The outcome was unexpected, the reaction predictable and rational. The quoted sector rose by 8% in the week ahead of the referendum, and fell by 22% over the next two trading days.
The sector leaders now trade at 40% discounts to historic NAVs and their shares briefly traded close to prices seen in January 2009 when property values fell by more than 40%. The June valuations will be largely meaningless, given the paucity of investment market evidence, with values adjusting, perhaps slowly, to sentiment as much as reality. The uncertainty in the political, economic, and legislative arenas will add fuel to the sudden absence of reality.
However, I am not paid to say nothing, so here goes.
UK fixed-income yields are now at an all-time low with the 10-year gilt below 1%, further exacerbating the global scramble for income. The sector is well and cheaply financed and balance sheet leverage can be discounted for most companies, though less so operational leverage. We had been promised a surge in investment activity on a remain vote but none of the experts commented on the opposite outcome. It follows that it just got at least 10% cheaper, and some Far Eastern and other overseas investors were non-Brexit sensitive, apparently. We will find out.
Precedent exists most obviously on European Exchange Rate Mechanism withdrawal, when bond yields and sterling fell sharply and a cheap, Armageddon-rated real estate sector exploded upwards, notwithstanding that rental values had fallen sharply: City rents dropping from £70 down to £20 per sq ft.
This is key. Why? Because rental income in the UK cannot go down until the lease expires, so all that is being bought is a fixed-income bond that will yield whatever it yields until the lease expires in however many years’ time, with the redemption yield impossible to price because no one knows where rental values will be at expiry. It worked and may work again. Lease lengths have been getting longer in the office and distribution sectors, but shortening in retail.
This is critical. Falling rents do not make the sector underperform even if the spreadsheet says it should. Yields remain the key sector driver and it is perfectly feasible to now talk of yields falling again in a way that it was not until Friday morning. It will not happen tomorrow, it may not happen at all, but, given current share prices, it is well worth airing the argument.
A fall in rental values would seem likely, probably a given, and the sector is pricing in the collapse of tenant demand ubiquitously, but especially London exposure and those with developments in train or proposed. Perfectly understandable. If a “100,000 London bankers leave for Paris and Frankfurt” headline pops up, then we have a serious issue.
The sector may continue to fall as redemptions in direct and indirect funds are met and the falling knife may get sharper. This will persist until there is evidence of what investors are doing in the direct market (six weeks?) and what tenants are doing in the occupier market (six months?). I would take a decent bet that investors will panic, do nothing, and then work out that a greater than 5% yield on effectively a high-grade corporate bond is not such a bad thing after all and buyers will emerge. The occupier market will be more fragile for sure and confidence will take longer to return, and indeed it may not, but I doubt it. Uncertainty is the killer.
The global hunger for income has not disappeared, the UK has not just been cast out into the economic wilderness, indeed some say the exact opposite has happened. Whichever way you cut it, REITs are trading on big discounts given the yield structure in financial markets with dividend yields of more than 5% with long duration, well covenanted income streams and with reversionary potential that may be eroded but will still pay the dividend for many years.
To say I am now a bull would be a step too far, but I do not see the sector falling much lower than the level it hit last week.
Any interest in a 15-year income stream to yield near 5%? The Walkie Talkie springs to mind. There might well be.
Alan Carter is managing director, specialist sales, at Stifel Nicolaus Europe
