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UK commercial property trading at a discount

Commercial property is trading at a discount in London, suggesting investor pessimism.

Important: This is not a recommendation for you to buy or sell any shares or to invest in commercial property. I’m just a private investor, storing and sharing notes for wider interest. Please read my disclaimer.

A couple of years ago I made the case for buying commercial property listed on the UK stock market.

The various UK REITs1 had been hammered by big writedowns that downsized their net assets (NAVs). They looked vulnerable against the large loans they’d secured against those depreciating assets. Some had to raise extra cash via rights issues.

There were also fears that banks would dump property they acquired in the boom years (or been lumbered with after loans turned sour) as they desperately tried to shrink their own books.

Buying into this scenario might have seemed as appealing as elbowing past widows and orphans for last-minute tickets onto the Titanic. But there were reasons to be positive.

Rents for the better REITs had held up more than their plunging share prices suggested. Share prices had also fallen far below NAVs. At the bear market low you could buy £1 of Land Securities’ assets for as little as 36p!

Obviously, investors feared commercial property prices would fall further, taking NAVs with them. But as it turned out, the steep fall to 2001 levels in the prices of offices, warehouses and shops was enough to tempt in bargain hunters.

From 2009, commercial property prices firmed and then began rising, especially in the South East, and the REITS followed. (Some vulture funds set-up specifically to buy distressed property in London were complaining when prices bounced back too quickly!) It proved a great time to buy.

As well as traditional property players mopping up unfairly reviled assets, I suspect the QE operations began by central banks in early 2009 also helped stabilise the market.

Commercial property is an inflation-resistant asset, since both property values and rents should increase broadly in-line with general inflation. If you fear higher inflation down the tracks, it’s a good asset class to be in.

The idea is to buy cheap

Today REITs seem to have fallen out of favour again, perhaps due to fears over Europe. Well, that and the UK economy, which is now doing a good job of impersonating a hit-and-run driver reversing to make sure.

But I think the market is again being too pessimistic about commercial property.

Only a few years ago, investors couldn’t get enough of it, with new funds raising billions of pounds and helping to inflate a bubble that slashed yields and primed the crash to come. Price seemed irrelevant. Yet now commercial property looks pretty good value and the market seems to be taking a more balanced view of its prospects, the average investor doesn’t want to know!

That’s their loss. Commercial property is an attractive asset class to own, whether you’re a passive or an active investor, and I think now looks a good time to buy – not as cheap as in 2009, granted, but unless you expect a European blow-up not as risky, either.

The big players certainly haven’t capitulated; work on new skyscrapers in London is continuing apace. While I don’t think this expansion is due to any pressing shortage of floor space, I do think such confidence in the future of the UK capital is a handy wake-up call.

Commercial property for passive investors

Many passive portfolios include a substantial allocation to commercial property. David Swensen’s Ivy League portfolio suggests a big 20% holding, for example. Several other lazy portfolios have significant allocations.

Note that UK index trackers will give you some exposure to commercial property, since big REITs like British Land, Land Securities and Hammerson are all in the FTSE 100.

But the real estate sector is relatively tiny – less than 2% or so of the FTSE 100 – and dwarfed by basic resources, energy, banks and the like. Personally I’d add a specific property allocation to any passive portfolio, which I’d expect to dampen volatility and increase my income over time.

The iShares UK Property ETF (ticker IUKP) is an easy place to start. It’s yielding 3.1%.

(Note that very nearly 50% of that ETF is invested in the three largest REITs, which some may consider excessively risky, though it’s a fair reflection of the UK listed real estate market).

Active investing in property REITs

Those of us who undertake the dark practice of active investing should certainly consider the commercial property market at present.

  • If you tilt your portfolio towards income, the sector offers plenty of potential to grab higher yields for the long term.
  • Value investors might consider the discounts to NAV as attractive, though I don’t deny they could get a lot wider in the more dire scenarios.
  • If you have your own theme or pet view on where the economy is going, there may be a REIT for you. It’s easy to bet on London, for example. If you’re more optimistic about UK retail than most (I’m not!) then that’s another possibility.

UK commercial property trading at a discount

Here’s a summary of the ten largest companies in the UK real estate sector by market cap, price to book value (P to BV in the table), and forward yield.

Company Market Cap P to BV Yield
Land Securities £4.9bn 0.7 4.5%
British Land £4.1bn 0.8 5.7%
Hammerson £2.6bn 0.7 4.4%
Capital Shopping Centres £2.6bn 0.8 4.9%
Derwent London £1.6bn 1.0 1.9%
Segro £1.5bn 0.6 7.0%
Shaftesbury £1.2bn 1.1 2.4%
Capital & Counties £1.2bn 1.1 1.2%
Great Portland Estates £1.0bn 0.9 2.5%
London & Stamford £0.6bn 0.9 6.7%

(Data as of lunchtime on December 14th)

As you can see most commercial property companies are trading at a discount to their net assets again (prices went above net assets earlier in 2011) and there are tasty yields on offer. Companies on lower yields tend to be either owners of only prime London assets or more development-orientated companies, or both.

Please note you’ll want to check all these figures – and a lot more – before considering an investment. Various data services define net assets / book value in different ways, and forward yields also vary. Download the REIT’s latest annual results and do your own research.

While you’re at it you should also evaluate:

Debt: How much does the company owe, how heavily is it geared against assets, and how comfortably can it meet interest payments? When do loan to value covenants kick in? (They could trigger rights issues).

Rent: How much of the portfolio is let out? Is that number rising or falling? How bad did it get in the last slump?

Earnings and dividend: REITs must pay out most of their earnings as a dividend, so dividend cover is of little use here. Instead look at how earnings are growing, in conjunction with your rent research. How hard was the dividend cut last time?

Development: To what extent are upcoming developments pre-let? Does the company have the funding to complete its work? (Not a problem with big REITs, but a factor for smaller developers with money still tight).

Sector and geography: What are you buying into, and where is it? If you’re bullish on a bounce back in The City, you don’t want to buy a load of shops in the North.

Management: Subjective and difficult, perhaps the best thing to do is look back through management’s statements in the last downturn. Many key players have moved on, however.

Which UK commercial property companies look attractive?

Personally I like the look of the big two – British Land and Land Securities – which offer the chance to buy into incredibly diversified property portfolios at a discount and to hopefully secure a long-term growing income.

The most contrarian play is probably Segro, which focuses on industrial warehouses and the like. Not a happy sector, hence the high yield. Could be worth investigating if you sense the economy bottoming out.

The big London specialists such as Derwent London and Great Portland look pretty fully priced already. British Land and Land Securities have substantial London assets, too, albeit with plenty else besides.

London & Stamford is interesting. Veteran real estate moguls established the company just ahead of the slump, but they didn’t get a chance to deploy much of their funds before the recovery began. They’ve been very cautious about investing into the rising market, and have plenty of firepower left. Could be a good option if you’re cautious on the short-term but would like some professionals running your money. Great yield.

Price is the firmest foundation

None of the commercial property companies are going to thrive if the UK enters a deep recession or the Eurozone blows up.

I don’t think either is likely, and I’d argue the general gloomy sentiment makes it a good time to be hunting for bargains. I am not claiming prices will soar next month, or even next year.

Property has generally rewarded those who think long-term – provided they’ve bought into the sector at decent prices – so even if the immediate outlook isn’t great, I think valuation makes it a good time to consider investing.

In part two: A few ways to invest in small cap commercial property companies.

  1. Real Estate Investment Trusts []

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{ 20 comments… add one }
  • 1 ermine December 15, 2011, 10:17 am

    Fascinating summary, looking forward t the next instalment. I am interested in this area, even though I do expect a European blow up 🙂

  • 2 hotairmail December 15, 2011, 10:27 am

    Thank you for your considered articles monevator.

    I worry about the prospects for commercial property mainly because of the sheer overhang of repossessed property on bank books and the fact they are keeping many commercial property companies on life support in order to avoid write downs.

    You are right about QE providing the finance to stop ‘fire sales’ but also the effect of the massive Sterling devaluation of course. The latter blew an instant hole in many overseas investors’ balance sheets such as the Irish banks tripping them into insolvency. NAMA and others will be trying to sell the properties on their books.

    And as Europe looks to deleverage rather than raise capital and dilute existing owners, I have heard of German banks and the like looking to sell up their City assets. And if there is a concerted attack on the City in the long term…well, all bets are off.

    So yes, you might be right that fears have reached an irrational level and therefore this might be the right time to invest. Current yields and NAV look tempting. But for me, I would rather see that overhang reduce significantly and for the financial world to be somewhere nearer normality – for this is a credit induced sector if ever there were one.

  • 3 The Investor December 15, 2011, 11:20 am

    Thanks for your thoughts! My research so far suggests London & Stamford could be a good option to hedge your bets. It’s got several hundred million pounds of cash / debt available to buy if prices fall further, while it also has some skin the game should prices firm. The chaps running it are pretty canny, having built very large property companies through two cycles previously and doing some nimble deals in the latest downturn. They’re also investigating the residential market and are looking to create a residential REIT, although I have mixed feelings about that. Another negative is the dividend is effectively supported by the cash reserves, rather than rental earnings, to date.

    Still. the recent fall looks excessively sharp to me, given the strength of the balance sheet.

    (All just my personal opinion as ever, not a recommendation that anyone buys these shares on my say-so!)

  • 4 mark senior December 15, 2011, 6:13 pm

    @ Investor

    Great article…. as usual!

    Looking forward to your article on Smaller property companies. From my own perspective, I would like to buy a fund/trust that specialised in smaller property companies to spread risk and keep dealing costs under control.

  • 5 hotairmail December 16, 2011, 8:51 am

    Lukewarm demand for about 5.75 billion pounds of London offices on the market will likely force sellers to cut prices up to 15 percent, bringing them back to more realistic levels, property experts told Reuters.

    So far, offers are believed to have been made for about 1.7 billion pounds of the offices, which are in London’s City financial zone and Canary Wharf business hub, global real estate consultancy CBRE said. It is not clear how many are under offer.

    “Realistic pricing remains the key if the ‘under offer’ is to become a ‘sold’,” CBRE executive director Mike Edwards said, noting the dearth of big deals in the last quarter of 2011.

    “The total level of transactions is being restrained by some unrealistic asking prices. If these were to ease, total investment turnover would increase,” Edwards said.

    http://uk.news.yahoo.com/londons-9-billion-property-sell-off-risks-price-160138026.html

  • 6 The Investor December 16, 2011, 11:47 am

    @hotairmail — I’ve inserted a portion of the article in your comment above as I think that’s more helpful to readers. In terms of the content, of course as I mentioned in my piece there’s lots of gloom around about property prices. Fact is plenty were saying the same thing two years ago and prices moved up continually over that time.

    I suspect prices in London are now fairly-valued, if not slightly fuller than that, from my reading of experts such as the canny managers at London & Stamford. Prices in the likes of Land Securities are already down 30% from their 2011 peak though and as noted above are trading at decent discounts, so on the surface there’s a fair margin of safety.

    Pays your money (or not) and takes your choice. 😉

  • 7 The Investor December 19, 2011, 11:49 am

    Just an update to say I’ve bought a fair chunk of London and Stamford in the end, but I’m possibly not done with this sector.

    I’ve been reading the literature of the UK Commercial Property Trust (Ticker: UKCM) for the past couple of days. While I’ve not quite decided what I think of the managers overall, their commentary is certainly interesting and informative, if possibly a bit reactive. The latest factsheet is here:

    http://www.ignisasset.com/propertytrust/documents/UKCPT_Factsheet_Q3_11.pdf

    UCKM is now yielding 8.1%.

    In June it was 6.1%, when the trust was trading at a 12% premium, compared to a 13% discount as I write.

    That’s how quickly sentiment can change, as this well judged snippet from The Scotsman back in June points out:

    http://www.scotsman.com/business/one_to_watch_uk_commercial_property_1_1692188

    It will probably be a bumpy ride, but short of full meltdown I think buying this commercial property investor yielding 8.1% as a long-term hold, say in an ISA, is likely to prove rewarding.

  • 8 gadgetmind December 21, 2011, 4:55 pm

    I’m currently moving a SIPP to Bestinvest and will be putting about 10% into property. I’m considering a three way split of 50% of this into IUKP, and 25% into each of UKCM and LSP (London and Stamford).

    Thoughts?

  • 9 Paul R December 23, 2011, 5:01 pm

    gadgetmind –

    Sounds good to me, i’m doing similar – with II, reg investing into IUKP, whilst also added UKCM and LSP. Any more weakness , i’ll buy more.

  • 10 gadgetmind December 23, 2011, 6:26 pm

    Sadly, my funds are still in flight. Of course, this is when the market goes up for no good reason, and LSP up nearly 4%.

    Ah well.

    Looking more at IUKP, I’m tending more towards adding HICL and JLIF alongside UKCM and LSP.

  • 11 The Investor December 23, 2011, 8:15 pm

    LSP is indeed up nicely today, as management has yet again disposed of a property above the carrying value:

    http://www.investegate.co.uk/Article.aspx?id=201112230700135514U

    Bad luck on the timing, but at least another vote of confidence in management IMHO.

    Shares are pretty volatile over Christmas, so perhaps it will drift off out through sheer apathy again.

  • 12 gadgetmind December 23, 2011, 8:26 pm

    Regards timing, I’m fairly cool as I’m expecting funds to hit my SIPP in three additional gouts (two transfers and a HMRC 25% extra on new funds), and I’m still 30% in cash, so I’ll be able to take advantage of the inevitable bad hair day(s).

    Everyone seems doom and gloom regards commercial property, and it will only take a few more mainstream “bombed out sector, no hope, avoid” articles for me to *know* that now is the right time to “go large”.

  • 13 The Investor December 24, 2011, 12:05 am

    @Gadgetmind — As a knee-jerk contrarian I’m similarly minded, but of course the doom and gloom is occasionally justified. I bought 95% of my Christmas presents via Amazon this year, so for me the threat to secondary retail is very credible, for instance.

    Would you agree infrastructure is a pretty new sector and those are pretty new funds, without much of a track record? I’m not saying I wouldn’t invest in them (as we’ve discussed, I can’t and don’t do personal advice anyway! 🙂 ) but I’d be inclined to think of them as a somewhat different asset class (or sub-class maybe), likely driven at least partly by different variables.

  • 14 Paul R December 24, 2011, 1:32 am

    Re infrastructure, I have been in 3IN and INPP for 2+ years , they have been solid, very good yields. Share prices don’t move too much, but that’s been ok this year.
    Other fund options are ishares etf of INFR, and Oiec of first state infrastructure.

  • 15 gadgetmind December 24, 2011, 9:19 am

    Yes, commercial property carries risk, and I’m also 95% online regards shopping, but I really do think that’s more a “bloke thing”. I expect well-run and (most importantly) low-geared REITs to do well and others to fail. With failure will come opportunity for those with strong war chests.

    I’m definitely counting infrastructure as a separate sector to property and it’s only getting 5% of my pot, and even this will be split two ways.

    @ paul r – thanks for that. 3IN were on the list, but I worry about layers of management and Indian exposure. I guess I could split down further as I’ll still have a few £k in each, but you can over-diversify.

    I’ll look at INPR but I already hold a lot of First State Global Listed Infrastructure in an ISA. I bought into FSGLI last October and it’s up 3% since then despite the torrid times.

  • 16 gadgetmind December 24, 2011, 9:24 am

    I’m pretty happy with the whole passive thing, but it must be said that IUKD, IUKP and INFR all seem a trifle grim compared to many/most of the active alternatives. I’m prepared to be convinced that “survivorship bias” and other factors are at play, but when it comes to buying, selling, and running physical assets, and being able to sense when yield=value and when yield=danger, there does seem to be value to active management.

    Discuss!

  • 17 The Investor December 24, 2011, 12:43 pm

    Well, IUKP is dominated by the major listed REITs, which were hammered in downturn after being bid up to absurd levels in early 2007 on the introduction of REIT legislation. I think it’s fair to say you’re getting a representative chunk of the UK commercial property market.

    IUKD is a different beast altogether, IMHO. It’s basically a mechanical strategy for trying to pick value shares through yield and so outperform. I’ve discussed several times on this blog why I think it’s a poor choice for those looking to add traditional ‘value’ to their portfolio — I’d prefer an equity income investment trust. IUKD may have merits as recovery play, but you’re basically backing a back-tested strategy to win again some day.

  • 18 gadgetmind December 24, 2011, 2:29 pm

    I think it was the problems with IUKD that prompted Vanguard to introduce a per company and per sector cap for the UK Equity Income tracker. I hold some, cautiously!

    Regards IUKP, I’ve looked at its performance relative to current (surviving?) REITs and have struggled to find any REIT that’s performed worse over recent years, but maths tells us there must be a goodly number.

    So, I’m ending up with trackers for equities and bonds (the latter with mixed conviction) coupled with hand-chosen REITs and HYP shares. Can you sense my inner torment? 🙂

  • 19 The Investor December 24, 2011, 3:03 pm

    @gadgetmind – the big three are all down slightly more, according to Google: http://bit.ly/vRrFJI

    They are the dominant holdings in the fund, as you’ll see from the iShares fact sheet.

    Anyway, your choice of course — just some food for thought.

    Good luck with the demons — I’ve got a veritable menagerie!

  • 20 gadgetmind January 24, 2012, 12:49 pm

    OK, I currently have 15% of my SIPP in property/infrastructure, with First State Global Listed Infrastructure getting 27.5% of this and the rest spread between UKCM, LSP, HICL, JLIF and BBGI. I intend to reduce the FS fund over time, particularly when I decide it’s time to get back into gilts.

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