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 a client’s portfolio will depend upon their overall strategy, target returns, time horizon and appetite for risk but at least some advisers will 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, advisers and clients 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).

And yet someone, somewhere seems to think the gloom may be overdone and that there is some value to be had.

  • 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 as 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, Thomson Reuters Datastream

Even though advisers and clients are unlikely to have the time or inclination to get involved with individual stocks, or in this case REITs, such activity may catch their eye, especially as the full-year reporting season passed without major incident, with net asset values (NAVs) holding up well.

In addition, the dividend yields on offer are still easily surpassing anything 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 likely event that advisers and clients do not wish to embrace stock-specific risk, they can turn to funds.

There is a wide selection of active collectives from which to choose, although advisers and clients will have to research the mix of assets both by geography and by sector – offices versus warehousing/industrial versus retail – to ensure any fund fits with their view of the world and their appetite for risk.

Best-performing UK property funds over the past five years

Source: Morningstar, for UK Large-Cap Blend Equity category.
(Where more than one class of fund features only the best performer is listed).

Passively-run options are fewer and farther between, although the £780 million portfolio of the iShares UK Property Exchange Traded Fund (ETF) tracks a basket of 23 REITs that are quoted in the UK.

The ETF is, however, 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.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.