Economic uncertainty makes REITs’ future bleak

Ideas can be developed by understanding the “big picture”. Although commercial real estate is a series of micro-markets, the governing dynamic of performance is increasingly capital flows, not rental fundamentals.

The risk of sovereign debt default and the government’s deficit-attacking Budget have pushed gilt yields down to an astonishingly low 3.3% and with it the prospects of lower long-term funding rates.

BP suspending its £1.8bn quarterly dividend has rerated high dividend-yield sectors such as utilities, and put a floor under REIT shares. Obsessing over rents on shiny new office towers in the City misses the broader perspective.

One concern is that REIT strategies remain ambiguous. Many companies assume we are in a conventional cycle, where rents follow real estate price trends. The lesson of the last five years shows this logic is flawed. UK leases are shortening, so the second rent review is likely to be a lease renegotiation and “rent reset”, vacancies are expensive and dilapidations are difficult to recover in full. There are structural forces at work and long-term charts of property yields tell the truth, but not the whole truth.

Quite contrary

In January we forecast that real estate’s risk premium was likely to rise. Recent events in credit markets appear to be corroborating our contrarian expectation of a 4%-5% “relapse” in property values. This is now being priced into derivatives, but some estate agents are hanging on to 2010 return forecasts of 12%-17%.

The crest in real estate values probably passed a few months earlier than we anticipated. Fast-moving investment market conditions have ended with the wall of euro equity fading. The euro has depreciated as prime property values jumped around 20% – and any trading activity around this has played out.

Real estate needs credit transmission and rental growth to prosper, and there is a shortage of both. Max Property was candid last week, observing: “Serious fault lines are appearing
in the market with no more best bids, price chipping and deals falling through.”

The prognosis for rents is that they are probably weakening. The Budget’s “de-riching” process is only just starting and the government has estimated a 1.3 million increase in unemployment. Add to that the VAT rise to 20%, the public sector pay freeze – remember 10 public sector jobs support three in the private sector – and a negative
wealth effect.

Even the top-end residential market is now turning turtle. Savills claim that the uber-wealthy enclaves of SW1 and W1 are set for an “inevitable second slip”.

The staggered implementation of the new bank levy, which comes into effect later this year, makes predicting City office requirements even trickier. As one agent quipped: “It’s like ordering a suit from his tailor but wanting it in five years, not next month: ’What shape will sir be?’”

Add to that tighter regulation and we find it difficult to countenance City rents recovering to much more than £50/sq ft by 2015, and grade A to nearer £60/sq ft, probably with 18 months free rent. This makes the Cheesegrater and Walkie-Talkie developments viable – but only just.

REITs remain financially straitjacketed. Leveraging averages an aggressive 50% loan-to-value ratio on a portfolio and the legacy of keeping them artificially full with discounted leasing deals and selling prime assets at secondary prices has diluted cashflows. They will struggle to grow their dividends, and risk under-investing in their portfolios, as well as missing the rental recovery bus. With good-quality real estate priced at 5%-6%, and REIT funding costs around 6%, they cannot buy earnings growth and dividend cover like their European peers.

REIT and direct real estate returns are diverging when they need to converge. The equity market appears to view portfolio valuations with renewed scepticism – shares are trading on an average 16% discount to net asset values, probably pricing in the risk of falling values.

If the stated NAVs were stable and reliable, then should REITs be buying their own shares? After all, a risk-free 16% “turn” investing in your own portfolio seems to be a better proposition than high-risk and deferred speculative developments. It’s an interesting debate, but if REIT shares really were good value, then wouldn’t their boards be buying the shares with their own money? It is telling that none of them are except Francis Salway, chief executive of Land Securities.

REIT shares, like Newton’s apple falling from a tree, are both governed by the laws of gravity.