This Reit epitomises British real estate – but that’s not a good thing

Right now, however, that is not a good thing. The UK commercial property market is in the middle of its worst downturn since 2008, and there are a lot of reasons to expect that this will continue for much of 2023. For the time being, the bear case for British Land's shares remains strong. Not because it is a bad company, but because it is the embodiment of the British commercial real estate sector.

Real assets, real problems

According to real estate analysts Costar, UK commercial property dealmaking is at its lowest ebb since records began back in 2010. Just £7bn was transacted in the final quarter of last year as higher interest rates shrank property buyers’ budgets. Meanwhile, the last six months of capital value changes and returns for UK commercial property have all been negative – with October regarded as UK property’s worst month ever on that basis – and the trend suggests there are a several months of negative returns and valuation declines to come.

That sinking feeling

Tenants of all stripes have been tightening their belts, too, resulting in limp rental figures for commercial landlords. Real estate services giant CBRE said average rental growth for UK commercial property was just 4.7 per cent for the whole of 2022. That represents a real term drop in income, given inflation was double that figure for much of the year.

A looming recession combined with existential questions about the future role of offices and shopping habits is likely to hit office and retail rent flows. There are questions around warehouse occupiers’ appetite for space and rent increases as well. Ecommerce giant Amazon, which has typified the confidence and the desire for growth of the UK’s warehouse tenants in recent years by signing tens of millions of square feet of space a year, has just announced plans to close three UK warehouses.

CBRE is forecasting that “green shoots” of recovery will emerge by the end of this year, based in part on a prediction that a fall in inflation will mean lower interest rates. However, the Bank of England’s chief economist warned against such forecasts and suggested inflation could last longer than some are anticipating, setting the scene for persistently high borrowing costs.

A British success story?

All of this will impact British Land in a variety of ways because of the diverse nature of its portfolio. Its assets have long reflected the parts of the British property market that have thrived over the years, as well as the parts that haven’t. And while it has tried to spread its assets across a variety of real estate types, the degree of exposure to subsectors has often depended on the strength of that market.

In theory, this sounds sensible. By owning a swathe of properties across a range of proven markets, British Land has spread its risk. In practice, however, the group often moves too slowly to take advantage of hot pockets within commercial property. One painful example of this has been its allocation to warehouses. For nearly a decade, as players such as Segro (SEGRO), Tritax Big Box (BBOX) and LondonMetric (LMP) made huge returns from these assets, British Land sat on its hands. 

Then, in April 2021, it finally entered the market with an £87mn purchase. By the following May, it revealed that it had snapped up £1.3bn in London warehouse assets – just days after an Amazon profit warning sent warehouse values plunging.

British Land’s top-of-the-cycle entry into logistics was reflected in the 6 per cent drop in the value of its warehouse assets in the six months to 30 September 2022. Adjusting for rents, the portfolio delivered a negative return of 5 per cent, compared with a 3 per cent valuation decline drop and a negative return of 1 per cent for the group’s wider portfolio.

British Land’s lack of nimbleness can also be seen in its exposure to struggling asset classes such as shopping centres. According to real estate agency Lambert Smith Hampton, shopping centres have traded at a 58 per cent discount on average over the last two years and one-fifth of shopping centre space is unlet. Partly due to valuation downgrades and partly due to selling into that falling market, British Land’s shopping centre portfolio is worth 66 per cent less now than it was in March 2018. The result is inefficient space and capital usage. Despite accounting for 23 per cent of the portfolio by size, those shopping centres account for a mere 8 per cent of the portfolio’s value and 18 per cent of its annualised rent.

British Land's portfolio has shrunk over the years

This charge of inefficiency can be levelled across the portfolio, too. As the largest diversified Reit in the UK, Land Securities (LAND) faces many of the same issues as British Land, but the leadership team which arrived in 2020 has embraced a braver (albeit riskier) strategy of selling low-yielding assets and snapping up higher-yielding ones. As a result, LandSec has been able to sweat its assets for more, and last year made 43 per cent more in operating profit – defined as rental income less operating costs and valuation changes – despite having a portfolio which is only 28 per cent bigger than British Land’s.

A land of opportunities

Beyond a sharper strategy, the bull case for British Land's shares rests on its discount to net asset value (NAV). Although wide, the tempted should note that this is hardly a new opportunity and the discount is only a tad wider than the average level of 35 per cent over the past five years.

Stronger arguments could be made for the possibility of a swift real estate market recovery and British Land’s long-term investment in Canada Water, south London. If CBRE’s “green shoots” do appear by the end of this year, British Land will no doubt benefit for the same reasons it is struggling now – its vast and varied exposure to UK property.

As for Canada Water, the company’s eventual plan is for it to comprise “up to 3,000 new homes, two million square feet of workspace and one million square feet of retail, leisure, entertainment and community space”. The early signs are good, and the Canada Water assets British Land has developed saw the smallest drop in valuation across the portfolio during a bruising year for commercial real estate.

Still, those are potential future gains. In the near term, it is likely that British Land will struggle in a downturn which is not over yet.