Deflation upsets the balance of the real estate universe

Similarly, it’s tough being a REIT CEO having spent all those man-hours confecting strategies to fit the economic cycle, only to find it has changed because someone has moved the centre. REITs didn’t understand how quantitative easing restarted the cycle in 2009 and they probably won’t understand how it ends - unconventionally.

Grade-B real estate is outperforming prime, buildings in the regions are beating those in London and industrial has been repriced towards retail yields, such is the transfer of value from shops to sheds and big boxes with the evolution of multi-channel retailing. These are the hallmarks of a mature cycle.

The risk-free rate measured by 10-year gilt yields has dropped 60bps from 2.0% to 1.4% this year on deflationary pressures, and that’s bad news for real estate. What’s good for the economy is good for real estate rents, and the economic recovery is spluttering so much that the Bank of England may follow Japan with negative interest rates as growth struggles. Looking at corporate bonds, the yield on Baa-grade credit has shot up 100bps over 12 months, so the lease on a building to a Baa-grade tenant has just got riskier as well.

The collapse in global commodity prices, with oil at $33 (£23) per barrel, and the Chinese economic slowdown are being ignored by REIT boards, just as the cracks in the US housing market were ignored in 2007. It’s real estate ‘disaster myopia’ again, less than eight years after the collapse of Lehman Brothers.

More than China syndrome

Since we started selling the sector in August, REITs have fallen 20% in absolute value and have underperformed the equity market by 8%, so this isn’t just a ‘China syndrome’ sell-off. Real estate is losing its defensive qualities. In August, we cautioned: “REITs have become conditioned to super-liquid markets and super-abundant capital, but that is changing.” And it’s now happening. We are now cautious on the London office market, which we think is the UK’s most expensive real estate sector.

A slew of major office investment deals fell over last autumn. These petro-dollar-driven markets now cost the equivalent of 90 barrels per square foot in the West End and 45 barrels per square foot in the City. Sovereign wealth funds have been selling financial assets with real estate next as they face redemptions.

The central London office market has nearly 26m sq ft of proposed new space feeding into a 200m sq ft market over the next five years, but not all will be built. Nevertheless, it’s still a sizeable supply response even at current take-up rates. The reckless developer is back in town.

Companies are being deterred from taking on long-dated commitments ahead of the Brexit referendum on 23 June and new lease accounting rules that will drive tenants, especially retailers, to take shorter leases, which are more flattering to their balance sheets.

Deflation is the worst of all economic outcomes for REITs. Corporate and retailer margins are squeezed, rents fall and the value of buildings drop while the value of liabilities is amplified. Instead of ‘yield compression’, our new buzz phrase is ‘equity compression’. Landlords might like the sound of their valuers’ estimated rental values, but they risk becoming unaffordable and difficult to monetise with a rate hike in 2017.

Proposed legislation to limit corporate ‘tax shopping’ (OECD Base Erosion and Profit Shifting Action Plan, action 4) means that highly leveraged real estate businesses could be the collateral damage, and it’s likely to be on the statute books by 2017. REITs are seeking an exemption, but that still leaves them exposed to the wider market risk of non-REIT investors being forced to de-leverage and joining the rush for the crowded exit.

With the increasing risk of petro-dollar repatriation, the banks are full up with property debt and lending margins are creeping up. The Achilles heel is open-ended funds, which now own 5% of the UK commercial property market (REITs have a 12% market share). In 2008, they saw sharp outflows and became forced sellers of assets, as did the New Star Property Fund.

We now expect an average 50bps rise in investment yields on the IPD index in 2017, with capital values stalling in 2016 and then deflating by 5% and giving a zero total return.

With REIT shares trading at 20% discounts to their net asset values (NAVs), either the share price or the NAV is wrong. In 2007, British Land frittered away £500m buying back its own shares thinking the share price was wrong, when in fact it was the NAV. Then CEO Stephen Hester said: “We believe the gap that has recently opened between sector share prices and real asset values is too gloomy in its implied view of our prospects.”

REIT CEOs are not opening their own wallets to buy their own shares, nor are they buying them in for the company to invest in their own businesses at 20% discounts, so why should we? Remember, property shares can go down as well as plummet.

Mike Prew is MD and head of real estate at Jefferies International