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Property gloom is not really justified

Garry White
UK property REITs are trading on a double discount but it may take some time for valuations to rise

The amount of construction going on in the City of London makes the British capital look like a boomtown. Yet, following the UK’s vote to leave the European Union, the market has been distinctly downbeat on the value of London office space and the share prices of London-listed real estate investment trusts (REITs) has collapsed. Is the market right to fret – or has a great investment opportunity been created?

Fears of declining rents and weakening commercial property prices has pushed the share prices of major British property groups into the doldrums – yet the price achieved for London towers this year has been much better than the pessimists expected. Indeed, share prices have fallen so much that opportunistic M&A activity has started to happen, with management ofHammerson offering to snap up rival Intu Properties in recent weeks.

At the start of December, Hammerson, the UK’s largest shopping centre owner, made a £3.4bn offer for Intu after its share price hit multi-year lows. The combined group would own 17 of the UK’s 25 biggest shopping centres.

The £3.4m offer prompted a near 20% jump in Intu’s shares, although Hammerson’s fell on concerns that the deal could be a case of “two drunks propping each other up at a bar”. The fall in Hammerson shares was because the deal would increase its exposure to UK retail, which is in structural decline because of the rise of internet shopping. However, these losses have since been recovered as investors warmed to the deal on valuation grounds.

The sector is undoubtedly cheap. In the wider sector, there is actually a “double discount” on UK REITs. Recent sale values suggest valuers of major buildings appear to have undervalued the properties and the REITs themselves are trading at a substantial discount to the net asset value (NAV) calculated from these subdued valuations. This discount to NAV is as much as a third in some cases. For example, Land Securities NAV per share at September 30 was £14.68, compared with its current share price of around 940p. For British Land, its NAV per share was 939p at the end of September, compared with today’s share price of around 640p. This discount is repeated across the sector.

Asian buyers eye bargains

The fall in sterling has prompted overseas buyers to heavily invest in the UK, particularly property. These investors see a “triple discount” as the pound has devalued, the shares are trading below NAV and valuers are ultra-cautious. In March, Chinese property developer CC Land Holdings paid £1.15bn for 122 Leadenhall Street, known as the “Cheesegrater”. This was at a yield of 3.45pc. A report in the state-run China Daily suggested this was the “biggest Chinese investment in the United Kingdom's real estate market.” Indeed, two-thirds of the £4.8bn invested in London offices in the third quarter of last year came from Asian buyers, according property services company CBRE. More than 90 per cent of all commercial property transactions in the city during the period involved investment from overseas. Of course, this makes sense following the devaluation of sterling, which has put UK property at a discount for foreign buyers compared with two years ago.

The most significant thing about this purchase was that it was at a 26 per cent premium to its valuation in the previous September. A similar situation was seen when the “Walkie-Talkie” building on Fenchurch Street was sold to a Hong Kong investor for £1.3bn by Land Securities and its partner. The price achieved was 13 per cent above what valuers had put in the company’s books.

The sale of buildings at a higher price than their book value by belies the negativity of the professional valuations of buildings. So, with flagship London buildings sell above the value of these properties in a company’s books, why are the UK’s property valuers seemingly so gloomy? The answer is Brexit uncertainty, which has made them cautious and fearful. However, the price of anything is a function of supply and demand and concerns about Brexit have resulted in property developers putting their foot on the brakes.

Supply to shrink

According to the latest bi-annual London Office Crane Survey, released at the end of November by Deloitte, commercial construction in London is down by more than 9 per cent compared with the previous six-month period, with 12.6m square feet currently under construction. This is the second-consecutive fall, as developers proceed with caution.

Although the slowdown in new space may not be great for the construction sector, it implies there could be a shortage of office space in a few years’ time. Or, in the words of Deloitte: “The continued fall in activity may be good news for those looking to spot the next window of opportunity in the cycle”.

UK property REITs appear to be priced in the bargain basement – but they could possibly stay cheap for some time as uncertainty around Brexit prompts caution on all fronts. However, Asian investors – and the management team of REITs such as Hammerson – appear to see substantial value. I suspect they are right.

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