Market showing signs of life

In every seven to 10 year cycle there is a point when real estate looks good value. With property stocks some 40 per cent off their June 2007 peak, some believe that point is now, while others predict the downturn will see out the year. While the global quoted real estate market rose 21 per cent in the last three weeks of March, this was a correction to a double dip in January and February. The average global Reit still stands at a massive discount of 36 per cent to NAV – compared with the long-term average 3-5 per cent premium. At yields of 7-8 per cent, commercial property is paying out over 5 per cent more than 10-year Treasury bonds – and this from stocks that have already proven they can endure difficult markets. Further to fall However, valuations could still conceivably fall by perhaps another 10 per cent over the next six months, as rental income comes under additional stress because of the broad economic backdrop and increased risk of tenant failures, in a further adjustment to a cyclical downturn. Commercial property loans are going sour at an accelerating pace, threatening a second wave of multi-billion dollar losses to banks, according to data from Deutsche Bank. The delinquency rate on about $700bn (E540bn) in securitised loans backed by office buildings, hotels, stores and other investment property has more than doubled since September to 1.8 per cent, Deutsche analysts say. “Global Reits are pricing in weak property fundamentals and the question is what will be the catalysts to drive a recovery off these low levels,” says Bruce Eidelson, a director of Russell Real Estate Advisors in San Diego. “We think that the Nav numbers are reasonable and even if valuations come down further, there is still a good steep margin there. Reits may look to make dividend cuts to preserve capital, but spreads are currently much higher than the ten-year Treasury equivalent, and they would be able to absorb some downward movement and still provide a decent yield,” he says. “The key issue is the refinancing risk,” Mr Eidelson adds. “Strong Reits can still access capital albeit at a higher cost but a number of Reits don’t have ready access to capital and are planning rights offers.” This bifurcation between the big quoted Reits, which are largely able to refinance, and the secondary, private property market, which may not be so fortunate, is a key characteristic of the sector. “There are two distinct markets,” says Jakes Ferguson, partner and fund manager at Sarasin & Partners. “There’s the quality end such as major shopping centres owned by quoted Reits like British Land or Liberty which in the main have good length leases to good quality tenants,” he explains. “A number of Reits have been close to their covenants and have had to refinance but they have all been fully subscribed. We estimate that around £2.8bn (E3.14bn) of refinancing has taken place in recent months and this gives a good floor to the market. “So the Reits story is that balance sheets look strong and there is no immediate threat regarding refinancing. In fact I believe many are now preparing to go on the offensive to acquire distressed assets,” adds Mr Ferguson. “However, the secondary, private market has higher borrowing levels with 75-90 per cent gearing, or even 100 per cent gearing, compared with 45-50 per cent for the big Reits,” he says. “When the smaller private market has come to refinance, in many cases properties have had to be handed back to the banks, which have found that the equity in these loans has completely disappeared,” explains Mr Ferguson. The break-up of the Esporta fitness-club group bought by Simon Halabi is one example. The luxury retail market is still signing new leases with good quality tenants, in shopping centres such as Cabot Circus in Bristol and Westfield in Shepherds Bush. In Westfield, for example, Italian labels Pal Zileri, Fratelli Rossetti, and Frette have all signed up and a Louis Vuitton store is currently fitting out in time for a May opening. The upmarket Village part of the complex has seen the opening of 12 stores since the centre opened in October, including Burberry, Prada, Gucci, Versace, Ferragamo and Miu Miu. Size no protection However it is too simplistic to assert that the rental risk is concentrated in small retailers with two or three branches. Certainly, shares in the big commercial property firms jumped recently following a deal with national retail chains to cut service charges and rent by up to 20 per cent, as property investors acknowledged the risk that even big retailers could face administration. Yet there is a sense that huge sums are waiting to come to market, with substantial new raisings every day. Property company Catalyst Capital has closed its first dedicated European fund with a total of E228.5m of committed capital, while Morgan Stanley is reportedly close to raising $6bn for a new global property fund. Some big global Reits are building up firepower to buy distressed assets. In particular bid activity can be expected from the US and Germany, boosted by the weakness of sterling, and also a little by the thinking that because the UK went into recession early, it could recover earlier. Bid candidates include quality west London property specialist Brixton and Liberty International, which both scrapped their final dividend payouts for 2008 in a bid to conserve cash. Simon Property Group from the US and Westfield have both acquired stakes in Liberty. To demonstrate the impact of sterling weakness on foreign purchasing activity, Ferguson calculates that Fleet Place, near London’s Chancery Lane, which was purchased by Legal & General for £135m four years ago and recently sold for £76m, would have been 80 per cent cheaper to a Swiss buyer had sterling’s weakness against the Swiss franc been factored in. “The fall in value plus the currency impact makes these properties suddenly incredibly attractive to overseas investors,” Mr Ferguson says. “It’s a once in a lifetime opportunity to acquire assets at these prices.” The Royal Institution of Chartered Surveyors has reported that £1.5bn worth of UK property was purchased by overseas investors during the first three months of the year - accounting for 42 per cent of all purchases made during this period. With property stock discounts so high, and liquidity a critical issue, funds that invest in Reits rather than physical real estate seem to be favoured at the current time. “Some of the big quoted firms provide access to property that would be impossible to buy direct, as well as exposure to managements that add value,” says Jim Rehlaender, fund manager at Schroders, citing French company Unibail-Rodamco and Mitsui Fudosan in Japan as examples of access to fantastic and scarce properties. “Good operators can get through the tough times,” he adds, and cites the skill of the can-do ‘gorilla warfare fighters’ at Derwent and the long-standing contact book of Simon Property Group in the US. Careful selections But in this climate, fund managers are being highly selective in their stock-picking. “Some companies are further down the road to repairing their balance sheets than others,” says Shaun Stevens, investment specialist at Fortis Investments. “We like companies that have faced up to their problems. We look at how realistic earnings growth projections are and how far the recession has been factored in,” he explains. “Lots of companies have optimistic rental predictions that look out of kilter with economic fundamentals and will be exposed as unemployment starts to bite across Europe and impacts property demand,” adds Mr Stevens. Despite the spike in asset correlations last year, investors are still attracted to real estate as a diversifier. The correlation between Reits and the S&P 500 in a good market is 0.5-0.6 but in recent months this has been thrown out of kilter as some fairly artificial factors have come into play. One is the simple necessity that many investors have had to raise money wherever they could, without consideration as to the asset sold off – and so have resorted to offloading listed real estate companies which have remained highly liquid. Another artificial drag has been the activity of hedge funds which started to sell short the sector once financial stock shorting had been prohibited, on the basis that real estate shares many characteristics with financials such as capital intensity and big questions over valuation and refinancing. Asian market The UK is a favoured market characterised by its long lease upward-only rent reviews and rigorous valuation regime. The Hong Kong market is also favoured for its close links to the US, and has performed well, up 7 per cent since the start of the year, compared with Singapore’s 7 per cent fall and Japan’s 20 per cent meltdown. Frankie Lee, fund manager and co-head of property equities, Asia, at Henderson, is relatively bearish about the region, pointing out that unemployment is still high in Asia and this usually has a prolonged impact. “There is still a lot of stress,” he explains. “Companies are in downsizing mode so there is a risk of vacancies going up. In the physical market it will be a few more quarters before the market bottoms out.” “We have a good history of bear markets in Asia and this is the worst,” adds Mr Lee. “The last two bear markets were supported by consumption in the West. Ironically we can still pick up good returns because some stocks have been oversold.” But he also points out that companies in Asia lived through 1997 and many have therefore held back from over-gearing. He is overweight China, because its economy is still relatively strong, growing at 5-7 per cent per annum, and the country is also benefiting from 4000bn Yuan in fiscal measures which he says are already having an impact in reigniting the economy. Clients, he says, are very sticky, seeing Asia as a way to diversify their portfolios and believing in the long term structural story of the region.

Jakes Ferguson