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The property forecast

Jonas Crosland carries out a detailed survey of the UK property market to discover where value lies and where the rot has set in
April 1, 2016

The UK real estate sector has experienced a huge renaissance in the wake of the financial crash, but as yield compression slows and storm clouds gather, is it time to take a fresh look at how much value is left?

There are two relatively easy camps in which to sit. On the one hand, there are worries about a possible exit from Europe as well as a potential slowdown of foreign investors as China’s economic slowdown reverberates through the globe, (although investment from China into UK real estate continues to rise) as well as worries in Russia, and the Middle East. There are also concerns about the pace of economic growth and whether we are about to see another period of financial turmoil.

But there is also the view that there is still plenty of mileage before we meet that apogee that seems inevitably to follow any period of sustained growth. Looking at the recent clearout in equities, it would be tempting to think otherwise, but there is a case to be made to suggest that instead of following the economy, equity markets are trying to lead it. This is not sustainable when considering that the macro fundamentals are more robust than the sell-off in equities suggests. Employment is at a record high, inflation is all but zero and the economy is expanding at a sustainable rate. Could it be that with so much money pumped into global economies, equities have simply run ahead too far and too fast?

To justify the current market malaise, there is no dotcom crash or financial meltdown. And we have survived far more tangible trials such as Greece, the US fiscal cliff edge and the hair-raising troubles in the Irish, Portuguese and Spanish economies.

 

 

There is little doubt that some sectors of the real estate market are further advanced towards some sort of levelling out than others. But for the time being, demand continues to outstrip supply in nearly all of the hot spots, even in London. So if there is going to be a radical change in sentiment, there must first be real progress in closing the supply/demand imbalance. But this does not have to occur when extra supply comes on tap; it could happen if that level of demand were to dissipate. Such a scenario is hard to visualise right now, but there are a host of imponderables that could cause investors to pause for thought.

It’s hard to generalise because the real estate market is a pretty broad church, and a change in circumstances will affect some parts significantly while having little impact on others. So even something as dramatic as the UK leaving the EU provides us with little clear insight as to what the implications could or would be. But, needless to say, equity markets are notoriously poor at riding out periods of uncertainty.

What is crucial for real estate is the value of the underlying asset. If asset values decline, pressure may start to build on covenanted loans, although in the wake of the last financial crash, most real estate companies have adopted a more cautious approach to debt. Looking at the companies themselves doesn’t provide us with an obvious answer, either. For example, Great Portland Estates (GPOR) has a total development programme of 2.6m sq ft; that’s the equivalent of nearly 60 per cent of the existing portfolio. That may look risky, but of the nine committed schemes, 59 per cent is already pre-let or pre-sold, and much of the development money has come from recycling existing assets, which, together with a valuation uplift on the portfolio, means that the loan-to-value ratio is a paltry 17.4 per cent. And the 15 new lettings secured are generating rent that’s 17.9 per cent ahead of estimated rental value as at March 2015. On the other hand, Land Securities (LAND) has made it known it will not be committing itself to any further development projects unless they are largely pre-let. And at the moment, there is very little in the development pipeline after next September. And this is the company that correctly called the bottom of the downturn in property values in 2010.

 

 

However, the real estate sector is down in the last three months by more than the broader market because of worries that weakening international growth will have an impact on investment demand. It’s sensible to suggest that equities are driven to where the market thinks the economy is going, but it doesn’t mean that the direction or the extent is the correct one. On that basis, the recent fall in real estate equity and the prospect of a further decline could presage a fundamental change in underlying trends, or it could present an opportunity to buy into quality assets that have been oversold.

Interestingly, a recent survey by the Royal Institution of Chartered Surveyors revealed that 81 per cent of contributors see commercial real estate in central London as overpriced, which suggests that there is a limited life expectancy for any further yield compression. This in turn means that rental growth will have to take over as the main driver of investment activity. However, taking the UK as a whole, around 85 per cent still see asset prices either at or below fair value.

But the real estate sector is quite diverse, and unlike market sentiment that is applied to the sector with a broad brush, there are clearly sub-sectors that are significantly less vulnerable to macro-global trends.

 

Student accommodation

The days of cramming a crowd of unruly students into a run-down terraced house may not be a thing of the past but it certainly has little future. Demand for student accommodation has moved into the 21st century with the construction of purpose-built facilities, in part in response to the significant increase in student numbers. This follows a lifting of the cap on foreign students, most of whom are happy to pay for their accommodation upfront. Building these nice facilities is not as expensive as you might think because a majority of student areas fall outside the expensive south-east of the country. Companies such as Unite (UTG), Empiric Student Property (ESP) and GCP Student Living (DIGS) have had little trouble raising funds through share placings in order to expand their respective portfolios. The business model is simple: build quality student accommodation and generate a rental stream to pay a highly attractive dividend. The influx of overseas students could be compromised by a global economic retreat, although the relatively high cost of installing an overseas student into the UK means that high income families will probably still be able to afford the commitment.

Medical centres

The need for modern purpose-built medical centres in the UK is acute, but after years of fiddling around with the NHS, the government has finally cleared the way for some serious investment. A majority of doctors’ surgeries are not fit for purpose, and cannot be upgraded into the sort of medical centre that will not only provide a much wider range of services but will also relieve much of the burden imposed on overworked accident and emergency centres in hospitals. In fact, the cost of building new premises will be far outweighed by the savings within the NHS. There are three major players at work here: Primary Health Properties (PHP), Assura (AGR) and MedicX Fund (MXF). The task of dragging medical care centres into the 21st century is immense. Between them, these three companies operate around 700 healthcare centres; a tiny fraction of the number of surgeries across the country. And the revenue stream is about as blue-chip as you can get because indirectly the rent comes from the UK Treasury. The dividend payouts are pretty decent, too, with MedicX leading the pack with a yield of nearly 7 per cent. And while the valuation yield on the portfolio maintains a decent spread over the cost of capital, the business model is sound, although at some point interest rates will start to rise, which could squeeze margins.

Tourism

Visitors to London remains a growth industry, and new transport links will make it easier and more pleasurable getting into the tourist heartland. This favours one of the principal landlords Shaftesbury (SHB), which collects rent on 313 shops, 257 restaurants and cafes, 418,000 sq ft of office space and 528 apartments. These are clustered in prime tourist spots such as Chinatown, Carnaby, Covent Garden and Soho. Further attractions include a lack of new space opportunities, which means that Shaftesbury has no trouble in filling vacant space. In fact, most tenants tend to stay put. There is also limited maintenance cost because units are let on a shell form, leaving tenants to pay for the fit-out. In terms of growth and capital return, Shaftesbury may seem to be a relatively slow burner, but at the same time it is relatively immune to the macroeconomic factors that influence other real estate outfits.

Buying shares in Secure Income Reit (SIR) is another way to tap into tourism. Secure Income doesn’t pay dividends but is likely to introduce payments later this year, and initial projections are to pay a dividend yielding over 4 per cent. The key attraction aside from this is the quality of the rental stream; over half the rent roll is guaranteed by Ramsay Health Care (Aus:RHC), one of the five largest private hospital groups in the world, while a further 39 per cent is backed by Merlin Entertainments (MERL), the largest operator of visitor attractions in Europe. Unexpired lease terms average 23 years, and all rents are subject to annual uplifts at fixed rates or linked to retail price inflation.

 

Offices

Operating below the big office giants comes Workspace (WKP), which provides flexible office and work space for small- to medium-sized companies. Demand here has been very strong, and with improving transport links and a shortage of space in central London, previously unattractive areas are now becoming quite presentable. This has given Workspace the opportunity to acquire derelict industrial sites for development. The business model also takes out much of the development risk. Typically, Workspace will bring a site through the planning hoops and then enter a joint venture with a housebuilder, whereby the builder constructs apartments and sells them, while also building a purpose designed centre for Workspace to rent out. It also operates with relatively short leases so any reversionary element on the rent is regularly crystallised. Land Securities (LAND) has moved derisking up the agenda and is making more disposals than acquisitions. This has brought the loan-to-value ratio down to a very modest 25 per cent, and the company is focusing on renting out the remainder of its development portfolio, thereby limiting the exposure of the development arm. Yet despite this cautious approach, the shares stand at their biggest discount to net asset value since the financial crisis. These kinds of discounts can precede a financial meltdown, but uncertainty rather than economic weakness is behind the latest shift away from the sector, which some suggest represents an ideal buying opportunity.

 

Big boxes

Changing consumer habits have also been harnessed to advantage by companies such as LondonMetric (LMP). More people are buying goods through the internet, and expect them to be delivered to their homes. This has spawned a big demand for distribution centres at a time when new construction had all but ceased. This has had a beneficial effect in that both valuations and rental growth have been significant. In fact, over half of the rental income is based on fixed, upward-only rent reviews. What’s more, the average unexpired lease term is 13.4 years, while the occupancy rate on the portfolio is an incredible 99.9 per cent.

Tritax Big Box (BBOX) is another fast-growing warehouse landlord. Having floated on the London Stock Exchange in December 2013, Tritax now owns more than 25 big boxes, valued at over £1.3bn. More acquisitions are likely, but the key growth driver will be rising rents, as purpose-built large warehouses remain in short supply. In the year to December 2015, the contracted rent roll jumped by 89 per cent to £68.4m.

Residential

New flats in the inner London area are taking on some of the characteristics of a new car which loses value the first time you turn the ignition key. That’s because there has been a perfect storm brewing made up of investor caution and growing supply. New flats have been selling at premiums of up to 25 per cent over older property, and their subsequent appreciation has lagged behind that on older buildings. In addition, the new-build market is saturated with over 75,000 units in the development pipeline. This has raised serious doubts about how easy it will be to shift this amount of property. Already, Capital & Counties (CAPC) has admitted that selling flats in its Earls Court redevelopment remains a challenge. At phase 1 launched in the spring of 2014, 213 apartments were released of which 204 were reserved or exchanged on in just five weeks. But in phase 2, launched in September 2015, 70 flats were released and by 10 November the company had exchanged/reserved on 28 of them. The trouble is, the same update accompanied the full-year figures in February this year, implying that nothing has sold over the past few months. In some cases, though, the subsequent downturn in share prices may be overdone. Shares in St Modwen Properties (SMP) have fallen significantly as a result of its exposure to the Nine Elms residential redevelopment, and some write-down in the book value seems inevitable. But St Modwen remains very upbeat and the shares, trading at barely half forecast net asset value, look cheap.

 

 

Brexit worries

Perhaps one of the biggest unknowns is the possibility of the UK leaving the EU. It’s very difficult to assess the real effect when all we have to go on at the moment is the rather unrealistic projections that both sides of the argument are peddling around to justify their side of the case without much regard for solid fact. Life would go on, as would trade flows, if the UK were to leave. And with the weight of seasoned minds counselling against such a move it would be natural to see a positive but narrow majority to vote in favour of staying in. But plebiscites are dangerous and unpredictable when put in the hands of an electorate which, by nature, sees such opportunities as the ideal opportunity to embarrass the government of the day. Leaving the EU would also present the UK with the opportunity of accelerating its access to trade deals with emerging nations without having to go through or be bounded by the multifarious cogs in Brussels. But it would take years to untangle all the mechanisms. A greater danger for prime office space would be the threat of some large companies such as HSBC (HSBA) looking to consider moving some jobs out of the UK.

The other principal worry centres around the possibility of lower economic growth that could affect demand in the commercial property sector. There is also concern that many companies have used the UK as a gateway into the single (EU) market. Without this, there is less reason to operate out of the UK. In addition, some companies in London’s financial centre could opt to relocate. This could have an impact because the UK attracts more than a quarter of all foreign direct investment into the EU, and much would depend on what sort of trade agreement the UK could secure with the EU. So there is a risk that a fall in demand for office space could see vacancy rates move up, and that would be bad news for a sector that is currently financing developments to meet demand.

The bottom line is this. The real estate market in the UK is always vulnerable to a change in the economic climate; a shift in stance by lenders and a change in the mix between supply and demand. When asked about when he thinks the cyclical peak will occur, one real estate chief executive said, “Hang on, I’ve just spent five years climbing out of a recession”. The fundamentals underpinning the renaissance in the property sector remain in place. These include cheap funding and a supply/demand imbalance. And despite recent volatility in equity markets, overseas investors and listed property companies were still net buyers of commercial property assets in January, according to Capital Economics. In fact, purchases made in January were higher than the average seen in the last 12 months.

This sends a mixed message, however. It’s not wise to take the statistics of just one month, but it might be worth noting that investment in office schemes was down whereas retail, mixed use and investment in hotels was higher than in December. Taking all of this on board, it strikes us that, having been woefully late in anticipating the last economic crash, there are many interested parties keen to be early in predicting the next one. Their predictions therefore have to be taken with a large pinch of salt. Despite recent volatility, UK real estate as an investment medium retains its long-term attractions, although you may have to be more selective.