Three reasons why commercial property is back in the investment spotlight

The FTSE 100 is off to a decent start, showing a capital gain of 3% to date, but the FTSE 250 is up by nearly 7%. This suggests that the dominant post-referendum theme of ‘pound down, stocks up’ is proving less powerful in 2017 than it did in 2016, as the more domestically-focused mid-cap benchmark is doing better than its better-known mega-cap counterpart.

There may be two reasons for this

• First, the pound has stopped going down. It held its ground as it neared multi-year lows of around $1.20 and has since traded between that mark and around $1.25.
• Second, it just may be that last year’s underperformance by domestic names relative to exporters, overseas asset plays and dollar-earners created some value in sectors and stocks that were more dependent on the UK economy.

This brings in echoes of legendary American investor Warren Buffett’s comment that: “Most people only get interested in stocks when everyone else is. The time to get interested is when no-one else is. You can’t buy what is popular and do well.”

One of the sectors which did worst in the post-referendum aftermath was Real Estate Investment Trusts (REITs, for short). The grouping fell 10.6% last year, to rank it as the 35th best performer out of the 39 that constitute the FTSE All-Share.

The sector has started this year slowly, too, but performance has begun to pick up of late. REITs have surged up to twenty-first out of 39 with a 3.6% capital gain year-to-date, a figure which matches the advance made by the FTSE All-Share.

REIT sector has started to perform a little better

Source: Thomson Reuters Datastream

There are four possible reasons why this might be:

1. A fresh plunge in UK Government bond yields may be serving to highlight the REITs’ income attractions, as no fewer than nine of them offer a dividend yield of more than 4% for 2017, based on consensus analysts’ forecasts. By contrast, the Bank of England’s reticence over raising interest rates and doubts over the sustainability of the spring surge in inflation have combined to drag the UK 10-year Gilt yield from a February peak above 1.4% back to barely 1.1%.

Several REITs offer what could be tempting dividend yields for income seekers

	2017 E Dividend Yield
Newriver	6.4%
INTU	4.9%
Londonmetric Property	4.9%
British Land	4.7%
Hammerson	4.4%
TRITAX Big Box	4.3%
Hansteen	4.2%
Town Centre Securities	4.1%
Big Yellow	4.0%
Land Securities	3.5%
SEGRO	3.4%
Safestore	3.3%
CLS *	3.1%
Workspace	3.1%
Derwent London	1.9%
Shaftesbury	1.6%
Great Portland Estates	1.5%
Capital & Counties	0.5%

Source: Digital Look, consensus analysts’ forecasts, Thomson Reuters Datastream

2. The full-year reporting season passed without major incident, as net asset values (NAVs) held up well (and certainly much better than the shares did last summer) and the widely-feared collapse in rents in the face of new supply failed to materialise. News flow this spring has also been encouraging. In the past month alone:
   • FTSE 100 REIT British Land and its joint-venture partner have sold the Leadenhall Building (also known as the ‘Cheesegrater’) in the City for £1.15 billion, compared to a September 2016 valuation of £915 million, for a 24% premium to book value.
   • CLS Holdings, a FTSE 250 firm, announced the sale of its Vauxhall Square development in London for a net consideration of £144 million, compared to the site’s December 2016 balance sheet valuation of £100 million, providing an uplift to the firm’s stated net asset value of some 70p per share (compared to the last published figure of £19.51).
   • Capital & Counties, another FTSE 250 REIT, has exchanged and completed on the sale of the events venue Olympia London for £296 million, or £229 million adjusting for debt and transaction costs, in line with previously published valuations. Note that this deal had been postponed last year in the wake of the Brexit vote.
3. The Sunday Times newspaper has reported that Hong Kong billionaire Samuel Tak Lee has built a near-20% stake in Shaftesbury, the owner of large swathes of property in Soho, Covent Garden and China Town in London, with a view to launching a possible bid. Note also that in the three property deals listed above, two of the buyers were Chinese and one German, so the weak pound may be again tempting buyers.
4. Finally, many REITs still trade at big discounts to net asset, or book value, to suggest they may still be too cheap, in light of the deals outlined above and the possible bid for Shaftesbury.

Several REITs still trade at deep discounts to net asset value (NAV)

Source: Company accounts (using historic NAV per share), Thomson Reuters Datastream
* Excludes effect of Vauxhall Square sale which will add 3.5% to NAV

A matter of price

These lowly valuations reflect the manner in which the REITs sold off heavily after the UK’s referendum vote on EU membership amid fears of a post-Brexit downturn and dash to the door among major financial services firms.

In the 1990-92 recession discounts to NAV reached around 40% but the tax rules were different then – property developers paid 20% tax on asset sales whereas the REIT structure is much more tax-efficient (REITs pay no tax so long as at least 90% of net profit is then distributed as dividends to shareholders).

As such the current discounts with no tax bill look similar to the depths of the early 1990s recession and so a lot of bad news has already been priced in – even if that bad news in the form of rising vacancies, falling asset values and falling rents has yet to materialise (if anything the opposite is still happening, if the latest news flow is a reliable guide).

Not all of the REITs have a sufficiently lengthy stock market history but this next table compares current discounts to NAV with historic averages since 2006, to bring in the 2007-09 downturn, which is many ways was even deeper and more frightening than that of 1990-92:

Several REITs trade at discounts to NAV which look large relative to their own history

Source: Company accounts, Thomson Reuters Datastream

None of this is to say the REITs are certain to zoom higher – the column’s crystal ball is no better than anyone else’s – or that these stocks are suitable for every investor’s portfolio.

It may even be that the market is correct and a post-Brexit slowdown is coming, just as a lot of fresh supply comes onstream, especially in the City, to the detriment of those REITs with exposure there (and the trend in the NAV discounts table above is the less City exposure a REIT has, the less London exposure it has and the less new development exposure it has, the higher the valuation it currently commands).

But at least such potential grief is at least partly priced in by the lowly valuations.

These stocks, and commercial property as a sector overall, were very unpopular in the second half of last year and the early stages of this one and it will therefore be interesting to see how the share prices and news flow develop as the Brexit negotiations continue.

Russ Mould, AJ Bell Investment Director