Monday, 6 October 2014

Commercial Property - time to invest?

And UK Commercial Property Trust PLC


One Canada Square, courtesy Wikipedia
Commercial property can be a risky investment. Canary Wharf's One Canada Square bankrupted its developer, Olympia & York. And the financial crisis took a huge toll on property companies. The funding crisis forced many companies into emergency rights issues and the hasty sale of properties. As a result, commercial property prices plunged by 44% between June 2007 and July 2009. Some property companies went into liquidation. Shares in even the largest, British Land and Land Securities (Land), lost 75% and 79% of their value respectively.
Excessive leverage exaggerated the fall in property shares. When Lands' net assets fell by 58%, net debt, which in March 2007 seemed a reasonable 48% of net assets, suddenly became 131% of net assets. The company had to sell property in a falling market. And, to avoid breaking its loan covenants, Land resorted to a 756 million pound rights issue in February 2009 at the bottom of the stock market.
Commercial property prices staged a partial recovery, but the damage to property companies was long lasting. Land's share price is still 56% below its pre-crisis peak.
However, under normal conditions, commercial property offers the long-term investor a steady and growing source of income via rental reversions plus an increasing capital value - data from
% annual return on capital*
    1980 to 2013
    Last 10 years
All property
Property equities
UK Gilts (Barclays equity/gilt study)
                *Capital plus reinvested income. The all property figures are based on gross returns, not net.
In the wake of the financial crisis, leases were broken or renewed at lower rentals. Land Securities, which provides like-for-like rental returns for its own properties, suggests that rents, after five years of decline, have started to recover:
Year to March
Rental returns*
Real GDP/capita**
* Land's like-for-like rental income compared to the previous year. **Lagged one year.
The fall in rents appears to be over, as Land has reported for the 12 months to March 2014. How can the individual investor best capitalise on this turnaround?
1. Exchange traded funds (ETF). The only ETF in the UK Commercial Property sector is the iShares UK Property UCITs. This ETF tracks companies in the property sector, not underlying property values. Consequently, it adds another layer of costs to the sector (0.4%) and does nothing to reduce gearing. It also yields only 2.3%, compared to the FTSE Real Estate Investment Trusts Index of 3.3%. 
2. Open Ended Property Funds. The financial crisis laid bare the flaw in this model. Investors rushed to redeem their holdings, and the illiquid nature of property meant that many funds were forced to halt repayments while they sold their assets at knockdown prices. Investors had to wait six months for their cash and then it was much less than they had anticipated.
3. Property companies and investment trusts. Directly investing in quoted companies is the best route for the individual investor. However, when choosing a company, it would be wise to consider:
Ø  The level of debt. Managers are tempted to gear up a company in the often-justified belief that property values will increase at a greater rate than the cost of finance. However, as the last property crash illustrated, this can be very risky. This is particularly the case when the funding is short-term - property can be hard to sell in a crisis.
Ø  The share's premium or discount to net asset value (NAV). Evidently it is best to buy at a discount to NAV. However, the best run property companies command a premium to NAV while those that trade on a discount often do so for good reason. As share price premiums are fairly volatile, the current premium - or discount - should be compared to its historic average.
Ø  The dividend is paid out of net rental income. Property companies and investment trusts often pay a dividend that is well in excess of the net profit from renting properties. Paying part of the dividend from capital is not sustainable.
Ø  Market capitalisation. Given that properties are high value investments, companies require substantial funds to offer some degree of diversification. Anything less than 100 million pounds is small by this yardstick.
Ø  Retail, office or industrial? And location? Depending on a wide range of factors, property valuations vary between different sectors and different locations at different times. While the property professional expends much energy on the subject, the individual investor should accept a degree of ignorance and invest in a company that spreads its investments over all three sectors.
The prudent investor will note:
1. Commercial property has historically been a lot less profitable than residential property. Between 1980 and 2013 residential property, according to, returned four times as much as commercial property.
2. Data on commercial property returns assume that gross yields are all reinvested. This exaggerates the possible returns, as it ignores the cost of managing and maintaining commercial properties.
3. The pressure on retail businesses from the internet adversely affects rental yields. Internet retailers require very little space, and as the margins of traditional retailers are threatened, they spend less on their properties. However, according to IPD, retail property has performed better than offices but worse than industrial over the last 33 years. 

 UK Commercial Property Trust PLC


Junction 47 Leeds, from
UK Commercial Property Trust PLC (UKCM) floated on the stock market in September 2006, a year before the collapse in commercial property prices. UKCM invests in 41 properties, with the largest, the Junction 47 Leeds retail park, representing 5.9% of its value.
Sector weightings are as follows (from the 2013 annual report):
% of portfolio
Property - Retail
Property - Office
Property - Industrials
Property - Shopping Centre
Net Current Assets
All UKCM's properties are located in the UK and they are spread around the country. The property portfolio has been managed since launch by Ignis Investment Services, a subsidiary of Standard Life PLC. The company has a market capitalisation of 1 billion pounds, trades on a 4.5% premium to net asset value and yields 4.5%.
The directors' decision to limit the trust's debt helped it to weather the financial crisis much better than the majority of its peers. UKCM's share price (in red) has declined far less than iShares UK Property ETF (in blue) that I have used as a benchmark.
      Chart courtesy Yahoo, click to enlarge.
UKCM offers the investor a fairly secure route into the commercial property market. Consider:
1.       Net debt is just 17% of net assets, which UKCM claims is the lowest gearing in the sector. Loans are long term and their weighted cost is 3.85%. As Standard Life Investments owns 55% of the trust, it should ensure that this conservative approach to financing continues.
2.       The property portfolio is well diversified, both by sector and by region, though the concentration on wealthier parts of the UK means that Southern England has a much larger weighting than elsewhere.
3.       Vacancy rates of 3.7% are low by the standards of the sector and 99% of rents are received within 28 days of becoming due.
4.       The directors decided in 2014 that the dividend should be covered by net rental earnings. As a result, they reduced the dividend for 2014, but the shares still yield a healthy 4.5%.
5.       Revenue earnings per share have been stable over the past five years. Total costs, which include a 0.65% management fee, amount to 1.8% of the trust's total assets.
6.       The NAV per share reported as of June, was 7% higher than December and UKCM expects it to be higher again at the year-end.
The main valuation tool for property companies is to compare the share price to the underlying net asset value. Currently, UKCM trades on a 4.5% premium to net asset value, which is about average for the past five years:
                                     Chart courtesy Investors Chronicle, click to enlarge.
It is likely that the NAV per share of 78p in June will soon reach the current share price of 81.5p.
Both the directors and the managing agents are unreservedly optimistic about the future of UKCM's business. Two directors have backed this judgment by buying shares at 76p in February and 81p in August.
Nevertheless, prospective investors will note:
·         Rising rents and commercial property prices depend on a continuing recovery of the UK economy.
·         Investors are attracted to commercial property for its steady income. An increase in yields in other asset classes could depress the value of property company shares. And UKCM's premium could disappear or turn to a discount, as it did in late 2011.
·         Property companies provide limited diversification from other equities. A study by Rick Ferri in the US suggest that the correlation between Real Estate Investment Trusts and the stock market has been inconsistent over the last 32 years. At times it approaches one and at times it approaches zero.
Disclosure: I hold a long position in UKCM.

Thursday, 14 August 2014

The Water Utilities - Waiting for Ofwat

And Dee Valley Group PLC

Cathryn Ross, Chief Executive of Ofwat, courtesy
One of the first stops for the investor seeking income is the water utilities. Currently, they yield between 3.8% and 4.5%. But every five years British water companies must negotiate their terms of business with the regulator, Ofwat, and this can be a source of grief for investors. Both United Utilities and Severn Trent reduced their dividend payouts after the last 5-year review.  
However, the Gas & Water sector (in blue) has performed better than the FTSE All Share (in black) over the last five years and these indices do not take into account the higher income that shareholders have received from this sector:
Graph courtesy www.Interactive Investor, click to enlarge
The corollary is that the water utilities are highly valued. Income stocks have seen their prices bid high by investors looking for alternatives to the low yields available elsewhere in the financial markets.
Further, one way that the water companies have found to improve their performance is to borrow at low interest rates. They have relied heavily on loan financing to meet their capital requirements and to pay generous dividends. The result is that they are all heavily indebted.
PE Ratio
Market Cap pounds Mn
United Utilities
Severn Trent
Dee Valley Water
The water companies are now facing another 5-year review from Ofwat for the period 2015 to 2020. What is in store for them? The regulator has stated that it intends to reduce the regulatory weighted average cost of capital (WAAC) for the water companies from 5.1% to 3.85%. The WAAC is one of the inputs for the financial model Ofwat uses to set prices. If all other factors remain unchanged, this would imply a reduction of 24.6% in the companies' post-tax earnings. However, in part this reduction reflects the declining cost of debt. And Ofwat offers incentives to the water companies to meet certain performance targets.
But it comes as something of a shock to shareholders that Ofwat proposes that the cost of equity (post tax) should fall by 20%, from 7.1% to 5.65%, when using the model to calculate prices for the next five years.  
In broad terms, water company revenues can only grow by:
Ø  Ofwat-approved price increases. But Ofwat is looking for price increases below the rate of inflation.
Ø  Large projects that require new capital to, for instance, replace water mains or water treatment plants. Ofwat permits an increase in price to provide a return on new capital.
Ø  Growth in household and business use of water. The number of households is growing by 1% per annum.
In practice, average revenues of the four quoted water companies have risen by exactly the rate of retail price inflation in the past four years - 3.2% per annum. Meanwhile, earnings per share, once adjusted for extraordinary items, have stagnated.
Before investing in the water sector investors should consider:
1. Ofwat's final decisions will most likely be published in December 2014. The uncertainty running up to then will most likely be reflected in share prices.
2. The water sector is rated very highly by the market in historical terms. In part, this is the search for income and in part, the result of last year's bid for Severn Trent. Three institutional investors offered a 15% premium to the market price for that company.
3. The outlook for the next five years is determined largely by the regulator. And the indications are that Ofwat wants to keep prices low. There is political pressure on all regulators to restrict price increases at the cost of shareholders. This could mean that some of the companies would have to cut their dividends, just as United Utilities and Severn Trent did in FY 2011. Some might have to raise new capital from shareholders.

Dee Valley Group PLC (DVW)

The River Dee at Chester, courtesy Wikipedia
The Dee Valley Group (Dee) is by far the smallest of the four water companies quoted on the London Stock Exchange. This has, for the individual investor, some advantages. The company is so small - it has a market capitalization of 63 million pounds - that only one analyst bothers to cover it. As AXA S. A., the general insurance company, holds 35% of Dee's shares, the free float is further reduced. As a result, perhaps, Dee is on the lowest PE ratio and yields the highest dividend of any of the water companies and it has the lowest debt to equity ratio.
Dee provides a pure water service to 113,000 homes and 8,000 businesses in southern Cheshire and northern Wales. It does not offer a sewage service or run any other business than providing water to its market. Its small size enables the company to keep in close contact with the local authorities, agencies and its customers.
Financial Results
Ø  Earnings per share have increased by 3% pa over the 2007-14 period and dividends by 4%. This is slightly ahead of retail price inflation and indicates the bond-like nature of the regulated water business.
Ø  Return on equity is a healthy 15% reflecting in part the highly leveraged nature of the company's balance sheet.
Ø  Debt to equity ratio has remained fairly stable and it is currently 185%. Based on its regulatory asset value of 74 million pounds, debt financing is 68% compared to equity financing of 32%.
Ø  Net operating cash flow, including capital expenditure, was 12.4 million pounds over the period 2010 to 2014, just falling short of dividend payments of 13.5 million pounds. The company has not issued or bought back any of its shares in these five years.
Ø  The main risk to the business is probably the company's defined benefit pension scheme (DBPS). Although the scheme is currently in surplus, it could require substantial funding at some time. Because of the open-ended obligation of such schemes, nearly all companies with DBPS have closed them in favour of defined contribution schemes.
Dee's share price (in blue) has outperformed the FTSE All Share Index over the last five years, without counting its superior yield.

Graph courtesy Yahoo, click to enlarge.
Ofwat's review is influenced by the Customer Challenge Panels (CCP) that monitor the water utilities. Dee's CCP has supported the company's plans that it has lodged with the economic regulator Ofwat. The company proposes an increased capital spend for the next five-year period coupled with a small increase in prices above the rate of price inflation. Dee's customers are currently paying one of the lowest tariffs in the country. It has also argued that it should receive a small company premium for its cost of capital, on the grounds that smaller entities do not have the scale or credibility of larger entities. On the debt side, this is covered by Ofwat's intention to include the cost of 'embedded debt' - debt the company has already contracted.
However, Ofwat's decision on pricing will not be known until December 2014. The Company states, "Future dividends will be considered in the context of the results for the period and the outcome of the current price review process."
Assuming that Dee's business continues on its past trajectory, then my model values Dee's shares at around 1170p.* This is 16% below the current share price of 1385p. At 1385p the company's shares trade on a PE ratio of 15 and yield 4.5%.
*Assumptions: Eps growth of 2% p.a.; dividend payout of 66% of earnings; 15% return on equity; equity per share growth of 5% p.a.; average PE ratio of 13; discounted at 8.8% p.a. for the five years to 2019.
The cautious investor will:
1.       Wait until Ofwat's review is complete, which should be at the end of this year. The company is sure to make a statement on the impact on its business of the regulator's decisions.
2.       Note that Dee's share price reached a 12-month high of 1610p in April and a low of 1308p earlier this month.
3.       Consider that Dee's shares are close in nature to an index-linked bond with the risk of unfavourable quinquennial reviews by the regulator Ofwat.
4.       Keep an eye on the company's contribution to its DBPS.
Disclosure: I hold a long position in Dee Valley Group.