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Looking for value in real estate? Cue commercial landlords

Commercial property groups are gearing up to increase acquisitions in the hope value will emerge post-pandemic
Looking for value in real estate? Cue commercial landlords
  • Commercial landlords look to increase acquisition spending over the coming months
  • Investment has already flooded into the logistics market as rental values have risen
  • The office sector may provide the most compelling value

After disposing of around a fifth of its assets last year, Schroder Real Estate Investment Trust’s (SREI) cash buffer saw it through rent defaults in the face of the pandemic. But now the commercial Reit’s manager and Schroders’ global head of real estate, Duncan Owen, wants to put some of that cash to work in the office investment market. “There’s still a gap between some asking prices from owners and what we’re prepared to pay, but we think asking prices are going to come lower,” says Mr Owen.  

Mr Owen is not alone. Commercial property groups are gearing up to spend on acquisitions in the hope value will emerge in the wake of the pandemic. 

Investment market activity has already staged a sharp bounce-back after lockdown caused volumes to slump to one of the lowest levels ever recorded during the second quarter. In the three months since then, investment volumes have risen by more than half, according to data from Savills (SVS), but are still behind the pre-pandemic norm.

With UK gilt yields at historic lows, and in negative territory for two-year government debt, investors have turned to the property market for income, says Savills joint head of UK investment, Richard Merryweather. “There is more capital out there looking at UK commercial property than I can ever remember,” says Mr Merryweather. 

Yet the recovery has not been uniform. The acceleration towards ecommerce and enforced closure of non-essential stores has heaped pressure on bricks-and-mortar retailers and forced estimated rental values down further. Investment into the sector – excluding supermarkets – during the first three quarters of the year was down by more than half on the five-year average, according to Colliers International, a more substantial decline than that recorded by the industrial and office sectors. 

Industrial deals hard won

The office and logistics markets are sparking more interest. The latter has attracted ferocious levels of capital as investors have scrambled to gain exposure to solidly rising rental income and asset valuations that have resulted from the acceleration towards ecommerce. In October, investment volumes of £715m were above a 2019 monthly average of £640m, according to Colliers International. 

“In the industrial sector there has been occupational demand almost across the whole geographical and quality of bricks and mortar,” says Mr Merryweather. In the immediate months after the outbreak of the pandemic, some appealing opportunities presented themselves, according to landlords. 

Londonmetric (LMP) managed to pick up almost £100m in assets during the six months to September. Those included London urban warehouses from high-net-worth vendors concerned about the economic outlook and sales and leasebacks from occupiers looking to boost their cash reserves, including sites from Ocado (OCDO) in Walthamstow and Royal Mail (RMG) in Epsom.

However, those sales and leaseback opportunities have now disappeared, says chief executive Andrew Jones. “Now we’re in a bun fight with the world and his wife and husband for urban logistics,” says Mr Jones.  

Similarly, multi-let warehouse specialist Urban Logistics (SHED) has invested more than £200m in acquisitions during the six months to September from sellers including open-ended property funds needing to make quick sales and owners that have lost development funding partners. With £115m left to deploy, chief executive Richard Moffitt is hopeful that more assets will make their way to market in the coming months as owners need to free up capital. “There will be people that find debt restructuring difficult in the current environment,” says Mr Moffitt.   

However, bargains are in short supply. In an indication of the heady rise in the sector’s valuation, the average investment yield for industrial multi-let warehouses had fallen to the same level as offices in the City of London by September, according to Savills. That fact is reflected in the sizeable premiums attached to the market valuations of London-listed industrial property groups, led by Segro (SGRO), which have strengthened in recent months. 

Are investors at risk of overpaying? It is worth noting that most of the increase in values over the past five years has been due to rising rents, says Mr Merryweather. Will that continue across the board? No, he argues. “We just think there will be a bigger differentiation to where the rents will grow a lot compared to a little,” he adds. The winners will be determined by where availability of land is most restricted, for example in the south-east and London.



Opportunity in a polarised market

The outlook for the office sector, both in London and the regions, is more debatable. It is here that many commercial landlords are hoping discounts – and greater opportunities for redevelopment – will emerge. 

Greater financial pressure on property owners could lead to increased insolvencies and more companies needing to offload assets, believes Neil Sinclair, chief executive of regional office landlord Palace Capital (PCA). “We’re building up our cash position because we think the opportunities will be arising in spring,” says Mr Sinclair. 

On the surface, the value of offices in London’s West End and City appear to be holding firm. Yet real estate investment specialists say there is increasing bifurcation in the market, between Grade A, quality space and tired offices that are in need of refurbishment. “[For] most of the core assets, I’d say people, on the whole, are happy to pay broadly the same prices as they were earlier in the year,” says Mr Merryweather. However, where money needs to be spent on upgrading space and improving occupancy, there is a greater level of letting risk and that has already resulted in bidders gaining offices at a cheaper price than pre-pandemic he adds. 

There are signs that tired space is becoming even harder to shift. “We have seen rent-free periods push out substantially in London now over the past six months,” says Guy Grantham, director of research and forecasting at Colliers International. But he adds: “Even offering 32-36 months in a 10-year term for rent-free has similarly not enticed offers where the product doesn’t tick the boxes.”    

Just over two-thirds of new construction starts in London were refurbishments during the third quarter, according to Deloitte, up from 44 per cent during the first three months of the year as developers sought to improve the resilience of their space within the lettings market. That is unsurprising. The availability of space within central London had risen to 6.5 per cent by the end of September, up from 4.5 per cent at the start of the year, due to an increase in second-hand space entering the market. 

Revamping tired assets to boost returns is a strategy London-focused Great Portland Estates (GPOR) hopes to exploit in the coming months. It expects to be a net buyer of assets for the first time in seven years during the 2021 financial year. By buying assets in need of refurbishment, the group believes it can fend off competition from international buyers, says chief executive Toby Courtauld. “The sorts of things we are looking to buy are buildings we can improve, which they’re not looking to buy so we think we will find opportunities,” says Mr Courtauld. 

Rival Helical (HLCL) is also on the lookout for redevelopment opportunities in London, after selling three buildings in Manchester in November and reducing its loan-to-value to a conservative 22 per cent. “I think a lot of those older buildings, with up to five years left on the lease, were mispriced, they were overpriced because they weren’t taking account of the capex required to bring them back up to standard,” says chief executive Gerald Kaye. 

Some developers that have struggled to attract buyers at their desired price have chosen to refinance their debt and hold onto the development in the hope of securing a higher offer in the future. “A lot of buyers are expecting there to be a discount built up, but a lot of sellers don’t see it in the same way,” says Lisa Attenborough, head of Knight Frank’s debt advisory team. Yet that also begs the question what developers will do if lenders become more cautious in the coming months and they are unable to secure refinancing.

That there is greater uncertainty within the office sector is reflected in the discounts embedded in the shares of London-listed office landlords, on a price to net asset value basis. Yet retail investors should pay attention to commercial property groups that are seeking value in the office market. There is undoubtedly a higher level of risk attached to landlords’ income streams as tenants face increased financial pressure and question the amount of space they may need under future working arrangements. 

Yet for London-listed groups there looks to be increased potential for the shares to re-rate further than they already have, particularly the likes of Derwent London (DLN) and Helical, which have high-quality portfolios and the balance sheet firepower to extract value from acquiring cheaper assets, while withstanding near-term shortfalls in rent collection. Logistics assets may deliver safer returns, but it will cost. Investors may find more compelling value within the office sector if they are willing to stomach greater risk.