Property Week - Mike Prew - 02 February 2017
Festinger’s 1957 theory of cognitive dissonance notes that individuals seek consistency in their cognitions (beliefs) so they tend to twist facts to remove any conflict (dissonance). REITs now seem to be suffering from ‘valuation dissonance’ with low share prices and high portfolio valuations. But although they seem cheap, we don’t think they are good value.
We started selling REIT shares in August 2015 and if you were expecting us to turn buyer of the sector after a near 30% fall from its peak and then a Santa rally of 10% in December, look away now. We didn’t predict Brexit or Trump but we did assign a 50/50 possibility based on voter demographics and Brexit is more likely to be hard-boiled than soft.
We maintain our negative sector stance, while the consensus bulls have not started capitulating yet. Our investment thematic for 2017 is the risk that foreign investment in the UK commercial property market, which has buoyed pricing, will retreat.
You know the game is up when equity markets don’t believe property valuations any more and REITs don’t buy their own deeply discounted stock - either corporately or personally.
REITs are selling the assets they can afford to in order to de-gear and are now top-slicing development risk by driving leasing volumes ahead of values.
Tenants are using Brexit as an excuse to chip rents or do nothing, which is reminiscent of Schroders pulling its HQ relocation mandate in 2011 in the face of uncertainty over the eurozone banking crisis.
London office demand is still TMT and serviced office provider-centric. Headline rents are being propped up by expanding tenant incentives and our original forecast of a 9% decline in grade-A rents over 2017-18 is now projected to be 20%.
The shopping centre market is still, we think, a slo-mo train wreck and the transfer of value from shops to sheds is accelerating. Retailers are internally cannibalising sales with physical sales densities declining and undermining rents.
Big box logistics is an oasis in the alternative sectors, offering high-income returns and capital preservation with most REITs converting capital into income by spending their net asset value to maintain passing rents.
A parlous state
Real estate pricing has become a capital market event, the Bank of England has cut economic growth rate forecasts and the lazy man’s property risk premium is there for good reason. Notwithstanding that bond markets are artificially illiquid, real estate is more macro-prudential than inflation-driven and excess liquidity has led to real estate being mispriced, with abundant capital compounding market vulnerability.
Foreign money will withdraw and the UK commercial real estate market is now in a parlous state, having become overly dependent on inflows of foreign capital. REITs have become used to cheap capital but conditions are reverting to normal.
Sterling has devalued 40% against the US dollar since 2009, which makes real estate look ‘cheap’ to an overseas buyer. Pessimistic US funds, however, talk of a rerun of 1985 and sterling/dollar parity, with the UK’s achilles heel being sterling-elevated volatility.
Yield-starved money chasing property is depleted with a list of large lot-sized deals falling over. Some £60bn of post-Brexit-vote quantitative easing (QE) didn’t go far with 10-year gilts yields at 1.3% - back where they were a year ago. Debt underwriting standards will tighten as lenders get more cautious as investment transaction volumes drop and valuation accuracy degrades.
The last prop for overvalued property is currently being provided by local authorities.
As the Public Works Loan Board, a government Treasury agency, lends to local authorities typically at 2%.
These proceeds are invested in high-yielding assets at 6% to 8%, usually sub-prime shopping centres. It amounts to state sponsored coupon-clipping and will tail as bond yields rise and property allocations are met.
As foreign capital ebbs, domestic investors with higher costs of capital and more realistic rental growth expectation can’t afford these high QE prices.
The scene is set for a toxic shock with falling rents and rising yields - and landlords probably won’t capture the growth embedded in their asset valuations. Irrespective of lower-for-longer interest rates, because weaker growth is priced into lease contracts, yields will rise to compensate - and that’s before Mark Carney’s epiphany that rates might rise.
REITs might have more problems than real estate as these businesses become forced office redevelopers and mall extenders and are still too highly leveraged.
The London property economy is most at risk. Regional markets will outperform, but only temporarily. To that, we add the risk that HMRC may clamp down on REITs booking tax-free development profits by selling schemes before practical completion as not conforming to the spirit of the REIT model of high-yield/low-risk rent collectors.
The UK REIT sector looks cheap but isn’t good value with a prevailing 17% discount a mirage as the NAVs risk over-reporting positive evidence.
We need to see trough property valuations coincide with trough share ratings before we repeal our underperform stance - and we don’t think we have got either yet.
Mike Prew is managing director and head of real estate at Jefferies International