Having re-embraced capitalism like only a 2,000-year old culture could do, the Chinese are also getting our traditional diseases of affluence.

No, not chronic obesity (yet) but the other kind of conspicuous consumption, and all its attendant evils.

That rich Chinese consumers like a bit of flash won’t come as a shock to anyone who has been following the earnings of companies with luxury brands.

While doomsters wonder how we’ll ever sell anything to China, firms like BMW, Tiffany and Burberry have been queuing up to load containers returning to Shanghai with our high end tat fanciest goods.

‘Keeping up with the Wangs’ researchers (genuinely!) call it.

Apparently the knock-on effects of judging yourself by your stuff versus your neighbours’ – as opposed to your devotion to the Glorious Chairman – is even affecting Chinese stock portfolios, the Wall Street Journal reports:

Compared to investors in the poorer provinces of China, those in the wealthiest provinces put more of their portfolios in stocks headquartered nearby (presumably because they aren’t tainted by proximity to the rural areas).

Wealthier Chinese investors also trade more in smaller stocks (perhaps because that makes them feel they are “in the know” relative to people who aren’t familiar with these names).

All this demand appears to have driven smaller stocks to steep prices, although high valuations haven’t discouraged wealthier Chinese from continuing to invest.

Quite the contrary: That seems to brand these stocks as a kind of luxury good, making them still more desirable.

Curious as these findings are, they won’t be wildly relevant to many of us (except perhaps Anthony Bolton, as he tries to pep up his flagging China trust). The Chinese stock market remains pretty tiny in the grand scheme of things.

No, this was the bit that struck me:

People in China’s richest provinces already report lower levels of happiness than those in the poorer areas. Extravagant housing prices, traffic jams, pollution and the pressure of constant social comparisons will do that to you.

Despite the sad universality of affluence and envy, I think China is probably a couple of decades away of being rich enough to afford to protest about it.

Then again, given China’s cavalier attitude to pinching our best ideas, perhaps Chinese anti-capitalism will soon go ironic full circle in Tiananmen Square?

Important: This is not a recommendation for you personally to buy or sell any small cap property companies. I’m just a private investor, storing and sharing notes for wider interest. Read my disclaimer.

We’ve seen how most of the UK’s big commercial property companies are trading at discounts. If you believe the pessimism about Europe and the global economy is overdone, then some offer good yields as well as seemingly undervalued assets for you to snap up.

There is also a plethora of small cap property companies and developers in the FTSE All-Share – although fewer than before the 2008/9 downturn, which inflicted several fatalities in the sector.

In many cases the surviving small cap property companies appear to be even more attractively valued than their larger brethren. But with the greater potential of small caps comes more risk, too.

Of the various elements I suggested you dig into when we looked at the large REITs, I’d say you should pay extra attention to management, insider ownership, and any funding commitments or requirements.

For example many private investors follow London developer Quintain Estates, which has residential sites in Greenwich and Wembley, and other assets and operations besides. On a net assets basis, it seems hugely undervalued. It has also attracted the interest of the well-regarded active investor Laxey Partners, which is now the major shareholder.

However I’ve not been able to reconcile myself to the seemingly large amount of money Quintain will need to complete work at its sites (at least when I last looked at them a year or so ago). I did hold the shares briefly, but I sold them for a small loss as I decided I wasn’t very comfortable.

Similarly, while I’ve owned shares in the first three of the following six firms at some point or another, I don’t currently hold any of them, as I’ve reshuffled the active portion of my portfolio to try to take advantage of the ongoing volatility (remember: don’t do this at home!)

Small cap property companies I like

I think all these companies have some attractive qualities and good potential, but obviously also risks. Please remember to do a lot more research before even considering investing – these are just jumping off points for further research.

Mountview Estates: This interesting company buys residential property that is blighted by legacy rent controls. (Blighted from our perspective, not the tenants’!) These rights eventually lapse with the death of tenants, and the property can be refurbished and/or resold. Mountview is potentially a very undervalued play on residential property paying a reasonable 4% yield, but you’ll have to think long-term.

Daejan: A family dominated FTSE 250 firm with residential and commercial property interests in UK and the US, especially London. Very steep discount to NAV (it’s priced at 0.5x book value) but the dominant family aspect and the more second tier assets it holds (in my personal opinion) means it very rarely trades at a premium. Perhaps also worth considering for the great long-term dividend record, though the starting yield is only 2.8%. Suffered recently in the fall out from the collapse from Southern Cross care homes.

Mucklow: Sort of a mini-Segro at £180 million but mainly focused in the Midlands region, Mucklow is another conservatively run family affair with a superb dividend record. The yield is currently 6.2%. I held until a few months ago, when I swapped it for something more volatile that has since fallen. The sort of company I should try to tuck away for the long term.

Panther Securities: A £52 million small cap run by wily veteran Andrew Perloff, who is noted for his hilarious and strident annual reports as much as his good long-term results. Almost like investing in a private company run by your clever uncle. Horrible spread, so try a limit order or a ‘real’ broker.

McKay Securities: Another £52 million outfit, this time focused on commercial property in the south east and around London. It’s priced at 0.6x book value but there’s around £120 million of debt, secured against just under £220 million of assets. That looks a bit precarious, but the managers do inspire some confidence. They didn’t raise cash in the downturn, and they recently spent £2.7 million on a new modern office in Bracknell that is being let for a yield of over 12%, even though it’s not yet fully occupied. Risky but could be very rewarding.

J Smart: An even smaller cap property developer with plain speaking management. It recently issued a mild profit warning as occupancy levels fell and construction remains subdued. Looks cheap, but under the cosh and will need a turnaround in UK PLC to get going.

Finally, a reader asked about commercial property investment trusts. The only big one I’ve ever invested in is £700 million F&C Commercial Property. It’s on a small 6% discount and pays a 5.8% yield. I suspect it’s becoming popular with income seekers at present, though that’s just a hunch. About four-fifths of the portfolio is in London, with the rest spread about the UK. As with nearly all property companies there’s a fair bit of debt, with gearing near 30%.

Of course, mainstream investment trusts might also invest in commercial property. The currently much-hated Caledonia trust has money in London & Stamford and the aforementioned Quintain, for example. Beware, Caledonia’s shares languish on a 25% discount, so while I continue to hold myself, the market clearly doesn’t think much of its manager’s judgement!

Final warning: All small cap property firms are likely to suffer badly if there’s a renewed and prolonged UK recession. I still don’t expect that myself, but the odds have undoubtedly risen sharply in the past six months.

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.

• Some investors might prefer to hold commercial property REITs directly rather than via dividend-paying ETFs for tax reasons, due to how property income distributions (PIDs) are treated.

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 14^th)

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 [↩]