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Tired of London?

Stephen Wilmot sees exceptional value in commercial property outside the capital
March 8, 2013

Two blocks from George Square, the centre of Glasgow's civic life, stands a handsome pair of 19th century town houses faced in the city's characteristic ruddy stone. Long since knocked together to make an office, they were bought for £3.95m last June by an investment trust, Standard Life Investments Property Income. The rent roll - which is paid by a couple of law practices, a surveying firm and an independent financial adviser - gave an immediate 9.5 per cent cash yield on the purchase price.

The fund manager, Jason Baggeley, thinks this is the kind of building today's risk-averse commercial property market is mispricing. Bidding was sparse because the tenants all negotiated break clauses after a badly-timed refurbishment in 2009. Most investors do not have the confidence to take on the explicit risk of vacancies, which typically involve paying agency fees, rent-free periods, fit-out payments or other tenant incentives and business rates while the space is empty.

Yet Mr Baggeley is confident his tenants will choose to stay. "Moving is expensive, and we've made very conservative rental assumptions, which means we can be competitive when it comes to lease renewals," he explains. He has already persuaded one tenant to waive his break clause in exchange for three months' free rent and found another for the floor that was vacant on purchase. "The yields will eventually come in for this kind of stock. People will eventually realise that central London is a bit too expensive."

Whether or not Mr Baggeley is right - that now is the time to leave London and start buying in the regions - is the big question facing the property industry this spring. It affects private investors in two ways. First, those that hold shares in big London-focused real-estate investment trusts such as British Land or Great Portland Estates need to consider whether it makes sense to reallocate some of their property exposure to smaller, higher-yielding players. Second, investors that own small shops or industrial estates – or are tempted to trawl through this month's auction catalogues in search of deeply discounted stock – need to decide whether to buy, hold or sell.

Market polarisation

The divergence between central London's property market and those elsewhere has been the defining feature of the current property downturn. The 2007-09 crash brought the whole market down by about 45 per cent, according to standard industry benchmark IPD, as both rents fell and yields increased. In the recovery, however, the market has polarised. Yields for top-notch buildings let on long leases in London have rapidly tightened to 2007 levels, thanks mainly to foreign capital in search of safe havens. In the regions, meanwhile, valuations have sagged after their initial bounce and – from what surveyors can make out in a very thin market – are on average lower than their 2009 nadir. Buildings at risk of vacancy because the lease will expire within three or so years have been written down particularly aggressively.

 

 

This has created what can either be seen as a once-in-a-generation buying opportunity or a value trap. By almost any measure, property outside the capital is cheap. The yield gap between London and the regional cities is as high as it was in the darkest days of the early 1990s, according to brokerage CBRE (see chart above). Picton Property Income, an investment trust that owns various buildings on short leases, reports that its regional office portfolio is currently valued at roughly half the latest estimate of its construction cost.

The problem - a familiar one for value investors - is that regional property also looked cheap a year ago, and has since only got cheaper. Mr Baggeley at Standard Life also bought an office in the summer of 2011 in Southampton, on a 7.9 per cent yield. At the time he thought it offered excellent value. "With hindsight, two years later would have been better," he now admits.

Perhaps the biggest problem is simply the passage of time. As existing leases run their ineluctable course towards expiry, the properties to which they apply are gradually devalued. Many crashed through their loan-to-value covenants long ago and are milked for cash by banks. That means no capital is available to offer the kind of rent-free periods or fit-out costs demanded by tenants in exchange for lease renewals or extensions.

Last year the banks became more willing to wash their hands of the problem by selling their properties at auction. A full 29 per cent of properties sold by Allsop's in 2012 had been repossessed - up from 20 per cent the year before. "We're seeing a lot more double-digit yields than we used to," notes partner George Walker. "The banks are giving up the fight."

These are the kind of properties that are dragging the market down. Many are functionally redundant and are sold very cheaply to investors who may hope to convert them to residential. "Some offices won't be used as offices again. Many from the 1980s are at the end of their economic life," says Simon Perkins, chief executive of McKay Securities, a small real-estate investment trust. The well-documented problems in the retail sector are arguably even more acute. A recent report on multi-channel retailing by Jones Lang LaSalle estimated that the internet has rendered 20 per cent of UK retail space surplus to modern requirements.

The trick for investors is to spot the babies that have been thrown out with the bathwater - those buildings that do still have an economic purpose and will flourish when economic growth and lending returns. All the investors we spoke to for this special report were united in believing plenty of these could be found. "The market isn’t differentiating between the secondary stuff that isn't worth buying - because the space is obsolete - and the stuff that is," says Duncan Owen, manager of the Schroder Real Estate Investment Trust.

Tellingly, however, there have been precious few transactions. One reason is that the severe valuation falls of recent years have left many investors with constrained balanced sheets. Mr Owen has been selling buildings to repay expensive debt, for example, and is committed to paying more in dividends than he receives in rents. But even those with financial muscle are reluctant to press the red button. Philip Nell, manager of the Aviva Investors Property Trust, one of the largest open-ended property funds, is bullish on the relative value of regional versus London property. "The likelihood of regional leases being renewed is higher than the yields suggest," he reasons. But he plans to use the money raised by selling a building on Piccadilly last summer to finance a development around Tottenham Court Road rather than increase his exposure to the regions. With valuations continuing to fall, it is clearly tempting to wait on the sidelines until the market finds a clear bottom. Nobody wants to dive into such murky waters first.

Yet there are tentative signs that the market as a whole may be close to turning. The January update from index provider IPD was encouraging, with the highest total returns in a year and smaller valuation declines in the regional office and industrial markets. Prompted by risk-taking in the equity markets, brokers have also started to chatter more about the opportunities in high-yielding property – albeit often with a deferred buy recommendation. The research team at DTZ put out a note in December entitled "secondary to outperform prime from 2014". Stockbroker Liberum Capital published a report on the property investment trusts last month, only to name the more London-oriented stocks as its key buy recommendations. Mat Oakley of Savills jokes that the recovery of regional property has long been the "great story of tomorrow".

More concretely, banks seem more willing to lend to the property sector. Ian Watson of Hansteen, which owns low-grade industrial estates, reports that the high-street banks are more willing to lend to him now than they were a year ago. "There's just a glimmer of hope," he says. Robert Ware, chief executive of vulture fund Conygar and a long-time property bear, expects the banks to lend more this year than they did last. "All this printing of money will come through somehow," he says.

The big unknown is, of course, economic growth, without which landlords will struggle to regain negotiating power from tenants. The Investors Chronicle will not be foolish enough to offer predictions - like the property recovery, the economic recovery always seems a year away. Yet buying too early is unlikely to lose you money if you have a long enough time horizon (say, five years) and pick assets that will, eventually, recover. This, of course, is the tricky bit.

 

How to play it?

Private investors have two ways into the high-yielding property market. The most obvious option is to buy small shops or industrial estates at auction. These have long been popular with private investors because they can be included within self-invested personal pensions (Sipps) - and no doubt also because they sidestep the City machine, with its hefty fees, slick sales talk and patchy reporting.

The problem with direct property investments is that they involve a huge concentration of risk, particularly in combination with debt. In our view, it is foolhardy to compound this risk by buying property subject to short leases - even if the cash yields do run well into double digits.

Three outcomes are possible when faced with a lease expiry or break clause. First, the tenant may renew its lease - in which case the risk will have paid off and the landlord can congratulate himself on a sound investment. Second, the tenant may renegotiate its lease at a lower rent. In this case, the property could still turn out to be a sound investment, depending on the price paid. Finally, the tenant could quit, leaving the landlord with business rates, refurbishment costs and cash incentives to pay.

The latter two options throw up risks that most private investors are badly placed to manage. Unless you know what rents should be and how financially healthy the tenants are – which requires local expertise or at least good agency contacts - you should prioritise quality over value.

So we would instead advise investors to buy into the distress of the regional property markets through small property companies and investment trusts. These offer a double dose of value. Not only have their portfolios been aggressively written down, but the shares often trade at a gaping discount to book value.

 

 

One problem with companies as opposed to bricks-and-mortar is that you lose oversight of the assets and have to put your faith in costly managers. This does neutralise some of the charm of property investing. Yet the professionals are worth their fees in this case. High-yielding buildings come with plenty of basic risks – expiring leases, empty floors, bankruptcies - that full-time managers can reduce or even exploit through so-called ‘asset management’ (see case studies below).

The other problem with companies is that they come with historical baggage as well as cheap assets. The sector is riddled with legacy problems, particularly excessive interest rate hedges and uncovered dividends, which may or may not spoil the investment case associated with the properties themselves.

On the next page, we profile six regional property landlords that have a good chance of flourishing when the recovery does finally arrive. We have avoided the very cheapest companies (notably Picton Property Income and Redefine International) in favour of those that have outperformed the market despite substantial exposure to higher-yielding property. These may, for a period it is impossible to predict, continue to underperform their larger and often better-capitalised brethren that operate in the West End of London. But investors cannot forever ignore the sheer value on offer in the regions - after a bear market that is now in its sixth year.

 

 

Seven value-hunting property companies

McKay Securities (MCKS) owns offices, mainly in the south-east of England. During the six months to 30 September 2012, it delivered portfolio growth of 1 per cent – a creditable performance for a tough period - and full-year performance should be boosted by the sale of an office in Glasgow last month at 8 per cent above book value. "Rental values have picked up in the most undersupplied locations, but demand levels need to increase before this extends more generally," the company reported last month. McKay's main problem is a portfolio of very long-dated interest-rate hedges, without which book value would be much higher at 231p a share (so-called EPRA net asset value). Last IC view: Buy, 137p, 20 November 2012.

Schroder Real-Estate Investment Trust (SREI) has been one of the strongest performers in the embattled property investment trust sector. That’s thanks partly to a geographic bias to the south-east and partly to Duncan Owen's strategy of selling off lower-yielding properties to pay back debt, which has underpinned valuations. Dividends are less than 70 per cent covered by rental income, undermining net asset value. Yet the discount looks disproportionately large, given the low loan-to-value ratio and resilient performance. Last IC view: Buy, 38p, 7 February 2013.

Town Centre Securities (TCSC), the property investment vehicle of the Leeds-based Ziff family, owns shops and offices in various northern cities. Earnings have come under pressure over the past year because of a refinancing that increased finance costs. But that’s a one-off that should now give way to earnings stability and even some growth from a regeneration site in Leeds. The investment portfolio itself remains highly cash generative, helped by a strong leasing discipline – the occupancy rate is nearly 98 per cent. One niggling problem is that it has not sold anything for years, raising doubts about its valuations. Last IC view: Buy, 187p, 13 February 2013.

 

Building up: Development Securities continues to announce small but significant success.

 

NewRiver Retail (NRR) was set up in 2009 by David Lockhart to take advantage of the rebasing of shop values. It owns a lot of value shopping arcades in marginal towns, which the company can manage aggressively because it bought them very cheaply and because it is well financed. Despite its exposure to one of the most structurally challenged sectors of the regional property market, its portfolio lost just 0.5 per cent of its value in the six months to 30 September 2012. Last IC view: Buy, 208p, 21 December 2012.

Hansteen (HSTN) is another aggressive asset manager that has tried to profit from the current market dislocation by buying distressed assets. Even more than NewRiver Retail, it benefits from an exceptional spread between its portfolio yield (8.4 per cent) and its cost of borrowing (3.3 per cent), making it highly profitable. The dividends should continue to grow as it fills up voids and sources more deals from the banks. Last IC view: Buy, 79p, 11 September 2012.

Development Securities (DSC) is a developer more than an income-paying property investor. But its shares have underperformed drastically and trade 34 per cent below book value, even though its book value accounts for buildings at cost rather than market value. That has even made its dividends look generous – the yield is now 2.9 per cent. It continues to announce small but cumulatively significant successes at a long shopping list of small development sites. Last IC view: Buy, 165p, 23 October 2012.

Conygar (CIC) hardly pays dividends. An opportunist vehicle run by property veteran Robert Ware, its great advantage is a £50m cash pile. Yet it also owns a portfolio of high-yielding regional real estate – a chunk of which it bought as a portfolio deal in December 2011 for £39.8m, a net initial yield of 10.6 per cent. With its shares trading 36 per cent below a growing book value, Conygar would be a major beneficiary of any return to risk-taking in the wider property sector. Last IC view: Buy, 89p, 29 November 2012.

 

How the companies compare

CompanyShare price (p)Share price performanceMarket cap (£m)Last NAVDiscountNet loan to valueAnnual NAV changeDividend yield
McKay Securities14411%66150-4%49%-6%6%
Town Centre Securities20020%106270-26%50%-6%5%
Schroder Real Estate Investment Trust4011%14147-15%31%-2%9%
Hansteen Holdings8310%527794%38%-1%5%
NewRiver Retail198-7%67246-20%50%-4%8%
Development Securities164-3%200249-34%35%-7%3%
Conygar Investment Co10716%96166-36%27%7%1%

 

CASE STUDIES

What is asset management?

Investors may think of 'asset management' as the business of Schroders or BlackRock. But in property it has another meaning – negotiating with tenants to reduce voids, extend leases and increase rents. This is particularly important in the regional property market, where clever space management can turn otherwise risky buildings into profit machines.

 

Norfolk House, Birmingham

Conygar Investments bought Norfolk House as part of a £39.8m portfolio that the previous owner, Caledonia Investments, had been trying to sell for some years. Valued at about £10m, with rental income of just under £1m, Norfolk House is a classic post-war office block located behind the dilapidated New Street Station and next to the Bullring shopping centre. "The appeal of the property is that it sits in a major regeneration zone," says property director Steven Vaughan. "The location will improve dramatically when the station is refurbished and a new John Lewis opens next door in 2014." Meanwhile, the company has renegotiated a couple of leases to the Inland Revenue to remove break clauses, and is refurbishing a floor that was vacated with a so-called dilapidations settlement on purchase.

Conygar's Norfolk House sits in a major regeneration zone.

 

800 Pavilion Drive, Northampton and 401 Grafton Gate, Milton Keynes

Picton Property Income bought these two offices in 2005, when it was launched. Both have lost about a quarter of their value since, but a recent trio of lettings should have stemmed the decline. Picton shifted one tenant, Texas Instruments, from the Northampton office into a vacant floor of the office in nearby Milton Keynes. That was in order to make space for Ricoh, the other tenant at Northampton, which wanted to expand. Meanwhile, the other tenant in Milton Keynes, SHI International, took the other vacant floor. Picton chief executive Michael Morris reports that the deals increase the rent roll by about £170,000 and - perhaps even more importantly in the current market - extend the company's average lease length.

Picton Property has increased the rent roll at its Milton Keynes (above, top image) and Northampton sites.

 

Pinehurst Park, Farnborough

McKay Securities bought this business park, consisting of a Victorian convent converted into offices and an adjoining modern office block, from a bank for £3.5m last June. It was previously occupied by IBM for an annual rent of £1.29m. As part of the deal, IBM paid the bank for the right to break its lease, which otherwise ran until 2016, and hand back the convent and half the modern building in January 2013 - which it has duly done. The new rent is £500,000, giving McKay a rental yield of 14.3 per cent on its purchase price. Meanwhile, McKay has obtained planning permission to turn the convent into housing. It now hopes to sell the residential part of the site to a specialist developer, at a yield on cost of 17 per cent. "Farnborough is not a particularly strong office market, but the site had residential potential and a good income. Having worked with the tenant before, we were happy to work with them again to help them achieve what they wanted," explains chief executive Simon Perkins.

McKay has planning permission to turn a former convent into housing.