Is London commercial property an opportunity?

For various reasons, I don’t write much about my active investing these days on Monevator.

One reason is we’ve found our niche explaining why you should ignore 90% of what’s written about investing in the popular press and instead invest passively.

In that light it’s no fun having to re-explain my antics to people who read Monevator for the passive material and who – understandably – get perplexed by what I’m up to.

(This series is my best explanation if you’re interested.)

The schism is made worse by my passively pure co-blogger The Accumulator still being mainly away writing the mythical Monevator book.

We used to do passive posts Tuesday, active Thursday, and the free-for-all links on Saturday.

But with that routine constipated due to a lack of Accumulated fibre, there seems to be even more upset and indigestion when I go off-piste.

Golden years

But there’s another big reason why I’m not writing so much about my active ideas at the moment.

And that is I haven’t got so many convincing active ideas!

There’s a passage in The Snowball, Alice Schroeder’s biography of Warren Buffett, where she talks about how in the 1950s Buffett kept finding “golden apples” lying around on the floor – and he could barely believe they hadn’t been picked up.

Hindsight is wonderful – and I know my stock picks didn’t always feel like no-brainers at the time – but still, that’s a little like how I felt between 2009 (when I was pretty sure the market was cheap) and 2013 (by when most things had been re-rated).

For instance, consider UK commercial property REITs, which appeared a good bet to me in the aftermath of the credit crisis.

As late as December 2011 I was able to write that:

If you believe the pessimism about Europe and the global economy is overdone, then some REITs offer good yields as well as seemingly undervalued assets for you to snap up.

In that article I suggested diving deeper into the small cap end of the property market, highlighting six companies I thought looked interesting.

Here’s how their share prices did between then and now:

Company	Gain
Daejan	115%
J Smart	31%
McKay Securities	75%
Mountview Estates	163%
Mucklow Group	73%
Panther Securities	1%
Average	77%
FTSE All-Share	31%

Source: Google Finance / Yahoo Finance

Golden apples, alright.

I don’t have total return data to hand, unfortunately, but taking into account dividends the outperformance of these six shares versus the wider UK market would be even better – and income is often the major attraction of holding commercial property.

Of course I owned a lot more in my portfolio than just these winners. In fact at the time of that article from memory I held precisely none of them, though I was buying various UK commercial property firms on and off throughout the period.

But that isn’t my point here. I’m simply highlighting that bargains could indeed be found strewn about a few years ago, at least the way things turned out. (“Things” including no UK recession or Eurozone implosion, and continued easy money from the Central Banks).

Brexit bargains

It’s been tougher sledding recently. Aside from the odd bit of “plunging” during market sell-offs, I’ve been mainly hunting around in commodities and energy companies, emerging markets, and financials over the past 12-18 months.

These have been anything but easy buys, and not always good ones.

I’ve repeatedly traded around my UK and US bank positions as they’ve waxed and waned, for instance, and while emerging markets have come good, I was optimistic too early. Energy has been strong in 2016, but 2015 was carnage.

However this year did provide one great buying opportunity – at least in retrospect.

The market was chaotic in the hours and days that followed the Leave win in the EU Referendum, as terrified investors raced to dump their UK shares.

I should know, because as an avowed Brexit-phobe I was among the dumpers.

In the weeks afterwards I felt I’d done okay getting through Brexit intact, especially considering how surprised I was by the result. I saw my portfolio rally like everyone else, and I tried to forget about the two or three holdings I’d sold at steep discount in the aftermath.

However it’s become obvious that as an active investor I left money on the table.

I’m not even talking about the crazy buys you could make the morning after the vote before.

Yes, in theory you could buy big UK banks at 20-30% or more down, but liquidity was non-existent. You had to buy blind, and you could only guess at what we now know – that a systemic crisis was not underway.

I’m thinking more about the good companies that were marked down in the sell-off and took some weeks to recover, even as the smoke cleared.

I picked up a couple of things, but overall I was too timid (partly, no doubt, because of my feelings about Brexit, even as Britain’s post-vote resilience has confounded me).

Six of the best

There does remain one corner of the market that I feel is still suffering from a Brexit hangover, however. While it might not be exactly strewn with golden apples, I think it’s probably not stuffed with rotten ones, either.

To go full circle, that corner is commercial property – specifically the big UK real estate investment trusts (REITs).

The REITs fell in the wake of Brexit and the coincident closure of several property funds, and they have not yet fully recovered.

The following table shows how the six largest such REITs are priced relative to their recent-ish peaks, and also their price-to-book value (a measure of the premium or discount of their price compared to the value of the assets on their books).

Company	Decline from 12-month peak	Price-to-book ratio
Land Securities	-23%	0.7
British Land	-28%	0.7
Hammerson	-11%	0.8
Segro	-2%	0.96
Intu Properties	-18%	0.8
Shaftesbury	-2%	1.15

Source: Google Finance and Company Refs

Well, that’s an interesting table, isn’t it?

The first thing I’d say is that dramatic as some of these falls are, prices have bounced since the bottom of the Brexit sell-off.

Shaftesbury fell 14% the day after the EU Referendum, for example, to hit 822p. It’s since risen 18%. And while British Land is still dramatically below its highs, it got as low 545p in the wake of Brexit, compared to today’s 632p.

So the panic seems to be wrung out, even if some of these shares are still languishing.

The more interesting column for me though is the price-to-book ratio.

In the case of British Land, for example, it most recently declared its net asset value per share to be 919p as of the end of March 2016.

In theory then, if you buy British Land shares today for 631p, you’re getting a 30% discount to their underlying value.

Bargain!

Well maybe – but things are obviously not quite so simple.

Why the discounts?

There are many reasons why REITs might trade at a discount to their net asset value (that is, NAV or book value):

1) NAV too high: Investors might not trust the NAV, either because they suspect it was over-stated at the time the accounts were filed, or because they think that underlying prices (buildings, in the case of REITs) have fallen since then.

2) NAV will fall: Investors may fear that prices are going to fall in the future, and so try to factor that into their purchase price now.

3) Supply and demand: Perhaps the typical investor believes the NAV is just dandy and reflects reality, but there simply aren’t enough buyers around compared to people selling for whatever reason to hold up prices.

4) Dividend yields can be a factor. If alternative yields are more attractive, dividend-minded investors may not buy REITs until the yield becomes competitive, which could cause their share price fall to increase the yield, even if the underlying NAV is unchanged.

5) General uncertainty: If you’re less sure about the future of the economy or the markets, you’ll typically demand a bigger discount. This is especially true in the case of REITs, where the underlying holdings (buildings!) can take months or years to sell, and where some of the NAV may include developments that haven’t yet been built or sold.

All these factor interrelate, of course. For instance it’s unlikely that investors will be demanding steeper discounts to NAVs and higher yields without something similar going on in the real-world market for physical property.

I should mention here that commercial property has its own sub-language, especially in the US, which talks about ‘cap rates’ and so on. At the end of the day though the metrics of investing are the same.

There a few fundamentals worth keeping in mind with commercial property, however:

• It is illiquid. You know how it can take an age and a small fortune to sell your house? Same here.

• Rents can be illiquid, too, for want of a better word. Rent reviews may be upwards only, for instance, so tenants cannot theoretically negotiate discounts. But they can go bust, so… Also at times of high inflation, rents may not keep pace (which can be a bit of a knock on commercial property’s inflation-fighting credentials in the short-term).

• Commercial property is fueled by debt, just like manure grows crops.

• The front line of the sector is speculative. Combined with all that debt, this means commercial property goes through cycles of booms and busts, especially in big cities.

I’ve written more about commercial property if you’re interested.

Opportunity knockers

So are these big REITs on a discount screaming buys?

Who knows – but I do think they’re worth a second look.

True, when you see discounts of 30% or more to book value, you might think the market knows something certain about their underlying NAV.

And there are dark clouds around, for sure. Negative voices were calling the top of the UK commercial property market even before Brexit threatened to send tens of thousands of bankers and related office jobs overseas.

However there’s not much sign so far that property prices have slumped 30%, or anything like it. In fact we’re only a few percent down since Brexit, and the pace of decline even in the capital is slowing.

The take-up of office space in London bounced back relatively quickly after Brexit, too.

Also, if you believe that the big discounts to NAV reflect the market cunningly sniffing out an imminent London property crash, then you have to square London-centric Shaftesbury trading near NAV with, say, Land Securities trading at 0.7x.

Their portfolios are not exactly the same, sure. But they share enough in common that the idea one could be slammed while the other sales through unmolested seems fanciful.

The big REITs are in general not highly-geared, either – certainly they’re not overloaded with debt like they were back in 2007 ahead of the last downturn.

This all raises the possibility that there’s a dislocation here in terms of price and value.

Popularity contest

Price-to-book ratios do definitely swing about in this sector.

In the two years between spring 2013 and spring 2015, for instance, British Land mainly traded at a premium to book value. (i.e. The price to book ratio was over 1x.)

Premiums may be justified if investors have correctly anticipated further gains to come – perhaps because the future value of development projects are modestly carried on the books, or because underlying prices for offices or shops are rising faster than company accountants can keep up.

But fluctuating ratios just as often reflect changing sentiment, too.

I can’t help noticing that the three companies with the largest discounts in my table are the three largest UK REITs. This trio alone comprises about 35% of the iShares UK Property ETF.

I wonder if they’ve been sold off more harshly – or have taken longer to recover – precisely because they’re so big and relatively liquid?

I read somewhere that open-ended commercial property funds were holding REITs in lieu of cash, and selling them when investors began redeeming their funds after the Brexit vote. Perhaps that’s piled on the pressure?

Because I remain relatively unconvinced about the UK and London’s medium-term prospects (I mean compared to the more positive view I had of the business-as-usual scenario rejected by voters in June) it’s hard for me to get super-excited about this apparent opportunity.

However I’ve had a nibble of Land Securities and British Land, among the big REITs I’ve mentioned today, and I may well buy more.

Time will tell if there’s a worm in these apples!

As mentioned I own shares in Land Securities and British Land, so who knows what biases are influencing my thinking. As always this piece is NOT a recommendation that you or anyone else should buy any shares mentioned. You must do your own research, and make your own decisions. Good luck. 🙂