £14m. So a fall in future rents of say £2m would lead to slower rental growth, but not a decline in income – a key attraction of commercial property.

But let’s look outside the London office market at companies such as Shaftesbury (SHB), which has a majority of exposure focused on retail and leisure outlets in and around Soho, Carnaby Street and Covent Garden. Sterling’s sharp fall means that overseas visitors will be attracted by the keen prices, while access is soon to become much better with the completion of Crossrail. Occupancy rates remain high, and in previous downturns Shaftesbury has shown these defensive qualities while others have struggled.

There are other sectors that really have little exposure to the referendum. One is student accommodation. Building purpose-built units for overseas students reflects the demand for decent accommodation from students coming from Hong Kong, China and Russia, and elsewhere. Just 5 per cent come from the EU and, with the cap lifted on overseas student numbers, together with a weak pound, the attractions are there to see. Crucially, companies such as Unite (UTG), Empiric Student Property (ESP) and GCP Student Living (DIGS) have had little trouble raising funds to develop their portfolios.

Another subsector that has passed under the radar is the primary healthcare centre. Every £1 spent on opening a custom-built centre that provides a host of facilities normally of the type only found in hospitals is calculated to shave £5 off the NHS budget. It’s a slow process replacing the thousands of GP surgeries unsuitable for enlargement, but the government has belatedly recognised the merits and is pumping in extra funds. The companies themselves, principally Primary Health Properties (PHP), MedicX Fund (MXF) and Assura (AGR) have the added attraction of having a very reliable tenant to pay the rent – the UK Treasury.

It’s also worth taking a look at the companies specialising in retail distribution centres. A change in consumer habits towards internet buying and click-and-collect means that big retailers need to build a network of distribution centres to meet the demand. Typically, these would be close to major urban areas, but the problem is that, until recently, new construction in the wake of the financial crash has been conspicuous by its absence. In 2009 there was 94m sq ft of commercial property available, but by last year this was down to 22m sq ft against an annual take-up of 32m sq ft. Demand has been brisk. Last year, LondonMetric (LMP) secured Primark as a tenant at a new 1.1m sq ft distribution centre, on a 25-year lease with annual upward reviews on rent. Meanwhile, Tritax Big Box REIT (BBOX) doubled the value of its portfolio last year and pushed the contracted rent roll up by 89 per cent and, while yield compression is set to slow, rising rents will assume the position of the main growth driver.

There is also a common theme running through all these assets. Despite the perceived risks, property remains an attractive investment both for the investor with a long-term view and also for those funds seeking a decent return. With blue-chip gilts sliding into negative yields, the attractions of a well-covered dividend backed up by solid assets provide a compelling package for income seekers.

 

Favourites

Apart from the student and healthcare centre operators, who all get our vote, Land Securities is a solid operator. This is the company that called the bottom in the financial crash and embarked on securing assets at rock-bottom prices. More recently, it has been a net seller of assets for the past two years. This derisking has taken the loan-to-value rate down to just 22 per cent. UBS has forecast net asset value at March 2017 of 1,243p a share; that’s down 14 per cent from the previous year, and much in line with the share price fall since the referendum. With a forecast dividend yield of nearly 4 per cent, at nearly 20 per cent discount to the already revised down NAV estimate, the shares look attractive.

Outsiders

Intu Properties (INTU) has been through a tough period, and only recently started to deliver increased rental income from its retail and leisure centres across the UK. However, rents remain low compared with other regional shopping malls, and maximising rental income has been made more difficult by shifting consumer habits towards internet shopping. Last month, Intu bought the 50 per cent interest it did not already own in Merry Hill shopping centre in Birmingham for £410m; that’s an 8 per cent discount to the latest valuation. The worry here is that if Intu has not secured the discount as representing a good price, bearing in mind that the share was originally marketed at £500m, it could mean that the price is indicative of current market values, and this could lead to valuers marking down Intu’s net asset value.

Part 1: Resilient real estate

Part 3: Exodus? Take a look at Europe, but don’t ignore London