In a speech to the French revolutionary assembly, Georges Danton (1759-1794) said: “De l’audace, encore de l’audace, et toujours de l’audace” - a forerunner of ‘Who Dares Wins’.
We have been buying REITs for four years and they have doubled in value, but in August we broke ranks and turned sellers.
There was an immediate and precipitous sell-off of -10% and our ‘sell’ recommendations became ‘holds’ over the following week. It has since taken two months for the sector bulls - and that is everyone except us - to get the sector almost back to where we sold it. That’s ‘L’audace’.
We think the real estate cycle is broken. Prime property is priced for perfection and with the exception of ‘Britzerland’, where we forecast London office rental growth of up to +7% through 2016, we can’t see enough growth to offset yield ‘decompression’ after the US hikes Fed Funds.
Real estate is an expensive asset class and REIT shares have become over-bought. We now forecast the IPD all property capital index to fall -1% in 2016, which is down from our previous estimate of +6%, and we think under-yielding and over-costed shopping centres and retail parks will fare worst.
Property prices have fully adjusted to ultra-low interest rates, and whereas last summer there was a new high-water mark almost every week, ending with Land Securities buying Blue Water last July, values are now in equilibrium and investment demand is hollowing out. With vacancy rates and yields at all-time lows, the reckless developers are back.
The London office pipeline is 22m sq ft split 75% City and 25% in the West End. That is double the space completed over the past five years and equivalent to circa 10% of core grade-A stock being delivered by 2019. At current absorption rates 5m sq ft will be surplus looking for a tenant, which equates to about eight Gherkins’ worth.
The bulls think the spread between property yields and 10-year gilts at 300 bps is compelling value, but in 2012 the gap was 500 bps and property values then fell -5%. Rising rents assume an inflating economy, but low gilt yields need a near-deflationary economy, which is contradictory.
Prime London property was a one-way bet on sovereign wealth funds buying and holding assets for generations to come. Now £3.5bn is on the market and the ‘Great Wall of Money’ is ebbing. After the QE ‘helicopter money’, the Norwegian government, faced with lower oil revenues and a 5% fall in its sovereign fund last month, is now withdrawing capital to finance more QE in the form of health, education and infrastructure spending.
The Kuwaiti Investment Authority is now selling £4.2bn of assets including real estate so this seems to be the beginning of a trend. Add to that the Chinese economic slowdown, a re-intensification of the fiscal squeeze and a referendum on the UK’s membership of the EU in 2017; they all increase investment risk.
The recent buying spree has, however, led to the systematic underpricing of risk with subprime spreads reliant on delusional growth assumptions. Cash will regain its value when rates rise in 2016 and the bond tourists are going home, with the real estate tourists not far behind them. In REIT-land, NAV growth peaked at 20% in 2014 as it did in 2007 and 2009 and is, we think, set to stall.
Another risk is the OECD’s Base Erosion and Profit Shifting No 4, which has been backed by the G20 finance ministers. This proposes limiting corporate ‘tax shopping’ by Google, Starbucks, Facebook et al, and real estate could be the collateral damage. It recommends capping interest deductibility and real estate, which is habitually highly leveraged, could see forced degearing of assets to avoid hikes in effective tax rates. Again, these risks aren’t being priced in except by us.
The free QE ride is over. REIT cost of capital is rising, portfolio returns are moderating and they can only meaningfully boost their dividend yields to compensate investors by share prices falling. REITs are suffering from communal amnesia having become acclimatised to abundant free capital and super-liquid markets, but all this is coming to an end. Those unencumbered by experience are saying, “It’s different this time”, which Warren Buffett said has always cost him money. Those who have seen a cycle or two know ‘history doesn’t repeat itself, but it does rhyme’.
Mike Prew is managing director and head of real estate at Jefferies