Not so hot property

If this grim scenario were to play out, it would trigger covenant breaches on a wide scale, including listed companies, leaving the property industry at the mercy of the banks.

As things stand, a return of activity in the investment market is the only thing likely to stop the current valuation rot, not that the banks will want to finance any property deals. Lack of transactional evidence has allowed uncertainty to gnaw away at both net asset values (NAV) and share prices, with the FTSE 350 real estate sector falling 48 per cent since the start of 2008 (see graph). The sector's high gearing levels (debt expressed as a percentage of NAV) dash any hopes of a sudden recovery.

"We are sleepwalking as an industry," claims real estate veteran Mike Slade, chief executive of Helical Bar, which is one of the handful of property companies still adamantly refusing to conduct a half-year valuation. He takes great issue with the property industry's standard valuation metric, the RICS Red Book, which relies on what a willing buyer would pay a willing seller.

"Well, nobody is willingly selling, and nobody's buying anything at all at the present time," he says. The problem with this method is that it cannot be adjusted to allow for the industry's biggest constraint: unwilling lenders.

"The industry is set to walk into loan-to-value problems like you would not believe," Slade adds. "At the moment, the banks are lending to us at a price. They are not lending to everybody, and I'm very grateful. But they are tight for capital, and it's going to get worse next March with nasty valuations being thrown around. The banks will call loans in and sell off assets. They will think: 'Even if we get half the money for it, it's money'."

The banks are set to show no mercy when it comes to refinancing and covenant breaches. Look no further than the example of Invista European Real Estate Trust, which secured a three-year extension to its €460m banking facilities last week from lender HBOS.

The average rate of interest is nearly 7 per cent per annum. What's more, an upfront fee arrangement of 1.5 per cent applies, with a further fee due upon refinancing.

"It is expensive, but these figures reflect what the terms are in the market today," says the fund's investment manager, Chris Ludlum. Unsurprisingly, dividend payments have been suspended going forwards. "With gearing levels as they are, it is prudent to keep cash to pay down debt," he adds. To this end, property disposals of €150m are now being targeted.

MIND YOUR HEADROOM

The Invista example should be paid close attention when it comes to assessing the health of the large property Reits. Analysts are focusing on the amount of headroom remaining before gearing and loan-to-value covenants are breached, and the downward portfolio valuation necessary to trigger these.

Nomura research shows how much further portfolio values and net asset values would have to fall at the big Reits before a covenant breach occurs (please note, some property companies have more than one banking covenant):

SOURCE: Company data, Nomura estimates

It initially appears that Land Securities is at most risk of breaching one of its covenants, requiring a portflio decline of just 18 per cent to breach terms. However, it can easily offset this by offering additional properties as security for this particular facility.

The next most likely breach appears to be at industrial property specialist SEGRO, which would suffer a breach on unsecured banking facilities if its portfolio valuation dips 21 per cent.

LIQUID ASSETS

The need to balance headroom on covenants with development commitments and the prospect of further falls in values and rents means liquidity is the biggest issue going forwards.

Land Securities and British Land are both actively trying to sell a portion of the family silver to inject some cash back into their balance sheets. Last week, it was revealed that British Land is in talks with Middle Eastern clients of London & Stamford regarding the sale of a 50 per cent stake in its flagship shopping centre, Meadowhall which accounts for 12 per cent of its portfolio by value. It has also been reported that Land Securities is looking to sell a stake in its Bullring shopping complex in Birmingham.

Given the current market volatility, it is unfair to criticise the Reits for trying to create a greater degree of headroom than may be necessary to ensure they survive the downside intact. Selling into a downturn may dent values going forwards, but prime properties that can attract the discerning eye of Sovereign Wealth Funds should be seen as a potential life raft in today's illiquid market.

SECTOR VIEW

There is clearly more pain to come for the big Reits. As the recession bites, rising vacancy levels and falling rents will eat into earnings. Should a covenant breach occur, steep rises in financing costs are a major concern, and dividends remain under pressure. Although 2009 is likely to be mentioned in the same breath as 1974 and 1991 in the future, the challenges and opportunities presented in the calamitous year ahead will set the foundations of prosperity for the next cycle. We remain negative on the sector, but keenly await news of gearing-reductive asset sales or distressed purchases which would benefit shareholders as the market returns.

Outsiders

LIBERTY INTERNATIONAL

The only Reit with insufficient cash and banking facilities to cover committed capital expenditure and debt repayments next year, Liberty's high gearing and retail exposure will impede its chances of recovery. However, stakebuilding from mall giants adds interest.

BRITISH LAND

Still without a chief executive, British Land has been trying to sell a stake in its Meadowhall shopping centre for some time without success, and high gearing means liquidity is a growing issue.

Favourites

GREAT PORTLAND

The lowest geared of all the Reits, West End specialist Great Portland is least likely to breach covenants, and is superbly poised to take advantage of the fallout from volatile property markets.