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 IPD.com.
% annual return on capital*
    1980 to 2013
    Last 10 years
All property
                9.0%
                   6.3% 
Property equities
                n.a.
                   4.0%
Equities
               11.6%
                   8.0%
UK Gilts (Barclays equity/gilt study)
               10.5%
                   5.8%
Inflation
                4.0%
                   3.3%
                *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
2008
2009
2010
2011
2012
2013
2014
Rental returns*
+2%
-9%
-11%
-2%
-1%
-3%
+7%
Real GDP/capita**
+3%
-2%
-5%
+1%
+1%
-1%
+1%
* 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 IPD.com, 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. 
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 UK Commercial Property Trust PLC

 

Junction 47 Leeds, from UKCM.com
 
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):
Sector
% of portfolio
Property - Retail
47.19%
Property - Office
22.49%
Property - Industrials
22.35%
Property - Shopping Centre
4.95%
Net Current Assets
3.03%
 
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.

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