The 23 June 2016 was a dark day for the UK commercial property industry. The UK’s unexpected vote to leave the European Union (EU) unleashed a day of chaos on the markets. Among the hardest hit shares were those in UK property: as investors rushed for the exit the value of real estate investment trusts (Reits) plunged 23 per cent from their referendum day closing price over the following two trading days.
But leaving aside the initial shockwave, many early estimates of the likely effects of the Brexit vote on commercial real estate performance have so far proved wide of the mark. Yet the sector faces another D-Day on 29 March 2019, when the UK is scheduled to leave the union two years after triggering Article 50. As it stands, that will – according to the law of the land and lack of any consensus between UK lawmakers and EU negotiators – be without a deal. And just as was the case in the run-up to the referendum, those wishing to maintain the status quo – or at least, something that looks quite like it – are predicting an economic meltdown that will see businesses flee the UK or left in a financial wilderness that will force many to shut their doors.
We cannot know for sure what will be the case, and what fate will ultimately befall the UK commercial property sector. What we do know is that commercial property has proved far more resilient post-referendum than many expected. Putting aside the heavy sector losses in the immediate aftermath of the referendum, we see that FTSE 350 Reits have performed largely in line with the wider market. True, there has been slight underperformance, but this is largely the result of its largest constituents’ exposure to a secular shift in the retail industry from physical to online shopping and not a Brexit effect.
“But” some might say “Brexit hasn’t happened yet, the worst is yet to come”. Again, we can already see that the initial worries over the erosion of the wider financial sector, particularly those areas with EU exposure, were overstated. Responses to a recent Reuters survey of the UK’s largest banks, insurers, asset managers and private equity firms, indicates that only 2,000 jobs in financial services have been relocated thus far. Compare that with a report compiled by EY for the London Stock Exchange Group (LSE) in early 2017, which predicted that “232,000 jobs would be at risk or likely to be lost”.
Certainly, the initial anxieties linked to the Brexit effect and the subsequent re-evaluation have been reflected in London’s market for commercial office space, with initial weakness in 2016 followed by stabilisation in 2017 and price increases in certain sub-sectors through last year. Tellingly, research from real estate firm Colliers also indicates that even in the event of a so-called ‘hard’ Brexit, demand for regional office space is likely to keep growing, particularly if the UK “creates a favourable regulatory and tax environment”.
The post-Brexit landscape for the logistics/industrial property sector is difficult to predict; essentially a trade-off between restricted EU market access for manufacturing and assembly businesses and their ability to exploit the rise in inward tariffs and consequent fall-away in imports. There are certainly signs that manufacturing companies are delaying investment decisions because of greater uncertainty. Colliers notes, however, that the wider sector has benefitted from the boost to exports brought about by sterling devaluation in the wake of the vote, though “yields remain compressed with no signs of outward movement”.
|Warehouses of over 100,000 sq ft|
|Take-up Q1-Q3||Availability at Q3 end|
|2017 (m sq ft)||2018 (m sq ft)||Change (%)||2017 (m sq ft)||2018 (m sq ft)||Change (%)|
|Yorks & north-east||1||4.1||329||2.5||3.2||29|
When others are fearful…
Whatever the reality, we can’t ignore that there are still broad fears over the future health of commercial property, reflected in a widening of share price discounts to Reit book value since we ran this feature a year ago (see table on page 35). So, the uncertainty ahead of our nominal departure from the EU, perhaps more than the political or economic reality, has given way to a ‘risk-off’ attitude among some investors.
Analysis from the Investment Association indicates that retail investors pulled a net £336m from funds in the UK Direct Property sector in the final quarter of 2018, the bulk of which was withdrawn in December. According to the Financial Times, the Financial Conduct Authority (FCA) is now monitoring property fund flows to ensure there is no repeat of the series of ‘gatings’ that occurred in the wake of the referendum as property funds struggled to meet redemptions for panicked investors when £1.5bn was withdrawn from UK property funds in June (see box below).
|UK rental growth|
|Logistics||Rent (£/sq ft)||Change Q-on-Q||Change Y-on-Y|
|High-street retail||Rent (£/sq ft)||Change Q-on-Q||Change Y-on-Y|
|London (New Bond Street)||2,250.00||0.00%||2.30%|
|Birmingham (New Street)||210||0.00%||0.00%|
|Cardiff (Queen Street)||200||0.00%||-4.80%|
|Leeds (Briggate/Commercial Road)||250||2.00%||2.00%|
|Manchester (Market Street)||285||1.80%||1.80%|
|Newcastle (Northumberland Street)||240||0.00%||0.00%|
|Edinburgh (Princes Street)||220||0.00%||0.00%|
|Glasgow (Buchanan Street)||320||0.00%||0.00%|
|Offices||Rent (£/sq ft)||Change Q-on-Q||Change Y-on-Y|
|London (West End)||110||0.00%||0.00%|
|Birmingham (City Centre)||34||0.00%||3.00%|
|Bristol (City Centre)||35||1.40%||7.70%|
|Cardiff (City Centre)||25||0.00%||0.00%|
|Leeds (City Centre)||30||0.00%||0.00%|
|Manchester (City Centre)||33.5||0.00%||0.00%|
|Newcastle (City Centre)||24.25||1.00%||3.20%|
|Edinburgh (City Centre)||35||0.00%||4.50%|
|Glasgow (City Centre)||32||6.70%||8.50%|
|Source: Cushman & Wakefield|
However, it’s just as possible that the withdrawals in December were as much a response to general market weakness as any specific Brexit concerns. And the Colliers research suggests that for all the fearfulness of UK investors, international buyers still see UK commercial property as a good home for their capital. “Counter-intuitively, the Brexit vote looks to have boosted the UK property investment market through its impact on sterling,” it says. “Furthermore, the well-known liquidity of the UK property market has attracted safe-haven capital flows that were stimulated in part by the very uncertainty created by the UK’s decision to leave the EU.”
Meanwhile, we shouldn’t forget that commercial real estate markets are always evolving to meet new patterns of usage and tenant demand – Brexit isn’t always the primary consideration. Analysts at Peel Hunt believe that the rapid growth in flexible office arrangements (‘hot-desking’ etc) across central London “is a natural extension of recent trends (shortening leases, increased amenity etc) and a significant rush of hot money has merely accelerated this process”. This trend has been deemed favourable for the listed Reits, although they’ll have to adapt to a higher proportion of short-term tenancies, changes in employment patterns and the adaptability demanded by new, rapidly growing industries.
It’s also worth noting that property companies are generally in far better financial shape than they were at the time of the global financial crisis. Debt secured on commercial property now stands at around £150bn – a 40 per cent drop since 2008 – while loan-to-value levels are lower (apart from retail Reits). And the prospect of debt covenant breaches for the larger listed real estate companies is nowhere near as acute, even if we witnessed a marked deterioration in property values.
Ostensibly, the industry discounts on offer point to pockets of value. Taking all the property sectors together, total returns in 2019 are likely to contract to 3.2 per cent, according to research by Peel Hunt, well below the five-year average of 11.9 per cent a year. But extremes within that forecast show industrial assets delivering a 3.7 per cent return for 2019 and 2020, while at the other end, rents and capital values in the retail sector are expected to show a peak to trough fall in rents and capital values of 22 per cent. That, though, is arguably reflected in the wide discount at which Reit shares currently trade – any surprisingly ‘good’ news on the EU front could see those close narrowly given the sector’s sensitivity to political news.
But there are other factors that could stifle investment, even if – as many still believe – the UK exits the EU ‘in name only’, chief among them interest rates. If these start to rise, it would reduce the attractions of real estate as moving down the risk ladder becomes more attractive. Yet it may take quite a long time before this happens, especially if inflation remains subdued. There are also signs of a broad economic slowdown, which could hinder the investment needed to drive property returns – or at the very least lead to further negative sentiment towards a sector already struggling to convince investors of its resilience. When looking for an investment in real estate, now more than ever, it pays to be selective.
Logistics: Going the last mile
One sector that all forecasters agree on as being one of the strongest, with or without Brexit, is urban logistics. Demand for purpose-built warehouse space has grown sharply along with the change in consumer buying habits. Buying online has led to a growing requirement for big distribution centres, the so-called big boxes that can be as big as 1.5m square feet (sq ft), to the smaller building required for last-mile delivery.
Sourcing these close to large suburban areas remains a challenge. And supply has simply not kept up because for years the low rental return made new construction uneconomical. The question now is whether the sector will retain its attraction.
As the warehouses table overleaf shows, take-up of space in 2018 almost doubled from the previous year, with an extra 11m sq ft taken up. However, availability failed to keep pace, with just 8m sq ft of extra space becoming available. One risk to the investment case is that a growing supply side response will drag on returns, notably on valuation premiums that currently reflect the strength of the sector. Even so, supply will struggle to keep up: demand looks set to accelerate to keep pace with the penetration made by e-commerce. If, as predicted, the current rate of retail shopping online accelerates from 17 per cent in 2018 to 25 per cent in the next decade, this would imply an additional 112m sq ft of space required. Meeting this demand will be easier to absorb in areas where new-build is cheaper, but with such fierce competition for space from other sub-sectors, finding that space in urban areas will underpin rents.
One of the stronger performers in the sub-sector is Segro (SGRO), which benefits from having a development pipeline approaching 1m sq ft, of which around three-quarters is pre-let. The land bank and future development could add another 2.2m sq ft with the potential to generate £145m of rental income. This is significant when considering that gross rental income in 2017 was £297m. Another jewel in the crown has come from acquiring the remainder of a joint venture giving it full ownership and virtual control of all the storage assets surrounding Heathrow airport. It also owns assets in mainland Europe and should benefit from an acceleration in e-commerce penetration. Rental growth and valuation uplifts are expected to push adjusted net asset value (NAV) up from 648p per share in 2018 to 677p at the December 2019 year-end.
Tritax Big Box (BBOX) operates at the top end of warehousing in terms of space, and recently bought an 87 per cent stake in DB Symmetry, which owns one of the UK’s largest strategic land portfolios. The deal was funded with a £250m share placing that was significantly oversubscribed. The new assets will give Tritax access to a total land portfolio of over 2,500 acres capable of delivering around 38.2m sq ft of floor space, effectively more than doubling the existing 29.8m sq ft portfolio and making it an integral player in the UK’s logistics industry – the shares have swung into a discount over the year, which looks undeserved.
Meanwhile, demand for smaller warehouses to cater for last-mile deliveries remains equally strong, not least because of demand for space from other sectors such as residential. LondonMetric (LMP) has been busy refocusing its portfolio to take advantage of this demand, and in the past five years, distribution assets have risen from a quarter of the portfolio to three-quarters. Sensibly, retail assets have been sold off, and its exposure to retail parks is now just 5 per cent of the portfolio.
Retail: surviving the rout
The growth of online shopping that has lifted logistics assets has conversely meant a torrid time for physical retailers and their landlords – 2018 saw retail failures accounting for well over 1,000 stores. The unsurprising consequence was that in the last three months of 2018 all retail rents were down by around 1.5 per cent, while over the same period shopping centre values shrank by 3.7 per cent. Over the year, this has been the weakest sector of the real estate market, with total negative returns of 8.3 per cent, largely because of lower capital values.
This is bad news for the likes of retail landlords British Land (BLD), Hammerson (HMSO) and Intu (INTU), reflected in the heavy discount to book value at which their shares trade. Nor is there any comfort drawn from what were attractive dividend yields on offer. Twice jilted Intu is cutting its full-year dividend altogether, while Hammerson has all but halved its dividend growth guidance. Furthermore, valuers have been advised by the Royal Institution of Chartered Surveyors to take account of the change in consumer shopping habits when making valuations. The outcome of this will be seen when company results start coming out in the spring – a 13.3 per cent full-year downward revaluation of Intu’s properties revealed this week doesn’t bode well.
In response, British Land has been busy reducing its exposure to retail, flogging off over £600m of assets in 2018, while Land Securities (LAND) has held steady in valuation terms, but only because the underperforming retail side has been balanced out by a better performance in the office portfolio.
So, what does the year ahead hold? It’s possible that the share price discounts to NAV will narrow, but this doesn’t mean that shares will be good value again. Indeed, if the current discount is reflective of more bad news, then share prices look set for a further fall even as valuations decline further. All of this comes at a time when rents are coming under pressure as tenants look for revised deals, while others simply go bust, thus increasing voids which will be increasingly hard to fill, and certainly not at a rate anywhere near the rental levels paid by departing tenants.
However, it would be unwise to tar the whole retail sector with the same brush. Convenience shopping, for example, is likely to be a far more resilient business model favouring the likes of NewRiver REIT (NRR). The shares have taken a pasting in the past year, tarred with the same bearish brush that has painted the broader retail sector. This is hard to justify, given the fact that NewRiver has consistently steered clear of the big shopping centre market and has no exposure to hard-pressed sectors such as fashion.
Its business model is focused on non-discretionary shopping, and customers steering away from the weekly supermarket megashop towards shopping more frequently for perishable items. To build on this trend, it is using spare land acquired through the purchase of pubs to establish arrangements with retailers such as the Co-op, which runs convenience stores on sites that used to be pub car parks. Crucially, rents are around half the going rate, and for investors there is a dividend yield of around 10 per cent, paid quarterly.
Offices: space squeeze
Demand for office space has risen at a time when supply has been constrained by a lack of new-build, a consequence of low rental values making new construction uneconomic. Meanwhile, there has been a quiet revolution that has steadily gathered pace and centring on flexible office space. This sector in 2018 took more space than any other part of the business services sector, although one of the leaders in the co-working industry, WeWork, remains heavily lossmaking, even if customers continue flocking to its modern workspaces. In London, this demand has been driven by the fintech sector.
Meanwhile, despite Brexit uncertainty, last year Facebook, Apple, Amazon and Google all took up space in London, equivalent to 5 per cent of all space acquired in central London last year. Without doubt, the key performer here has been Great Portland Estates (GPOR). Sufficiently perceptive to buy land in the wake of the financial crash, it has been developing and selling assets at a considerable premium to book value. This has taken its loan to value ratio down to a nominal 6 per cent, and gives it considerable firepower to take advantage of any significant downturn in property values. It is also one of the very few real estate companies that has seen its discount to NAV narrow over the past year.
Demand for office space in London has been underpinned by a continued advance made by smaller companies, notably from the tech sector, which together with media accounted for a third of the take-up last year. This has been good news for office space provider Workspace (WKP). On the surface, its performance has looked lacklustre, but stripping out the volatility in property valuations, revenue from rental income has continued to rise. There is also a healthy pipeline of future projects, and investors have been comforted by a 20 per cent increase in the interim dividend.
But demand is also strong in the regions – according to property consultants Cushman & Wakefield, Glasgow was Europe’s strongest office market at the end of 2018, with 6.7 per cent quarterly rental growth. This regional outperformance is likely to continue, not only through fintech start-ups but also from the banking sector as banks attempt to increase efficiency in back-office operations, and in locations that offer better rental terms. There is without doubt more sparkle in the regions as decades of underinvestment are now pushing rental levels ahead against a backdrop of limited supply and strong demand. Regional REIT (RGL) has a cocktail of industrial and office assets in its portfolio, and there remains significant reversionary income yet to be crystallised by refurbishing assets and putting them on the market at much-increased rental levels. Funds for this are generated by selling off so-called mature assets, where there is limited rental growth potential. And because of the demand, these invariably command a premium to book value.
|Reit performance in 2018|
|Name||Ticker||Price (p)||Market cap (£m)||1-year change (%)||EPRA NAV (p)||1-year NAV change (%)||2018 premium/discount (-)||2019 premium/discount (-)|
|Civitas Social Housing||CSH||100||620||-8.2||106||-||-||-6.10%|
|Great Portland Estates||GPOR||726||1,995||18.3||849||4.40%||-23.90%||-14.50%|
|NewRiver REIT (REG S)||NRR||215||654||-27||-||-||-||-|
|Primary Health Props||PHP||117||909||3.3||105||-||-||11.10%|
|Tritax Big Box REIT||BBOX||136||2,258||-2.8||145||8.90%||5.90%||-6.60%|
|UK Commercial Prop Reit||UKCM||87||1,128||0.5||93||-||-||-6.70%|
|Source: Thomson Reuters Datastream|
Healthcare: Government go-slow
Another sub-sector offering stability is primary healthcare. Brexit or no Brexit, people still need medical attention. And with a growing elderly population who need more medical care, the demand for purpose-built medical centres is acute. Primary healthcare facilities are not only designed to offer a greater range of facilities, but offer the added attraction of being more cost effective, and will help to lighten the workload on overworked hospitals, not least accident and emergency.
The main operators in the well-established sector are Primary Health Properties (PHP) and Assura (AGR) – the MedicX Fund (MXF) recently merged with PHP. There’s plenty of room for expansion, with around half the GP surgeries in England and Wales deemed unsuitable for expansion. But overall growth is slow, because it’s difficult to persuade those with the power that the best way (in this case) to save money is to spend more money. As a rule of thumb, a visit to your local A&E department costs the NHS about five times as much as popping into a primary healthcare centre. However, it remains a struggle to get this message across, and willingness to embrace the obvious has been hampered by the fact that there are so many other calls for money within the health service. And rental growth, although improving, has been held back by the fact that most rents are open market, with a minority linked to inflation.
Nevertheless, these shares maintain their bond-like attraction, with nearly all the rental income drawn from renting out purpose-built healthcare centres paid for indirectly by the government. That’s reflected in the shares across the sector trading at a premium to NAV, even if that premium has narrowed over the year as NAV has sharply increased. PHP has also developed a new revenue stream, however, by exporting the business model to Ireland, where financing costs are lower and yields at least 100 basis points higher.
So will 2019 be the year when all the pieces fall into place? The government has made more funds available to the NHS, and continues to look for ways to achieve efficiencies. But given the slow-moving nature of government decision-making, investors shouldn’t hold their breath for an imminent boom – although the attractive dividend yields should be enough to sustain interest for now, with a low risk of capital depreciation.
Student property: Digging digs
Student accommodation is another sub-sector that has defied the gloom affecting the broader market. It’s true that student numbers arriving from within the EU could be affected, and domestically there has been a decline in the number of 18-21-year-olds in university education. However, demand for university places still comfortably outpaces the supply of new purpose-built accommodation. Of the 1.8m students in the UK, fewer than 600,000 live in purpose-built accommodation or on a university campus. What’s more, even though applications for a university place are below their peak, there remains an imbalance of more than 100,000 between the number of applicants and the number of places on offer.
Top provider Unite (UTG) has a bed portfolio of around 55,000, with the capacity to manage more than 80,000. Several positive steps have been taken to improve and increase rental income, with around 60 per cent of beds now coming through university partnership agreements or so-called nomination agreements. This is where a university guarantees to fill the building built by Unite at a prescribed rent, which includes an annual uplift, with an average duration of 10 years. This gives significant earnings visibility. GCP Student Living (DIGS) is another solid provider of student beds, and its approach is different in that it concentrates on providing beds in and around London. The attraction here is that there are such high supply-side constraints that there is no possibility of rental income being diluted by oversupply. So, with full occupancy, rental growth of 4.1 per cent exceeded the national average increase for student accommodation of 2.9 per cent.
However, it’s not always plain sailing as Empiric Student Property (ESP) found out to its cost. In late 2017, it revealed that margins and dividend cover would be affected by a number of financial and operational inefficiencies, a state of affairs that cost chief executive Paul Hadaway his job. A new management has set the company back on track, and the continuing discount to assets leaves plenty of room for further recovery in this booming market.