I was an unrestrained market bull, but last wrote here following my first cautious note on the quoted property sector since Q2 2011. I gave it the title “mind your eye”. Maybe it should have been entitled “mind everything”.
The quoted property sector has collapsed at a marginally faster pace (-12%) than the broader equity market (-10%). This may seem puzzling given the ongoing apparent level of investment demand for commercial property, allied to still strong tenant demand and rental growth, so I’ll try and make some sense of it.
My caution was based on the fact that life was about as good as it gets and that real estate and REITs were priced near perfection. Assets were being brought to market, especially in the City, that weren’t selling above asking for the first time in a long time – in fact some weren’t selling at all. Commodity prices were falling and some oil-backed sovereign wealth funds were repatriating capital. In short, yields had stopped falling and might rise.
I was right and wrong. New buyers have emerged, deals have been done, but perhaps pricing tension has eased. The buyers are still there though.
Forecasts for REIT NAVs from many houses (not here at Stifel) were based on ongoing yield compression and strong rental growth; major downgrades are now required. Forecasts for LandSec’s NAV to reach £17 now look rather absurd when the shares are £10.50, down £3.
The equity market has started the new year in a fretful and panicky mood. The China crisis, slowing global growth, a US rate rise that perhaps now looks premature, and no inflationary pressure whatsoever. When GDP slows, equities fall. The rout in REITs is simple. Expensive shares are most vulnerable and some REITs are suddenly not so reassuringly expensive.
Core investment portfolio growth is positive still but at a slowing rate, and REITs are increasingly reliant on development surpluses to drive NAV. The risk/reward of development is much less attractive than three or four years ago. There will be no more falling yields through a period of rising rents to give a double whammy to returns, plus construction costs that are more than 10% higher. Slowing growth has not yet dampened tenant demand, but the risk that it will is increasing daily.
Without strong NAV growth, dividend yields for most REITs were sub-optimal, sub-market and growing very slowly. If the party stopped, some had a long way to fall – and so it is proving. There are fewer wheels on the wagon.
January forecasts from surveying firms are more and more wary on rents and returns, especially core London office rents from 2017 onwards. Retail is recovering, a bit, but prime centres have greater pressures in terms of growth, and many retailers are not having a great time despite falling petrol prices. Distribution remains my favourite asset class.
If an economic crisis unfolds as the equity market is discounting, property does have one important attraction. Any asset, or equity, that has a durable income stream with security and possibly a little growth will be a valuable commodity – although just how valuable remains to be seen. A 3% rumoured yield on 1 Threadneedle Street, EC2, may be a very foolish or a very astute purchase.
The overall equity market may well pay out less in absolute cash dividends this year than it did last, and some (non-property) companies will doubtless be forced to cut their payout as the year progresses and reality bites.
REITs are growing dividends and the share price collapse has pushed the REIT dividend yield up to 3.4%. Not much, but in an income hungry world it’s seriously important. Show me a dividend yield near 4%, growing, and secured on decent covenants with perhaps a reversion in the portfolio, and equity investors will have to be interested this year.
I’m still cautious, though mawkish rather than bearish. As for my favourite stocks this year, well, I’m not telling you for nothing – I do enough of that for clients as it is.
Alan Carter is managing director of specialist sales for Stifel Nicolaus Europe
