The gap between investment and rental markets means the real estate risks are increasing, warns Alastair Ross Goobey
On meeting people for the first time during the 1990s, I became used to them saying: “You’re very keen on property, aren’t you?” Now, following my article in this spot in August, I am told that effigies of me are having pins inserted in them by property people who were angered by its rather cautious tone.
I have never been, and hope I never will be, permanently a bull or a bear of property. It is an asset like every other – sometimes attractive, and sometimes not, in either absolute or relative terms.
In early 2000, when GE Capital and Hermes bid for MEPC, “bricks” were certainly attractive against the ephemeral “clicks”. Today, as I asserted in August and continue to do today, direct property is not so attractive over the medium term as shares, including property shares.
Even John Ritblat has felt that his shares are an attractive buy, and Mike Slade of Helical Bar has also decided that British Land shares are better value than further property assets held directly.
Matthew Oakeshott has been attacked as “unhelpful” for pointing out the growing risks being embraced by property investors and lenders.Unhelpful to whom exactly? I continue to find it baffling that property professionals are so defensive that they feel property has to be promoted at all times.
One of the roles Matthew and I can play is to suggest that, from time to time, property investors need to be alerted to danger signals. They are clear enough in the market today to those with eyes to see.
There are two elements to these increased risks – first, a dislocation between tenant demand (and rental values) and the investment market; the second is the increasing financial risk many of the newer participants are embracing, to which Matthew referred.
The Cisco question answered
Colleagues will confirm that, throughout 2000, I was asking what I called the “Cisco question”: what was that company going to do in the over 1m sq ft of new office space it took in the Thames Valley in 1999?
Cisco’s major business is to provide routers – pronounced as a homophone of “out”, not “boot” – the switching system of the internet. Its products are not manufactured in these offices, and apparently the space was leased to house sales and service personnel. At last we have the answer to my question, which is: nothing. Cisco has begun the process of trying to find tenants to take the space at Green Park off its hands, space that it has never occupied and never will.
Market rents have already fallen in the Thames Valley, but they have clearly not reached market-clearing levels.
“Ah,” say the remaining bulls, “but this doesn’t matter if you have Cisco on a long lease with interest rates as low as they are.” True enough, but average unexpired lease lengths are falling inexorably.
Chris Turner, who runs TR Property, pointed out an interesting fact to me recently. The average unexpired lease length of Land Securities’ City office investments at the end of March was 4.75 years.
No doubt Ian Henderson will point out that the rent passing on this portfolio is below market levels. That begs the question: what will the market level be when the space created by the cranes I observed earlier this year is completed and offered for lease?
The risk is real
Those who are buying investments on 6.5% yields let for 10 years to a good covenant, and borrowing 85% of the value, are taking a real, if delayed, risk. By the end of the lease they will not have amortised their debt, and may be left with a building that is bleeding cash rather than supplying an income. This is what is happening in some parts of the residential buy-to-let market.
Yet the equity market, at its July and (slightly higher) September lows of around 3700 on the FTSE 100, still seems to me to be within 10% of a possible trough. It was discounting annual overall dividend growth of only 0.7% pa (gilt yield 4.4%; equity yield 3.7%). This would be likely only if the economy was going to shrink in real terms, or we faced falling price levels over the longer term.
Without dismissing that as a possibility (although with the world’s authorities pumping funds into the system through both monetary and fiscal policy it seems unlikely), I hope no one is still putting in an assumption of 3% pa rental growth in their appraisals of property investment. One of those assumptions is wrong: either dividends will grow faster than is being discounted, or rents will grow more slowly, or both.
Alastair Ross Goobey is chairman of TR Property Investment Trust, a director of Argent Group and a senior adviser to Morgan Stanley
