How to test the foundations of the property sector

He is unlikely to have appreciated it, or cared, at the time, but Mark Twain’s advice to “Buy land, they aren’t making it any more” has long since formed the basis of the investment case for UK commercial property, either via quoted stocks or dedicated funds.

Whether property is right for an investor’s portfolio will depend upon their overall strategy, target returns, time horizon and appetite for risk but at least some may look to it for income, some form of diversification or both.

It may also be cropping up on the radar of contrarians because it is easy to form a bearish view, despite Twain’s comments on the peculiarities of supply in the sector.

This is because Brexit is seen as casting a cloud over demand for UK commercial property, especially in London and The City in particular. In addition, the Bank of England is working towards its next interest hike and sentiment toward the property sector is taking a battering in the wake of the woes of the retail and casual dining sectors.

The collapses of BHS and Toys R’Us, planned Company Voluntary Arrangements at New Look and possibly Carpetright (so they can streamline their estates and cut their rent bills) and store closures at Mothercare, to name but one, all raise questions over the state of Britain’s high streets and shopping centres, and their capital and rental value to landlords.

These fears are all reflected in the poor performance of the quoted FTSE All-Share Real Estate Investment Trusts (REITs) sector. In addition, investors will remember the post-referendum panic of summer when some property funds went into lockdown in the face of an initial torrent of redemptions.

The Real Estate Investment Trusts sector has struggled since the EU referendum of summer 2016

Source: Thomson Reuters Datastream. Based on capital returns only. There are 39 sectors and a ranking of 1 would indicate the best performer of the year and 39 the worst. *To 20 March 2018.

And yet someone, somewhere seems to think the gloom may be overdone.

• Hammerson, the owner of the Brent Cross, Bullring and Cabot Circus shopping centres in London, Birmingham and Bristol respectively, has launched an all-share bid for fellow FTSE 250 stock Intu, which owns the Trafford Centre and Lakeside.
• France’s Klepierre has since launched an approach for Hammerson
• Hong Kong billionaire Samuel Tak Lee has continued to build his stake in another FTSE 250 REIT, Shaftesbury, the owner of large swathes of property in Soho, Covent Garden and China Town in London, although there is no intimation that a full bid is in the offing.

Big discounts

Such activity may not be brave as it may first seem, for all of the High Street gloom, given some of the valuations on offer. Many REITs, or at least those with exposure to retail and The City, are already trading at big discounts to net asset value, so it may be that a lot of bad news is already factored into valuations.

Several big REITs already trade at big discounts to net asset value

Source: Company accounts (based on historic NAV per share), Thomson Reuters Datastream

In addition, the full-year reporting season largely passed without major incident, with net asset values (NAVs) holding up well. The dividend yields on offer also still surpass the returns obtainable from Government bonds or cash (albeit in exchange for greater capital risk).

Several REITs also offer yields which may catch the eye of income-seekers

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

Fund options

In the event that investors do not wish to embrace stock-specific risk, they can turn to funds.

AJ Bell’s list of Favourite funds features two property collectives. The £3 billion, actively-run Janus Henderson UK Property PAIF has a mandate to generate capital growth and income over the long term and comes with a spread of retail, industrial/warehousing and office sites across the UK, with a bias toward the South East of England. It also has a 22% cash weighting to manage liquidity.

The passively-run, £780 million portfolio of the iShares UK Property Exchange Traded Fund (ETF) tracks a basket of 23 REITs quoted in the UK. As such, it is likely to provide less diversification for a portfolio that already has a heavy weighting towards equities, given that it provides property exposure via stocks rather than via direct ownership of the buildings.

End game

It may 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. There is a clear trend in the NAV discounts table above, in that 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 valuations are lowly and sentiment already depressed at those REITs with exposure to the City, retail, new development or all three. This brings to mind another quote, this time from Warren Buffett: “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.”

It will be interesting to see over the coming months and years whether this pungent aphorism works for property stocks.

Russ Mould, AJ Bell Investment Director