Shaky ground for British Land

British Land has more than its fair share of problems, but its greatest challenge in 2009 will be raising cash without eroding long-term shareholder value.

Burdened with net debt at 85 per cent of shareholders' funds, it is . Former chief executive Stephen Hester attempted to deleverage the group through asset sales, but not enough were achieved before the market turned. He went off to run the Royal Bank of Scotland.

The pressure to pay down debt intensifies with every swoosh of the property valuer's knife. The gap between September's net asset value of 1,043p and the current share price is close to 50 per cent, showing that investors expect more pain on the valuation front.

Last week, the Investment Property Databank's monthly index registered a 6.6 per cent fall in commercial property values, the steepest fall thus far into the downturn. What is more, industry body the expects property values to fall 25 per cent in 2009.

Research from investment bank Nomura shows that the value of British Land's portfolio would have to decline by a further 31 per cent for banking covenants to be breached, equivalent to reduced net assets per share (NAV) of just 465p. Were this to happen, an onerously expensive refinancing would be the penalty.

So how likely is it? Split by value, British Land's portfolio is roughly two-thirds retail, and one-third offices. Retail warehouses make up nearly 26 per cent of its portfolio, and City of London offices a further 26 per cent. The trouble is, analysts consider these two the UK's riskiest asset classes, which explains why British Land's share price has fallen 48 per cent from its 12-month high.

Although vacancy rates remain low in its properties, the growing risk of tenant default bodes ill for values and rents, with a wave of expected in the new year. The dire state of the City's office market is well documented: vacancy rates have hit 9 per cent, according to consultant Knight Frank. And active demand for office space fell 21 per cent in the third quarter of 2008 to 3.4m square feet, set against a staggering 7.6m sq ft of new space under construction.

Last week, British Land reported a shock 24 per cent reduction in the value of its Broadgate City estate, which suffered a £3m fall in rental income and a jump in vacancy rates from 0.2 to to 2.4 per cent, caused largely by the failure of a key tenant, Lehman Brothers.

Other British Land developments, Broadgate Tower and 201 Bishopsgate, have much space still to let. Ropemaker, a third City scheme under development that accounts for a big chunk of British Land's £298m committed capital spending, has yet to land a tenant. A fourth City scheme, , was put back in the cupboard in August as the outlook worsened.

True, British Land has unused banking lines of £2.7bn. Yet, paradoxically, it can't use them because, even if its bankers were foolhardy enough to sign off a loan, to draw on them would push gearing closer to permitted limits. This effectively bars British Land from snapping up "once in a lifetime" property deals from distressed sellers, which otherwise could have boosted future profits when the market recovers.

The need to improve headroom by selling properties has never been greater, but the timing could not be worse. In a market starved of debt, the only deals to attract the eye of cash-rich foreign investors are prime assets.

Following the pulled sale of its Sheffield shopping centre, Meadowhall, last year, the company is reputedly in talks to sell a 50 per cent stake to Middle Eastern clients of AIM-quoted recovery fund London & Stamford. Going by the September valuation, this could raise £700m. Were this to happen, British Land's shares would undoubtedly receive a short-term boost, though one analyst describes the sale as "long-term insanity".

"Technically, everything is up for sale at the right price," says Aaron Guy, real estate analyst at stockbroker Collins Stewart. "Selling off mature assets could enable a more profitable redeployment of capital, picking up distressed assets in the future. But the company needs more headroom on its gearing covenants."

In order to participate in the bloodbath, analysts quietly rate British Land as the most likely of the Reits to launch a rights issue in the new year. But it is very hard to second-guess the plans of a company that has no leader. Following Mr Hester's departure, the chief executive's post is still vacant. The rumour mill suggests that internal candidates and other property industry favourites are unlikely to be picked, suggesting an appointment from outside the industry.

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