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FTSE 350 Outlook: Real estate

Created:

24 January 2008

Written by:

Algy Hall

The real-estate sector has just endured a devastating year and there is little cheer as we start 2008. The mood has significantly changed since last January. At the start of 2007, optimism was buoyed by the introduction of real estate investment trusts (Reits), lofty transaction levels and record commercial property prices, whereas the landmarks being experienced by the industry moving into 2008 are generally negative. The widely followed IPD All Property index recorded an all-time record fall of 3.6 per cent in November. Meanwhile, forecasters expect developers’ bad debts to spiral and property prices to keep falling. And the discounts that property shares are trading at compared with their net asset values (NAVs) are their widest since the early 1990s crash, once Reit-related tax benefits are factored in.

Conditions in the underlying bricks and mortar property market are fuelling uncertainty and fear because transactions have slowed to a near standstill. Valuers are responding swiftly to the deterioration in conditions by marking down the prices of properties, which should help to adjust the market’s expectations and encourage transactions to pick up again. However, activity is likely to remain subdued while the credit crunch persists because the banks' new-found reluctance to lend is starving would-be buyers of the easy financing they had become reliant on in the recent bumper years.

And there could potentially be another serious dimension to the pain created by the credit crunch – its impact on the wider economy. So far, downward moves in property values are chiefly the result of dropping property valuations as buyers demand a higher rental yield on purchases. This process can be expected to continue. However, there is an added fear of how the occupancy market and rents will hold up should the credit crunch create serious economic strife. For much of last year investors' concerns have been particularly focused on the retail sector due to worries that consumer spending could take a hit and put pressure on tenants. Indeed, recent trading updates from retailers have provided credence for these fears. And now worries are turning to the office market, especially City offices. These concerns are especially pertinent due to the large amount of new office space that is under development in the Square Mile. That’s a worry for developers yet to secure tenants for their planned new buildings, such as British Land and Minerva .

Because property prices are falling, gearing, which exaggerates returns, has become a negative influence on performance for the first time in many years. This has weighed heavily on the shares of highly-geared companies such as Mapeley. There are also fears about companies that earn money by servicing the property market or making property investments on behalf of others. For instance, shares in upmarket estate agent Savills have collapsed. And Capital & Regional, a former sector darling, has received a pummelling due to fears about the impact of the slump on the fees it generates from its sizable fund management business. Sentiment has been further damaged by the group’s focus on retail and industrial properties.

However, the massive share price discounts to net asset value prevalent in the sector means that there is potentially a lot of value to be had if the underlying bricks and mortar market can find its feet again. And, encouragingly, there is plenty of anecdotal evidence that there's money on the sidelines waiting to be deployed. So while there are few indications that any upward re-rating is likely, it’s hard to imagine a repeat of a year as horrible as 2007. Indeed, 2008 could even provide some pleasant surprises.

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