The CFA Society of the UK, supporting ASIP, CFA and IMC professionals.

 Thu 28 Aug 2008

UK Society of Investment Professionals - CFA Institute

The real state of Real Estate

Getting big returns from property has not been easy this year. In the long-term, however, well-managed property companies should continue to reward investors, writes PATRICK SUMNER.

he past 12 months has been a difficult time for property equities. After four years of outperformance, the sector has been hit by a number of factors that have eroded investor sentiment: investors choosing to take profits; some unexpected inflation in the UK; a fall in the price of Spanish residential property; plus an assumption that rising interest rates will seriously damage returns. These things have all combined to convince the general investor, who accounts for the majority of the liquidity and pricing in the property equities sector , that now is the time to move on to new pastures.

The tendency was exacerbated by short-selling, momentum-driven investors, and by retail investors who interpret falling share prices as a sell signal. The collapse of the US sub-prime market led to further declines¸ and in the UK the run on Northern Rock caused a widespread sell-off, during which the sector hit 12-month lows.

The result of all this is that investor sentiment is as negative as at any time since the early 1990s. The difference today is that there is no oversupply in the pipeline, and it is the uncertainty that deters investors, as they wait for stability to return to market pricing.

Before analysing the present state of the property markets, it is worth remembering the three factors which have driven property equity performance over recent years, and which will continue to drive the market going forward: dividends, the net asset value (NAV) growth and the repricing of property companies. (See figure 1.)

REPRICING

During the four years from 2003 to 2006 the contribution to global property share returns from dividends and NAV growth remained fairly constant at about 12% per annum. However, the repricing effect more than doubled the returns over the period, transforming substantial discounts to hefty premiums. While premiums can be justified by strong rental growth and favourable interest rates, any ‘bump in the road’ can have an unsettling effect on a vehicle travelling at speed. The ‘speed’ was the result of excessive liquidity in a sector with limited free float, an effect that remains clearly visible in Asian stock markets today. So far in 2007 the UK property share index (FTSE EPRA/NAREIT) is down by about 30%, while Asia (ex-Australia) is up 18% and Hong Kong, in particular, is up 38%. Such divergent performance cannot be explained by fundamentals, but rather by a simple
excess of cash.

The fall in UK property share prices since the introduction of REITs (real estate investment trusts) should not be seen as an indictment of the legislation. The run-up in share prices in late 2006 anticipated a repricing as a result of the change, and of course was a self-fulfilling prophecy – just like the subsequent decline. It will take years for the REIT market to mature to the point where long-term dedicated investors dictate pricing, and in the meantime there will be short-term volatility.

The fundamentals in the UK are monitored effectively by the IPD monthly index, which in September showed the first monthly fall in value since 1992 and the second biggest fall (behind May 1990) since the IPD index began in 1987. We expect further falls over the coming months, with stabilisation unlikely before the second quarter of 2008. However, in the indirect (listed) market, share prices are already anticipating a significant decline in capital values. As highlighted in figure 2, stocks in the UK are currently trading at discounts of about 30% on average to their net asset value, implying a fall in the underlying value of their property portfolios of close to 20%.

The largest ever 12-month decline in all-property total return was 8.12% in 1990. The market is undoubtedly far stronger now than it was then. The full employment, modestly inflationary economy will keep demand for space strong. New supply, which has historically ended most real estate cycles, often with a thud, bears watching but seems manageable. The major concern is that current credit market uncertainty, following on from the sub-prime issues, will lead to a sustained economic downturn. However, share pricing now discounts a much greater fall in values than seems likely. This is not a re-run of the technology bust, rather a debate about the appropriate capitalisation rate given that the risk-free rate has risen and credit spreads are widening. We expect that once the general, indiscriminate selling has run its course, investors will re-assess the sector and try to quantify fair prices.

NEW MARKETS

It is important to remember that the vast majority of the portfolio is built around income-producing property with relatively conservative finance. We are basing our portfolios on th e fundamentals of the underlying property markets, which remain broadly encouraging.

However, with news flow likely to remain weak towards UK property in the coming months and no significant triggers for a meaningful rally on the horizon, we are increasingly looking for opportunities elsewhere in the market.

There is a strong case for overweighting European shopping centre specialists on the basis that rental income in this sector is more stable.

CENTRAL EUROPE AND CIS

Our favourite theme, however, is likely to remain small-cap, specialist operators who can add value in challenging markets. We have built up our exposure to the emerging markets of Central Europe and the former CIS countries. Our strategy has been to invest in developers rather than investors and to spread our exposure over a number of holdings in smaller companies rather than to invest in the majors. Investment yields are converging with mainstream European yields, and we would rather be invested in companies that capture development profits by selling to funds than in the funds themselves.

Through this strategy we have also gained exposure to residential development across the region. The communist era housing stock is rapidly reaching the end of its useful life, and demand, both to replace the existing stock and to meet the aspirations of the emerging middle and upper classes, will take many years to satisfy. We have been invested in the new EU states for some time, but more recently we have made a number of investments in Russian developers.

Figure 3 highlights the undersupply of retail space in CEE, showing the existing shopping space per capita. Set against a backdrop of strong GDP growth and an increasing availability of credit we feel there remains significant
potential for future growth in these countries. Our job is to find attractive, well managed companies, which give us access to these markets.

In the future, assets across all markets with strong underlying occupier demand will outperform those with little prospect of rental growth. Property markets tend to have a delayed reaction to the economic and financial market and is not yet clear how recent events will affect occupier and investor demand.

Against this background, property companies, whether REITs or not, need to add value through development, active management, capital recycling and intelligent financing. Once capital markets re-open, those that underperform will fall prey to more efficient operators or private equity. Our view is that cost of equity implied by share prices is in the region of 10%-12%, giving a weighted average cost of capital (WACC) of about 8.75% for a company with 50% leverage.

In the long run, the assumptions made by investors, in respect of direct, ungeared UK commercial property remain the same: a current yield of 5.6% plus long-run income growth of 2.5% equals a total return of 8%. Compared with expected bond and equity returns, this is appropriate.

The difference between the strong returns of recent years and those in prospect, apart from the scale of the returns, will be the greater difference between prime and secondary property. Investors will need to be much more discriminating in their stock selection today than in the past.