Derwent deals with falling values and increasing vacancies

Derwent London (DLN) suffered a big valuation hit in its results for the last calendar year thanks to the wider real estate market rout, which leaves investors with two questions: is the worst now over and what is the London office developer doing operationally to generate returns?

On the former, the equity market believes not. The stock is priced at a 28.6 per cent discount to net asset value (NAV), but we believe this is overdone. Data from real estate agency CBRE reveals that UK offices have lost 12.7 per cent of their value since the start of 2022. The market trend curve implies there is still some valuation loss to come, but the 28.6 per cent fall in Derwent’s portfolio being priced in by the market seems highly unlikely.

On the increasing returns question, the outlook looks mixed. Derwent posted a 6 per cent increase in net rental income, but this was during a year when consumer price index (CPI) inflation avaeraged 9 per cent. What’s more, the portfolio’s percentage of unlet space is ticking up, from 1.6 per cent at the end of 2021 to 5 per cent as of this week, which will make rent increases over the next year more difficult. The potential for a recession won’t help with tenants’ ability to pay more either, especially when wider post-Covid questions around the need for an office abound.

Derwent says it will counteract this by delivering high-quality assets in desirable London locations, and it should be noted that its 5 per cent vacancy rate is lower than the central London office average of 8.4 per cent, according to agency JLL. However, even if Derwent is doing better than most, the headwinds should make investors cautious. Hold.

Last IC view: Buy, 2,696p, 11 Aug 2022