Norman Bowie
Since the advent of Thatcherism over the past few years the commercial property market across the whole country has been almost entirely tenant-led. Suddenly the office pendulum has swung the other way in the City of London, and the ripples are spreading westwards and outwards into the suburbs. Retail units in many of the best pitches are eagerly sought after to the financial benefit of landlords.
The rental values of the best shopping are being driven up by the continuing consumer boom, and industrial sheds are reported to be back in favour. Office rents in the core of provincial cities are producing positive returns so that developers are once again active. There is some nervousness about the flood of hi-tech space available in the Thames Valley and beyond its normal boundaries, so that investors are becoming shy of the selling yield levels being talked about.
The market awaits the real impact of the relaxation of the Use Classes Order for general business and retail goods and services with a degree of uncertainty. No one really knows what is the Government’s actual attitude to the thousands of feet of greenfield shopping proposals, or what Whitehall has in mind for the vast areas of agricultural land which seem certain to be surplus to requirements in the near future. These are politically sensitive questions so one cannot be surprised if ministers are hesitant to commit themselves — particularly if they do not agree with some of their predecessors’ thoughs.
An added concern on the horizon for occupiers is how much rates will rise or fall when the revaluation has taken place, together with the interaction of rates with rental values.
The general consensus is that the UK is on a steady growth tack. Unemployment is falling every month, and every worker represents a space need to the employer. The 85,000 fall in the unemployed total in July could represent a space demand equivalent in broad terms of 3m sq ft. Much of the space required has to be of a design, quality and in a location to meet the economic needs of the growing new industries and services. The older and out-of-date buildings left stranded by the recession are of little interest unless they can be refurbished — probably expensively — or totally replaced.
For students of the space cycle the City of London presents a fascinating scene with the sudden emergence over the past year of a space famine. Yet many forecasters see a feast of space emerging around 1990. Canary Wharf is to be built but still has to be let. Investors have to decide the current worth of a building containing space either let or partly let at rents which may have risen by as much as 40% to 50% in the last six months. There is a greater need to use the DCF approach to decide investment worth to a particular investor and thereby incorporate risk judgments of the yield rate appropriate to the top slice of the income and the likelihood of rents growing or falling back in future years.
The development feast and famine cycles are on the move for all to see. Get it right and all is well — but the latecomer (and his banker) could find the going hard.
Suddenly a new scenario has appeared to confuse and excite investment market-watchers. The property company share price no longer stands at a discount to current asset value. In many cases the premium is enormous. The property company section in the FT All-Share Index stood at an all-time high of 1374 on July 16 1987, up 70% in six months. The dividend yield at 2.18% is one of the four lowest in the index; this is way below the yields which would be obtained on a sale of the assets. Questions need to be asked. What are the whys and wherefores to justify this re-rating? Are rental and capital value prospects better than the growth of profits for British industries and services? Or is something else at work?
Property companies are buying whole portfolios yielding anything between 7% and 11%. No doubt they buy some portfolios because they regard them as cheap and capable of exploitation. It may be that the sellers have not yet realised that groups of properties are worth to some buyers more than the sum of the value of the individual holdings.
Portfolios are being sold not for cash but for paper in the form of shares in the purchasing company. In some cases the dividend yield is a fraction of the property yield, and there have been transactions where the purchasing company still has to pay a dividend. Companies are selling some of their assets to another property company in exchange for shares.
Against general expectations interest rates remain high and the cost of borrowing often exceeds the development return on new projects. The institutions are still slow to come back in force with any real weight of money for direct investment in property. The financial houses seem to prefer company paper to tangible assets. Perhaps this preference is a prelude to SPOTs, PINCs and SOPACs, and if so their promoters will be delighted with this fresh attitude.
With borrowings being expensive there has not surprisingly been a steady flow of rights issues, which is another cheap way of raising money. If the money goes into new developments yielding not less than 8%, and the dividend yield is 3%, there is plenty of cover for substantial dividend increases in a company where the remaining assets produce a steadily rising income. The shareholders could be financing their own future increases in income, and could be better off by going direct into property.
Many companies are also active as traders, but they depend for their high rating on the continued existence of a sound investment market to buy the finished products and provide a steady stream of profits in future years. The market, with its high PE ratio of 35.3 attributable to property companies, is assuming that this profitable trading activity will continue and seems to ignore the inherent risks.
It is also apparent that property portfolios have a special appeal — and a special price — for a number of likely purchasers, particularly those who need to enlarge their asset base or use the ability to gear up and hold out hopes of increasing dividends and boost their share price. Consider a portfolio currently valued in a financial statement at £100m and producing an income of £7.5m. It is bought at this price, the purchaser borrows £50m at, say, 10% (he could raise a convertible loan stock at 7.5%) and thus the equity of £50m earns £2.5m. If the dividend yield is a generous 2.5% and the PE ratio 33 the equity would be worth perhaps £70m after making a broad allowance for administrative expenses and some taxation. So the value to the purchaser is £120m — 20% over the asset value. If the convertible route were chosen the figures could be of the order of £150m and 50%.
The purchaser has acquired three bonuses for nothing. First, the presence of special purchasers or deals with tenants, second, the opportunity to sell in the market some properties which may be undervalued and hold those overvalued, and, third, to inject new money profitably into the buildings to create added value.
So it can be argued that, as a yardstick, a portfolio may be worth around 25% above the total of the individual market values. The fact that there are purchasers willing to use this approach means that valuers and sellers must change their thoughts and asking prices to meet this new method of assessing worth.
No longer, accordingly, is property just being regarded in property and asset-related companies as a tangible fixed asset, but much more as a financial asset which can be manipulated to produce a cash flow and additional capital value in a buoyant stock market. The strengths and attractions of the property company to investors have moved from the value of the underlying land and buildings to the value attributable to management skills to trade and create financial gain. Perhaps they are now not unlike the banks, who borrow cheap and lend dear and earn good profits for the owners just as long as their borrowings and borrowers remain sound. Investors need to realise that it is a new game with new players and new rules — and that this is a time to understand the fundamental changes.
