Taking a bit of a Liberty

Retail property giant Liberty International holds a dubious distinction among the big real estate investment trusts (Reits) listed on the London market: it has the highest gearing (net debt in relation to shareholders' funds). Against a background where commercial property values have slumped 26 per cent in the last year, and the trend shows no sign of slowing, this matters. It threatens the loan-to-value covenants of debts secured on Liberty's property assets, including the Gateshead MetroCentre.

At the time of Liberty's third-quarter results in November, its net borrowings were £4.2bn, and the net asset value (NAV) of its shares was 975p. Using detailed information from the company's financial statements regarding its borrowings, stockbroker Nomura estimated that NAV would have to fall below 393p for a covenant breach to occur.

Worryingly, Collins Stewart, another broker, last week published research forecasting that Liberty's NAV could plunge to 290p by the end of 2009, with its high gearing exacerbating further slides in asset values. The bearish figure also takes account of higher finance costs (interest expense is estimated at £231m for 2008, a rise of 11 per cent on the year) and reduced rental income from

Of course, Liberty is not alone in this plight. Less indebted property companies have already mounted calls for more equity, notably Hammerson, which launched a deeply-discounted £584m rights issue this week. is widely expected to follow suit with a £500m cash call, and both companies are actively pursuing asset sales to raise cash.

Yet the values crystallised by forthcoming sales of prime retail assets could prove damaging to Liberty. At the time of writing, British Land is expected to sell a 50 per cent stake in its flagship Meadowhall shopping centre to for £550m (that's £300m less than it was put on the market for in 2007). The drop in value has forced up valuation yield on the deal (annual rental income as a percentage of the asset price) to 6.75 per cent. That's 1.4 percentage points higher than the yield on comparable Liberty assets at their September valuation. With precious little valuation evidence out there, the Meadowhall deal stands to set a grim benchmark for prime retail assets.

There have been no rumours of asset sales at Liberty, but City analysts have long speculated that the company will be forced into its own right issue, perhaps to raise £350m. Forthcoming full-year results, due on 26 February, seems the obvious platform. Press reports claim Liberty has the backing of its 22 per cent shareholder and former chairman Sir Donald Gordon, but this does not take away from the fact that a big rights issue will force shareholders to dig deep into their pockets or, effectively, reduce their holdings.

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This follows on from a dilutive debt-reduction strategy executed just before Christmas, when Liberty retired £30m of convertible bonds in exchange for shares and cash. Before this occurred, Liberty was the only Reit whose cash and undrawn banking facilities were insufficient to cover its committed capital spending at new developments (£276m) and debt due before the end of 2009 (£96m). Retiring the bonds means that deficit is a touch smaller, but for Liberty to fulfil its obligations implies it must take on an extra £200m of debt, which won't be easy or cheap in today's market.

As retailers succumb to the recession, there is also pressure on rental income. Liberty's third quarter trading update contained a £10.2m bad-debt provision against tenants in administration - a trend analysts expect to intensify this year and in 2010 - and its retail rentals are likely to fall. Collins Stewart forecasts that the company's net rental income will fall 3 per cent in 2008, and 5 per cent in 2009.

Nor does it help that almost 80 per cent of Liberty's rental income comes from its Capital Shopping Centres portfolio of UK shopping malls, where the average lease length is just seven years - the lowest among the four largest UK Reits. Indeed, a fifth of Liberty's leases will expire within the next five years.