Still searching for the bottom

eAll those who called the bottom of the property market at the end of last year got it horribly wrong. Commercial property continued to slide as the economic malaise deepened and managers now face falling capital values, declines in rental growth and even more reluctance on the part of banks to finance property deals. The UK market has lost 24 per cent since the start of the year, the US is off 11.9 per cent, and Japan is 22 per cent down, but even so these figures are a lot better than Asia, where Singapore and Hong Kong are down 49 per cent and 54 per cent respectively. Many managers believe the worst is not over, predicting no respite until the back end of 2010 or beyond. “In this market it is hard to be a contrarian,” says Dirk Molenaar, manager of F&C Global Real Estate Securities fund, which is bubbling under the funds in our table by size and would be ranked 15th. A nervous market “The market is extremely nervous and focussing on the direction of the economy and the length and depth of the financial crisis. We definitely expect risk premia to rise and that demand for office space will face more pressure. Widening credit spreads have impacted on borrowing costs and transaction volumes,” he says. “As economic data continues to disappoint, such as the recent US job growth figures which have now been negative for nine consecutive months, we expect further downgrades,” explains Mr Molenaar. Molenaar is picking off property stocks in the Netherlands, Hong Kong, Sweden and selectively in the US, focussing on balance sheet strength, availability of capital, limited refinance risk and solid cash flows. Many managers believe that the UK and the US could lead any recovery, and that US REITs are particularly defensive as they caught the downdraft from the credit crunch early on. Stocks not bricks As equities attempt to price forward and led the sell-off, it is thought that property stocks (rather than bricks and mortar) will also front-run on the way back up. “It’s been a very volatile sector for three years, and difficult to tell where the lowest point in the cycle will be,” agrees Romney Fox, investment manager at Aberdeen Property Fund, one of those managers looking to UK stocks with attractive valuations for their rebound potential, in preference to their peers on the Continent. The importance of a good yield as the bedrock of sound property investment is reclaiming centre stage, as managers focus more closely on the quality of income generated and management’s ability to grow that income. Dividend growth This renewed emphasis on strong dividend growth will be an emerging trend in fund management, says Richard Phillipson, head of investment practice at consultancy Investit. “I think there will be a big trend back to appreciating dividend growth funds as capital values have been shown to be volatile, while dividend growth has been solid over most long-term periods,” he says. Property stocks have been increasingly held by general funds that are mandated to allocate to financials, points out Jakes Ferguson, a partner at Sarasin & Partners LL. “Managers of general mutual funds are attracted by the property sector’s long leases, healthy dividends, 15-20 per cent discounts to NAV and conservative balance sheets with no gearing issues or need to refinance debt,” he explains. The appeal of the sector’s income streams may be further highlighted if Governments freeze the payment of bank stock dividends in return for bolstering their balance sheets. In such an uncertain market, cheap is not necessarily best, adds Mr Fox, pointing out that in the UK the sector’s four giants together account for 40 per cent of the benchmark, and that all bar Hammerson offer an attractive yield. Land Securities, which pays out 5 per cent, offers not only long leases and prime tenants but also restructure potential if it succeeds in spinning off Trillium, its property outsourcing arm, and demerging its property portfolio into two separately quoted specialist companies focused on retail and London property. Development activity remains thin on the ground, however. In most of Europe the last construction boom was in the 1980s, with the exception of offices in the late ’90s, partly because construction costs have been high and financing became expensive. The real cost of debt has now surged to around 7.5 per cent plus, higher than yields earned on offices at around 6 per cent and retail property at 6.5 per cent. Sooner or later this will have consequences. “One upside is that the big pull back from property lending has reduced new stock coming onto the market, so 3-4 years out there will be an undersupply,” says Gerry Ferguson, head of the £998m Scottish Widows Investment Partnership property trust. “Property developers have found finance hard and expensive to obtain which has made many developments look less profitable,” he adds. On a positive note, international buyers such as sovereign wealth funds, pension funds and hedge funds were out in force in the autumn, and new funds have also been seeded and will start to come to the market. For instance, the Ontario Teachers Pension Plan took a 10 per cent stake in Hammerson, a good sign that foreign investors are looking to buy into depressed markets, attracted by the UK’s regime of long leases, upward rent reviews and a solid dividend culture. “The market is dominated by foreign buying,” says Nigel Pickup, director of ING Real Estate Investment Management and manager of the Skandia Property Fund. “Lots of money is waiting in the wings, particularly from German open-ended funds, and the weakening of sterling has also made the UK more attractive, while our property market is more transparent when it comes to valuing assets,” he explains. “We expect a return to growth at the end of 2009, or in 2010, assuming inflationary pressures subside and interest rates are reduced to 3.5 per cent by mid-2009,” says Mr Pickup. “Banks from five different European countries have made enquiries with us in recent weeks – all banks whose clients have expressed interest in the real estate space,” adds Sarasin’s Jakes Ferguson. “Property unit trusts took £596m of new money in the second quarter, so you can see that investors are beginning to see value in the sector on any long-term measure,” he explains. Prime property is most valued for its defensive qualities as it has better tenants in more sought after locations. Multi-let property such as shops and office buildings are also attractive as they allow the owner to negotiate with tenants and leverage it throughout the building. The supermarket sector is well followed, as these businesses are still doing well and rentals are climbing. Iindustrial suffering Less favoured is the industrial sector, where occupiers are under pressure and much depends on the efficiency of the building operators. There is the obvious concern about City space, but most managers are seeing the banking collapses as a 5-7 year cycle to ride out rather than a new banking paradigm. The UK retail market has been impacted by a few enormous new developments such as Westfield in Shepherds Bush, West London, and Hammerson and Land Securities' Cabot Circus in Bristol, opened in September, which have created an oversupply of retail in certain locations and will require a readjustment of the local retail hierarchy. Many stock managers are keen to buy companies that are sufficiently entrepreneurial and dynamic to take advantage of the forced sales that will flood the market in the coming months, largely from unlisted corporates that are burdened with too much debt. Another strategy that is becoming more popular is to buy companies that operate in other markets such as leisure that also happen to be positioned to take advantage of property movements. An example might be hotel operator Millennium Copthorne, whose traditional followers will be focusing on its Profit & Loss accounts and earnings health, while its balance sheet has been improving to the extent it is virtually debt free. Redefining the genre Sarasin’s Mr Ferguson runs both long and short funds and has been forced to be more defensive in the long only, and stretching the definitions of property by buying for example significant holdings in public storage companies and data storage companies such as U Store It. Self-storage companies have fared better than most, posting gains in the third quarter, largely because these categories were so severely sold off last year. Ironically they are seen as beneficiaries of the slump in the residential mortgage market as they stand to benefit when the public delay moving trading up the property ladder, and even from foreclosure when borrowers look for places to store their belongings while they downgrade their accommodation. The Australian market has been one of the biggest fallers, losing 51 per cent since the start of the year, largely because some players took on too much short-term debt to fund their expansion plans and in some cases, paid out too much to investors in dividends. News from China is also worrying. In October, US private equity firm Blackstone Group dropped a deal worth about $160m to buy a 90 per cent stake in Changshou Commercial Plaza in Shanghai because of worsening market conditions. Government measures to cool the residential market have not helped. Beijing has clamped down on bank lending for construction, introduced a land appreciation tax and brought in other rules to deter property speculation, and these measures are also squeezing commercial property prices. But prices in the southern cities of Guangzhou and Shenzhen dropped by 30 percent last year, leading to speculation that Beijing could backtrack.

Gerry Ferguson