I last wrote after the referendum vote and ventured to suggest that I did not expect the sector’s relative rating against the All Share Index to again test the lows that it did in the immediate aftermath of the vote.
So far in Q3 the REIT index has performed in line with the broader market, but that does not tell the whole story.
The serenity that Mark Carney apparently enjoys after his interest rate cut and increased dosage of QE is not how the equity market feels about the quoted property sector just yet. Decidedly twitchy with a heavy sense of foreboding is more accurate. The post-vote carnage has been replaced with bouts of optimism and fear in
equal measure and that is the way it is likely to stay.
The referendum vote has thrown up a number of positives for UK real estate, not that it feels like it just yet. Interest rates have been cut and sovereign and corporate bond yields have plummeted. The currency has weakened by more than 10%, borrowing costs for the right asset(s) have cheapened, and the need to access yield has become even more pressing – and yet valuation yields have risen, albeit on minimal evidence. The concern is fear of the unknown and that fear could be with us for a good few years yet.
A steadier ship
IPD and CBRE indices recorded 3-4% capital value falls and marginal rental declines for July but a steadying of the market in August with a slowing rate of decline. The open-ended funds have made some sales to steady the ship, even though it is still listing a bit, and funds are now receiving strong inflows – hence reduced exit penalties and “un-gating”. Just as well, because further redemptions may have brought some less saleable assets to market.
That disposals have been made shows some liquidity is returning and the currency is “doing its work”. The hunger for income appreciates by the day, with negative coupons on recent corporate bonds issued in Europe. While pre-Article 50 political posturing on both sides of the Channel will continue to prompt optimism and fear, so far the economic numbers are better than the remain campaign argued.
A rental shock?
Overseas investor caution is entirely understandable, with the main area of concern the levels of tenant demand, especially in the central London office market, where occupier transactions have been thin on the ground. Forecasts for a 30%-plus London office rental correction abound and until some (any) evidence emerges such cataclysmic forecasts may well hold sway. Nonetheless, relative to historic sector collapses characterised by a mixture of speculative oversupply in the face of waning demand, a sharp economic slowdown, aggressive relative pricing of the asset class, and – above all – over-leverage, the asset class is much better placed by historic standards to withstand the worst. The worst, of course, is collapsing business confidence, the vapourising of tenant demand prompting severe rental falls. The first is possible; the second unlikely in my view. We stick with correction, not a crash. We expect capital values to ease by between 5% and 10% in the near term, and it is possible that most of that has already been factored into share prices.
Buyer beware
Providing the income aspect is fulfilled, the asset class must attract buying interest, and the scale of that interest will be determined primarily by the quality and longevity of the income stream. Caveat emptor. Short leasehold assets acquired for early refurbishment so heavily in demand until a year ago may have become un-fundable, whereas long-duration income streams with well-covenanted guaranteed minimum uplifts will attract very competitively priced debt well below the income yield. The equity market is fully up to speed on this, with specific share price performance YTD spread between the best on average up 10%, and the worst on average down 30%. Income vs development, income vs London exposure, but most importantly the performers offer a dividend yield averaging 4.25% with longevity and the under-performers a dividend yield of just 1.9%. So many quoted property companies offer the mantra “we are a total return business” but it is rather difficult to offer much of a positive total return when capital values stall or fall. Back to fundamental investment… it’s called income quality.
