Aim's £9bn property black hole

The exoticism of high-risk, high-reward foreign property investments was of immense appeal in the latter years of property's 15-year bull run, and London's lightly-regulated Aim market quickly became the venue of choice for overseas property firms' share issues.

In the wake of the property crash, the structural faults embedded in many of these funds are all too easy to spot. High levels of indebtedness and financially onerous management contracts are the two biggest problems. The global financial crisis has caused some risky foreign property markets to implode, development finance has dried up, and in a few cases, fraudulent activity appears to have taken place.

Companies in the sector have witnessed a near-universal collapse in share prices, with many funds joining the "90 per cent club", made up of shares that are 90 per cent or more off their peak. But that's not to say the sector is completely devoid of opportunity for the more adventurous investor. But to pick a good 'un, first you have to understand the nature of the bad 'uns.

CAUGHT IN THE NET

For starters, forget stock picking on the basis of how generous a discount to net asset value (NAV) a given company's shares are trading on. Valuing property assets - in the UK or abroad - is currently a torturous process, and this is reflected in the large discounts to NAV at which property companies now trade. This is because there are few buyers for property assets, even fewer sources of debt finance, and hardly any transactions on which to base valuation evidence. And remember, many foreign property markets are even more illiquid than the UK. Therefore, the market's view of true value is reflected in the price.

Of course, the rental income that properties produce is factored into the NAV. But look at the net rental income in close relation to a company's outgoings (notably finance costs, and management fees) to gauge how sustainable the business is.

Often, companies will inflate 'adjusted' NAV figures by including the value of development land with planning permission. Considering the dearth of development finance, most development land is as good as worthless, so these figures should be taken with an enormous pinch of salt. And a truly cavernous discount to NAV is usually indicative of other problems the company faces - notably indebtedness.

ATTACK OF THE ZOMBIES

A so-called company is one that is so heavily indebted, it is effectively controlled by its lenders. Loan covenants may be endangered, or breached. In either case, selling assets into the market to make good the loan is often impossible. Instead, lenders opt to keep the company on life support, paying off some interest, so the debt is technically a performing loan.

Zombies hold few attractions for investors - and the are the most highly geared. Develica Deutschland, Puma Brandenburg, Treveria, Summit Germany and Speymill Deutsche have gearing ranging from 150 to nearly 400 per cent. Deutsche Land has gearing of 251 per cent, although this hasn't stopped its previous fund manager from trying to buy the business since last November.

"The German companies are all penny stocks, each claiming €1-2bn of property assets for not far short of the equivalent amount of debt," says independent real estate broker Ian Wild. "That said, it's hard to believe all of them will evaporate."

RUSSIAN ROULETTE

Companies focused on Russia and the Ukraine have been bludgeoned by the current crisis. In particular, Ukrainian developer is teetering on the brink of insolvency (see Favourites and Outsiders). Fellow Ukrainian fund AISI has one substantial income-producing property with secure bank debt from European Bank for Reconstruction and Development (EBRD). The rest of its assets are development land, which may or may not be worth anything in the long-term.

Russian property play MirLand reported a chasmic 60 per cent fall in NAV at its full-year results last month, and logistics developer intends to embark on a share buy-back scheme following the internalisation of its management team. However, its portfolio of warehouses are well-let, and rental income is strong.

Considering the market risk, it's not surprising all these shares trade for pennies. But for investors with a long-term view, risking a bet on survival has slow-burning appeal.

DEVELOPING BRIEF

Aim property companies exposed to development present a different category of risk. Two interesting cases are and , both focused on development in central and eastern Europe. Though both have portfolios of income producing assets, Ablon has halted construction on several projects due to economic uncertainty, and breached its loan covenants in March.

Another company that's a bit different is , originally set up as an Indian office developer, which now boasts investments in various Indian infrastructure projects. It has an impressive shareholder register and a net cash position.

ACTIVISTS ABOARD

Many Aim-traded property companies with little debt and a strong cash position have attracted attention from , intent on influencing management to return capital to shareholders. To date, there have been , but precious few successes.

The proved a disastrous investment for hedge fund , and Laxey's stakebuilding in Italian industrial fund has also plunged in value. An activist-influenced asset disposal plan at Equest Balkan Properties is turning out to be a long and drawn-out process.

Laxey's involvement in merits more interest, as directors have been topping up their own holdings, suggesting the possibility of future activity. The company has net cash, but potentially troublesome land purchase agreements.

Indian developer also appears to have cash to shake down, though the current battle with QVT and Laxey risks damaging the company's residential brand. And fellow Indian fund has conceded to activist demands to realise cash by disposing of assets (see the Broker's View from Mike Foster of Fairfax).

Though risky, the reward is a re-rating when cashback deals are agreed. Last month, Ishaan (another Indian fund) saw its shares leap 31 per cent in a day after it decided to return cash to shareholders.

TAKE OUT CLOUT

One of the most seasoned activists of them all, Joe Lewis, was successful in his second takeover attempt of last month, which he intends to de-list. This follows takeover by Romanian-focused oil company Rompetrol of Romanian property developer in December at a substantial premium. Companies with sizeable director holdings could be taken private (this looks likely at Delek Global) but analysts don't expect much further action.

Nevertheless, there are a few hidden gems buried in the Aim property world - albeit somewhat tarnished by the general collapse of the sector. Our top picks are European industrial property specialist Hansteen, and French commercial property trust Alpha Pyrenees, both of which have strong income producing portfolios of well-financed assets and, shock horror, still pay a dividend.

Source: Investors Chronicle research

Also See the broker's view from Fairfax analyst .