Silver linings
London real estate woes beckon investors
‘Concerns about Brexit have resulted in developers putting their feet on the brakes’
The amount of construction going on in the City makes the British capital look like a boomtown. Yet, following the UK’S vote to leave the European Union, the market has been distinctly downbeat on the value of London office space, and the share prices of real estate investment trusts (REITS) have collapsed. Is the market right to fret – or has a great investment opportunity been created?
Fears of declining rents and weakening commercial property prices have pushed the share values of major British property groups into the doldrums – yet the price achieved for London towers this year has been much better than the pessimists expected. Indeed, share prices have fallen so much that opportunistic M&A activity has started to happen, with the management of Hammerson offering to snap up rival Intu in recent weeks. The combined group would own 17 of the UK’S 25 biggest shopping centres. The £3.4bn offer prompted a near20pc jump in Intu’s shares, although Hammerson’s fell on concerns that the deal could be a case of “two drunks propping each other up at a bar”, increasing its exposure to UK retail, which is in structural decline because of the rise of internet shopping. However, these losses have since been recovered as investors warmed to the deal on valuation grounds.
The sector is undoubtedly cheap; there is actually a “double discount” on UK REITS. Recent sale prices suggest valuers of major buildings may have undervalued the properties. And the REITS themselves are trading at a substantial discount to the net asset value (NAV) calculated from these subdued valuations.
This discount to NAV is as much as a third in some cases. For example, Land Securities’ NAV per share on Sept 30 was £14.68, compared with its current share price of around 990p. For British Land, its NAV per share was 939p at the end of September, compared with today’s share price of around 675p. This discount is repeated across the sector. The fall in sterling has prompted overseas buyers to heavily invest in the UK, particularly property. These investors see a “triple discount” as the pound has devalued, the shares are trading below NAV and valuers are ultra-cautious. In March, Chinese property developer CC Land Holdings paid £1.15bn for 122 Leadenhall Street, known as the “Cheesegrater”. This was at a yield of 3.45pc. A report in the state-run China Daily suggested this was the “biggest Chinese investment in the UK’S real estate market”. Indeed, two thirds of the £4.8bn invested in London offices in the third quarter of this year came from Asian buyers, according to CBRE. More than 90pc of all commercial property transactions in the City during the period involved investment from overseas.
The most significant thing about this purchase was that it was at a 26pc premium to its valuation in the previous September. A similar situation was seen when the “Walkietalkie” building on Fenchurch Street was sold to a Hong Kong investor for £1.3bn by Land Securities and its partner. The price achieved was 13pc above what valuers had put in the company’s books.
The sale of sites at a higher price than their book value belies the negativity of the professional valuations of buildings. Despite the sale prices being relatively high, rental yields remain supportive. For example, at the start of December, China’s Cheung Kei Group bought the former London base of Bear Stearns in Canary Wharf for £270m. The sale price represented a net initial yield of 5.2pc, according to Capital Real Estate Partners. This is a very attractive return when borrowing costs are so low. So, with flagship London buildings selling above the value of these properties in a company’s books, why are property valuers seemingly so gloomy? The answer is Brexit, which has made them fearful. The price of anything is a function of supply and demand, and concerns about Brexit have resulted in developers putting their feet on the brakes. According to the latest London office crane survey, commercial construction in the capital is down by more than 9pc compared with the previous six-month period.
Although the slowdown in new space may not be great for the construction sector, it implies there could be a shortage of offices in a few years’ time. In the words of Deloitte, this “may be good news for those looking to spot the next window of opportunity in the cycle”.
UK property REITS appear to be priced in the bargain basement. However, Asian investors – and the management teams of REITS – appear to see substantial value. I suspect they are right.