Stock markets have made a brutal start to 2016, with the real estate sector caught up in the volatility generated by the China slowdown, the oil price meltdown, the Fed rate hike and the rise in credit spreads.
As if that is not enough, there is also the general political uncertainty of a US election year, a Brexit vote and plenty more.
As a result, the UK major REITs sit at an attractive discount to NAV and look very interesting. However, most investors I speak to just wish they had more dividends in a post-yield compression environment.
So with the free ride in the sector over, other than yield shift created by management teams that can genuinely add value, the main upside in the sector in 2016-17 will come from businesses with strong operational gearing and efficient fixed costs. Financial gearing can, of course, accelerate the upside but this could be a big bet, given so many macro uncertainties.
The good news is that there are now several listed real estate companies that are run on strong operational lines, of which the best example is Big Yellow. Its stock trades on a premium to NAV, but I would argue that the reported NAV is irrelevant for a business that has such material revenue and earnings upside over the next five years.
Other strong operational businesses include Unite and Workspace, along with Derwent London, Great Portland Estates and Shaftesbury.
Some of the best examples lie in the homebuilding sector – just look at the IPO from McCarthy & Stone, which is not only a good brand and operational business, but also a market leader in a sector with compelling demographics and housing trends. The majority of housebuilders sit on premiums to book value of 1.5x to 2.5x, and yet the major real estate stocks trade on discounts.
Meanwhile, St Modwen and Urban & Civic are both plays on operational upside from the regions and the multiple added-value opportunities in their land holdings. These firms sit on large discounts relative to the housebuilders.
Provided the economy is turning over, not necessarily steaming ahead, all the above operationally geared businesses will continue to perform. The careful investor therefore has to judge which companies have the best operational upside and to what extent this is reflected in the share price. I will leave this to the current City experts, but I am enjoying being able to invest for the first time in 30 years [having stepped down as head of UK real estate corporate finance at JP Morgan Cazenove at the end of last year].
Two subsectors in the UK stand out for long-term growth potential: logistics and the private rented sector.
Hats off to LondonMetric (an inspired initiative by Andrew Jones post-merger) which has led the charge in retail logistics, but SEGRO’s strong investment in the wider logistics sector is underestimated. The growth and change in this sector is and will continue to be significant for the next decade, and I am surprised we haven’t seen more interest in UK logistics from the major overseas players, and how few new entrants there have been (although we should all follow Blackstone’s Logicor and TPG’s P3 with interest).
The other growth sector for the next decade is PRS. The barriers to entry have become higher, in particular higher land and construction costs, and there is always a lack of operational efficiencies until scale and branding is achieved, but this is what Unite and Big Yellow faced in their early stages of development. The prize for the first major PRS operator should be substantial.
What makes the year ahead so tricky are the macro and political factors and their impact on currencies. In the event of Brexit and sterling devaluation, the case for M&A could become compelling, especially if the US dollar is strong.
In addition, “public to private” could come back on to the agenda. I am not concluding that Brexit would be good for London, but lower sterling would be. This makes the UK sector more difficult to read this year but businesses with good operational upside and low leverage look defensive with growth.
