Insecure times for Land Secs

There was a collective shudder across the commercial property industry last week when Land Securities, the sector bellwether and the UK's largest real-estate investment trust (Reit), put out a grisly third-quarter trading statement.

The bloodbath on the UK's high streets has caused nasty blotches on Land Securities' balance sheet, with tenants in administration now representing almost 5 per cent of the retail portfolio's annual rental income, up from 3 per cent in September. Additionally, the company revealed that its retail development in Cardiff, due to open in September, has only 40 per cent of floorspace let.

But it is fears surrounding falling property values, rather than struggling retailers, that has caused Land Securities' shares to fall by nearly a third since the start of this year. Indeed, the London stock market's real estate sector has fallen more than 24 per cent since 6 January 2009, as the market prices in the impact of new share issues, which are .

Worsening market conditions and the defection of chairman Paul Myners to the Treasury spared any red faces when Land Securities made a last year. However, the sale of its misunderstood outsourcing arm, Trillium, proceeded as planned - albeit at £250m less than analysts once hoped it might fetch. The £750m sale to Telereal announced earlier this month will result in a £349m book loss, but crucially generates £444m of cash to pay down debt.

In the absence of functioning debt markets, the need for liquidity outweighs the benefits of delaying the sale until better days. Land Securities has also sold £214m-worth of other property at 8 per cent below their half-year valuations. To execute these sales now sends a clear signal to the market that management expects things to get much worse, and is cushioning itself against further falls in property values.

As things stand, the group's most recent portfolio valuation for 30 September 2008 is way past its sell-by date. Companies that do quarterly valuations, such as West End specialist Great Portland Estates, show the state of things to come. Its third-quarter trading statement showed a , wiping nearly 13 per cent off the value of its portfolio. This echoes three successive record monthly falls in the industry's valuation benchmark, the IPD Index, and a marked deterioration in the central London office leasing market.

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Accordingly, City analysts have been downgrading their forecasts for Land Securities' net asset value (NAV) - broker Collins Stewart predicts that NAV (net asset values) will hit a low point of 829p in 2010.

With so much puff already knocked out of the shares, which currently trade 39 per cent below forecast NAV for March 2009, there is an argument for saying the bad news is priced in already. The worry is, it may not be. First, there is some concern that the company's dividend may be cut (see table) - but the dividend yield is still likely to be fat. Then there is the possibility that shareholders will be tapped for new equity capital. Last, and most ominously, there is an issue about Land Securities' borrowing covenants.

Mike Prew, real estate analyst at investment bank Nomura, calculates the group's loan-to-value ratio to be 49 per cent, allowing for the disposal of Trillium and recent sales. But he expects this to rise to 58 per cent by the time the group announces its full-year results for 2008-09. Happily, he believes that this figure would have to reach 65 per cent before covenants are endangered.

Even so, broker Collins Stewart estimates that by March 2010 there may be a £450m shortfall in cash that Land Securities needs to put into a so-called liquidity pool to keep its lenders happy, as the ratio of loans to property values rises. If this happens, all solutions will be bad news for shareholders: further asset sales (which would reduce rental income and EPS); reviewing the dividend (which is likely to be only marginally covered by earnings in 2009-10 and 2010-11 anyway); or raising fresh equity.

The last option may not be that easy because, as Harm Meijer, analyst at investment bank JP Morgan, says, a "fight for capital" is looming. He estimates that the UK's six largest Reits will collectively require £625m to avoid breaching their borrowing covenants. Happily, he thinks Land Securities is one of the best positioned to raise the capital required. Its experienced management team and position as sector bellwether is likely to persuade shareholders to cough up if a cash call arises.