Derwent London has been hit by working from home and higher rates. Here is why we’ll hang on
Like many of its rivals, this Reit has experienced a steep share price decline. Rents, though, are rising – as is its dividend
‘Rate cuts would increase the relative attraction of Derwent London’s yield and in theory boost economic activity’
The highest income from new lettings since 2019, a drop in the vacancy rate, another increase in the dividend and an upgrade to 2024’s rental income guidance from management all read well but shares in Derwent London just do not seem interested.
Despite last week’s perfectly solid full-year results, the stock languishes at levels no higher than those seen in autumn 2012, to leave us with a nasty book loss relative to our tip in 2016. However, we shall tough it out, in the view that the property portfolio remains prime, the balance sheet is robust and the yield sufficient to keep income seekers interested.
We also have a lowly valuation on our side. The shares trade at a discount of 36pc to their year-end net asset value (NAV), or book value, figure of £31.29 per share. This gap is even bigger than the one that prevailed when this column first analysed the real estate investment trust (Reit) more than seven years ago.
The discount then was 35pc, as investors pondered what Brexit would bring to the economy and demand for sterling-denominated assets. That is a question to which we still do not really have a satisfactory answer, but what we do know is that Derwent London’s shares rose by 80pc between late 2016 and early 2020 as the market’s worst fears were not realised, only for us to gormlessly miss a chance to take profits when the stock briefly traded at a premium to book value just before the pandemic swept the globe.
There is no point crying over that spilt milk, but in essence that discount to NAV means investors think the value of Derwent’s property portfolio is only going to go one way: down. You can see why they might think that, given the combination of the rise of working from home and its impact on demand for office space, the relentless onslaught that bricks-and-mortar retailers face from online rivals and also Britain’s gradual slide into recession. Derwent London’s NAV per share fell by 14pc in 2023 and bears of the stock will argue that the gap between the share price and book value is more likely to close through the NAV going down than the shares going up, especially as NAV per share is already down by a fifth from its pre-pandemic high of £39.58 at the end of 2019.
Another factor to consider is monetary policy. Higher interest rates (and higher bond yields) drive up interest costs on property developers’ debts, drive down net asset valuations (thanks to how future cash flows from rents are valued using a higher “discount rate”) and make the dividend yield available from Reits look less attractive compared with the returns on assets such as cash and bonds, which are also, in theory, lower risk. Consensus analysts’ forecasts for a dividend payment of 81.4p for 2024 suggest Derwent London offers a 4pc yield – less than the Bank Rate and not quite matching the 10-year gilt yield (or “risk-free rate”) of 4.1pc.
At least improved new lettings activity lays the groundwork for future rental income, and it is rent – not asset valuation – that pays the dividend. The final 55p-a-share payment for 2023 is due in May and upon receipt our tally of dividends from Derwent London will increase to nearly 673p a share, or more than a quarter of our entry price.
Improved rental income and higher new lettings activity could also be one catalyst for a reduction in that discount. Interest rate cuts may help, too (as long as they are not a response to a deep, rent-ravaging economic downturn). Rate cuts would increase the relative attraction of Derwent London’s yield for a start and in theory boost economic activity over time. It may be that Reits’ share price malaise is the result not just of the pandemic and a change of working practices but of some degree of normalisation in monetary policy too. Derwent’s shares thrived during the 10-year-plus period of record low interest rates as investors fell over themselves to find alternative sources of yield. Now they can turn to cash or gilts and as a result Derwent London’s share price does not sit too far from where it was when the Bank Rate last exceeded 5pc. Perhaps this process of adjustment to a new era of monetary policy (if that is what it is) is nearly done and fundamentals such as occupancy rates, rent, dividends and balance sheet strength will slowly come back to the fore (for better or worse). We’ll stick with Derwent London. Hold.
Russ Mould is investment director at AJ Bell, the stockbroker