City View: Mike Prew - Sick leasing markets leave queasy feeling
Ailing occupiers will drag REIT prices down further, says Lehman Brothers European real estate analyst Mike Prew
Do you remember Fred Flintstone’s car? Propelled by leg power, it was always a lot of effort for very little forward motion. Well, that’s how we see the real estate industry shaping up in 2008.
We find it increasingly difficult to be optimistic after eight months of the credit drought. Gordon Brown is talking of a ‘containable fall in house prices’, all too aware that the last housing crash contributed to the fall of the Conservative government.
The International Monetary Fund put the total estimated cost of the US subprime meltdown at $1,000bn and downgraded UK economic growth in 2008 to 1.7%. Add to that estimates of up to 20,000 job cuts in financial services, and the City of London office market seems set to be saturated with space.
Five months ago we recommended buying UK REIT shares, anticipating that real estate yields would stabilise. The monthly falls in the Investment Property Databank All Property capital value index have backed this up, with declines of -1.3% in March against -1.6% in January and a peak rate of -4% in November and December.
As real estate behaved like ‘congealed cash’, REITs proved to be a safe refuge in the first quarter. Shares were up 5% and the equity market down 10% – a 15% relative gain – as investors retreated from structured financial products.
Real estate initial yields are now around 5.5%, against risk-free bonds on 4.5%, and appear to be finding a ‘suspension point’. The problem with this analysis is that the price of credit is academic if supply is cut off and it relies on stable or rising rents.
The widely held assumption that the banking system would restart has proved too optimistic. Given this, and the marked deterioration in the economic environment, it is time to stop obsessing about cap rates and look at rental prospects and REIT cashflows. Banks still distrust each other. Wholesale London Interbank Offered Rate money rates hit 6% recently before base rates were cut by 25 basis points to 5%.
Our concern is that the growth versus inflation trade-off with the Bank of England is like a lost boy scout with a Compass needle stuck on price stability. This is beckoning ‘stagflation’ with little wriggle room from the European Central Bank because sterling has been devalued 20% against the euro and the bank has been intransigent in unlocking credit markets. REITs look set to weather this credit constriction, assuming that bank lines are as watertight as the companies think.
The industry problem is that occupier confidence has plummeted in the last two months, and potential tenants have the excuse not to sign a lease for six months until markets settle down. The City office market and retail warehouse markets appear at greatest risk from saturation and rents in these sectors are probably softest. Valuations are valuations, but prices are negotiable and, in a credit drought, the risk is that pricing equilibrium may be less than fair value as rents come under increasing pressure.
It is time to stop obsessing about cap rates and look at rental prospects
You can’t blame the appraisers, who seem set to continue marking valuations down, until there is commercial activity and the ‘Mexican stand off’ between buyers and sellers is aligned. REITs were price takers during the real estate market’s debt-driven years, and should be the next cycle’s price setters. The problem is that their buying criteria are very narrow and everyone is preserving cash.
A lot of intellectual capital is now being focused on real estate, but it is not generally converting into dollar capital. This is investment market ‘wheel spin’and it’s bad for business – the wheels hit the tarmac when credit starts circulating again, but everyone is petrified of first-mover disadvantage.
Then we expect mergers and acquisitions, with the tax consequences of REIT privatisation now favourably clarified. The new factor is the unconventional ‘wealth conservationists’ looking to diversify.
We see no critical ‘fissures’ in the public real estate market – REIT balance sheets and cashflows are stronger than in previous cycles. Markets are better structured and accounting standards tighter.
The problem is that REITs own a little less than 15% of the UK market and the growth in ownership is in offshore funds, which are highly borrowed against grade B and C assets. Although loans may be in technical breach of covenants, the rents are still servicing the interest bills. After the ‘short sharp shock’ in valuation yields and capital market repricing, the risk is that rents are going to go through the same process and that is when there is a risk of triggering insolvencies.
The dislocation between REIT share prices and net asset values is now 20% against our bottom-of-the-market forecasts, and share prices are down 10% in the last fortnight since we published our Queasy on Quality St-REIT report downgrading the sector.
This would seem to vindicate our view that net asset values are more likely to fall to share prices than the share prices are to rebound to net asset values as some tipsters are still holding out for.
It’s interesting to note that Capital & Regional is this year’s best-performing share, based on the assumption that the business will be broken up with the departure of founder Martin Barber. Time will tell if this faith is misplaced or not.
Property may be a long-term asset class, but REITs are businesses that need to earn their keep.