by Michael Brett
Assets and earnings
We looked last week at two identical companies, each of which developed a property to produce a £5m surplus over cost. The first, Investor plc, held on to the property on completion and showed net income of only £260,000 after interest charges and tax. The other, Trader plc, sold its property to realise the £5m surplus and published net profits of £3.575m after tax. The stock market is likely to value Investor plc in relation to the assets it owns (its net asset value is £10m) and Trader plc will be valued relative to its earnings.
In practice, this might mean that Investor plc would be worth around £8m in the stock market: a 20% discount to the £10m of net assets.
What Trader plc would be worth is problematic. If it had a good record of producing property trading profits year after year, investors might indeed award it a PE ratio around the average enjoyed by industrial and commercial companies: say, 12. Other more cynical market watchers would reckon that it should be worth the profits it can produce in a single year — plus whatever assets it has — and no more.
The precise figures do not matter too much. What is important is the principle. If you are buying shares in a pure property trader with little in the way of net assets, you are not investing in property. You are simply investing in the skill and ingenuity of a management that attempts to produce property trading profits each year. This is a very different matter from investing in a property investment company, where your shares are backed by property assets and by secure rental income, and where income and asset value will probably continue to grow even if the company undertakes no new activities at all.
It is very easy to produce property trading profits for a year or so by selling what an investment company would regard as the fixed assets of the business. The next trick is to persuade investors to value your company at 10 or 12 times those (perhaps never to be repeated) trading profits. It is rather like the home-owner who says: “I bought my house at £40,000, built an extension for £10,000 and after a couple of years I find it is worth £100,000. If I sell it at that price I make a £50,000 profit. On a PE ratio of 10 that makes me worth half a million”. It is a nonsense, but the markets do not always spot it.
Thus property trading companies frequently try to acquire a high share rating on the basis of a short-term profit record, and use these highly valued shares to launch a takeover bid for another property company which owns some solid assets. Unlike stock market investors, operators in the property market itself tend to focus on assets and generally regard trading profits mainly as a way of financing the purchase of assets.
The lessons from this are clear. The investor has to look carefully to see where property income comes from, and whether it is likely to be a continuing and growing source of revenue. We have talked so far in terms of a pure investment company or a pure trading company. But many property companies are in practice a mix of investor, developer and trader and each one needs examining on its individual merits. How much of the profit comes from rental income? How much from profit on property sales?
And this points to a further technique that a developer may use to overcome the deficit financing problem that makes it difficult for him to hold on to buildings created with borrowed money. He may decide to hold on to some of the developments that he creates and sell others. Trading profits from the sales should help to cover the income shortfall on the properties that are retained (the difference between the interest on the money borrowed to develop them and the rents they produce) thus allowing the company gradually to build up an asset base.
The stock market’s approach towards trading companies or those with a mix of trading and rental income is not always logical or consistent. Sentiment towards property trading companies can fluctuate very widely and so can their share prices, as was demonstrated by the stock market crash of October 1987. Additionally, it is often true that when a property trading company begins to accumulate some assets in addition to its trading income, it does not get full credit for the added security in terms of its share price. The stock market seems to find it particularly difficult to evaluate a company which falls between the two stools of an asset-based stock and an earnings-based stock.
However, generating trading profits is not the only way of dealing with the income shortfall between rental income and the costs of borrowing. A whole range of other techniques has evolved to address the same problem, and we will be looking at them when we come to examine financing methods in detail. Broadly, they usually require the property owner or developer to give up a proportion of his development profit or the future growth in income and asset values in return for finance at rates below those for a straight loan.
But here again there are choices to be made. A property developer can give away part of the profit from a single development or he can give away part of the future growth of the company as a whole by issuing shares in one way or another in return for finance.
In general, investment companies are reluctant to finance new development by the issue of shares. First, the shares will normally need to be issued at a discount to asset value, thus “diluting” the assets (we will look at this in detail later). Second, future growth in the income from all the company’s properties — and future increases in the value of these properties — will need to be spread over a larger number of shares, thus diluting the impact on each individual share. A trading company does not usually have quite the same worries about issuing additional shares.
Debt finance — borrowed money — can also be raised on the strength of a single development (project finance) or as a debt of the company as a corporate entity (corporate finance). And if it is raised as corporate debt by a stock market-listed company, the borrower can choose between borrowings secured on the assets of the company and unsecured borrowings. But in practice only the larger and more established companies usually have the choice. The newcomer is not sufficiently well known as a corporate entity and is therefore probably restricted to raising money on individual projects.
Finally, there is the choice between fixed-interest borrowing and variable- or floating-rate borrowing (where the interest paid varies with changes in the general level of interest rates). An established investment company with virtually assured growth in income from its existing properties may be more attracted by the certainty that long-term fixed-interest borrowing brings.
