The severe tightening in financial conditions in the second half of 2022 caused commercial property values to fall at the fastest six-month rate on record.

As a result of much cheaper valuations, investors are asking themselves whether now is a good time to start taking positions in listed property companies and real estate investment trusts, also known as REITs.

We look at where valuations are, where they could go, and which stocks look the most attractive.

WHAT HAS HAPPENED TO VALUATIONS?

One key thing retail investors need to appreciate about property companies is the importance of interest rates in determining valuations.

Property is an income-generating asset, and changes in interest rates affect the rate of return investors require on their investment.

Before March 2020, the Bank of England’s official bank rate (also known as the ‘base rate’) was 0.75%, but within weeks of the Covid crisis the bank cut its rate first to 0.25% and then to 0.1%, a 325-year low.

As a result, the yield on UK government bonds or gilts – considered the ‘risk-free’ rate – slumped, allowing rental yields on property to fall and valuations to soar.

The best-performing property assets were retail warehouses and prime logistics centres as households shifted to shopping online.

With the pandemic in the rear-view mirror, the Bank of England began raising rates in December 2021, since when it has hiked the base rate nine times to 3.5%, meaning higher yields on gilts and property stocks.

Just as lower rates sparked a jump in valuations, so higher rates have seen valuations fall sharply, with the worst-affected sectors being logistics and ‘big-box’ retail which previously gained the most.

According to commercial property valuation expert CBRE, which compiles an index based on the value of over 1,000 commercial properties and 31 monthly-valued funds worth in total over £16 billion, overall capital values fell by 13.3% in 2022. That compares with a 13.8% post-pandemic bounce-back in 2021.

Industrial assets fell 21% in value, followed by a decline of 12.1% in offices and 8.1% in retail.

On a positive note, rental values rose 4.7%, the strongest since the millennium, with industrial rents up 10.3%, offices up 2% and a 0.5% increase for retail.

As a result, the total return for each sector was -18.1% for industrial assets, -8.2% for offices, and -2.1% for retail, with the overall total return -9.1% for the year.

IS THERE MORE DOWNSIDE TO COME?

The consensus view is that commercial property valuations will keep falling this year due to more interest rate rises, a UK economy which is weakening if not already in recession and continuing macro-economic uncertainty due to the ongoing conflict in Ukraine.

There are still valuation concerns over parts of the retail sector exposed to the cost-of-living crisis and parts of the office sector which need upgrading to meet new environmental standards, but most parts of the market are not overbuilt and there are supply shortages in some areas.

Therefore, the jury is out over how much further valuations will fall this year before confidence returns, but CBRE notes there is still an abundance of debt and equity capital available and towards the end of last year prices were beginning to firm, attracting buyers into the market.

Analysts Matthew Saperia and James Carswell at Peel Hunt are optimistic the bottom is near given the speed with which values have already fallen.

‘The quicker we reach the bottom the quicker investment activity will restart and the quicker we will find clarity on valuations and NAVs (net asset values). It feels to us like we could be close, and the sector is typically quick to rerate in such circumstances,’ they argue.

‘The sector-wide share price implied property yield sits at 6.3% on an equivalent basis, offering a significant spread over the risk-free rate,’ they add, while the quality and exposure of the listed sector is ‘far superior to the broader benchmark’.

Richard Shepherd-Cross, managing director of Custodian Property Income REIT (CREI), which invests in smaller commercial properties across the country, believes valuations have overshot to the downside in many cases.

‘There is an expectation that commercial property yields should show a premium over gilts, the risk-free rate, but don’t overlook rental growth.

‘Certain sectors could be oversold if growth isn’t factored in, and there is a very strong case for rental growth in smaller lot-size industrial and logistics assets, regional offices where clients are offered a high level of service and amenity, and in some retail locations where values have fallen too far.’

COULD THERE BE TAKEOVERS?

Michael Nicholson, Peel Hunt’s head of mergers and acquisitions, believes higher operating costs combined with higher interest rates highlight ‘the merits of scale’ for many UK companies.

Historically, the main acquirers of UK firms over the past five years have been North American, but in the property sector most deals have been domestic such as last year’s merger proposal between Shaftesbury (SHB) and Capital & Counties Properties (CAPC).

While deals have been few and far between since Covid, share-price premiums for transactions have been healthy at around 25% reflecting the big discounts to net asset value in the sector and a tendency by sellers to leave the door open to attract competing bids.

The Peel Hunt team believe private equity firms are likely to be looking at UK property, and we note that US investment giant Blackstone (BX:NYSE) has been active raising capital and deploying it in property assets in the past year.

WHICH STOCKS LOOK ATTRACTIVE?

While the listed property sector covers many specialist areas, we believe the best option for retail investors is to keep it simple and go for a big stock with quality asset-backing such as Land Securities (LAND).

The company offers exposure to a broad spread of UK property, which makes it a good play on an economic recovery. It is a FTSE 100 constituent which means its shares are liquid enough to buy (and sell, if needs be), and it has a solid balance sheet.

It also has the kind of assets which high-end tenants are looking for, says Montfort’s managing director of real estate Andrew Teacher, such as The Forge, a 139,000 square-foot Grade A London office building which is the UK’s first net-zero commercial office development.

‘Companies have realised that if they want to get people back into the office, as well as providing an attractive place to work they need it to be located in an area where there is plenty going on,’ argues Teacher.

It’s also not beyond the realms of possibility that Land Securities becomes a takeover target, suggests Peel Hunt’s Saperia.

‘The company has a portfolio of prime UK assets valued at £9 billion, but in the grand scheme of things that’s nothing compared to the value of the global real estate market and there is plenty of cash out there looking for a home.’

Peel Hunt has turned positive on Assura (AGR) which owns buildings used as GP surgeries, as robust a tenant as you could imagine. It says the stock offers a yield in the region of 5.6% and has an improving rental growth outlook.

Last month, Numis flagged the appeal of LXi REIT (LXI) in a report on the property sector. LXi REIT recently merged with Secure Income REIT and Numis says the enlarged group has 98% of rents linked to inflation or subject to fixed uplifts, meaning rental growth should support earnings. Its tenants include Costa, Aldi, Lidl, Travelodge and Premier Inn.

Elsewhere, Teacher at Montfort says FTSE 250 buy-to-rent specialist Grainger (GRI) is misunderstood by the market. The firm provides high-quality, professionally managed rental properties and has a portfolio of over 9,600 homes with a market value of £3.2 billion, which makes it the UK’s largest listed landlord.

With interest rates and therefore mortgage costs set to continue rising, more people are likely to want or need to rent a property rather than buy one, and the firm has a strong pipeline which will see it double in size in the coming years.

‘Although household budgets are being squeezed, the one thing people are going to keep paying is their rent,’ concludes Teacher.

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