Buying REIT shares is like breaking into a bank that’s already been robbed. The real estate market usually creates problems for REITs, but that could reverse in this cycle.
What our contrarian REIT ‘sell’ note misjudged three years ago was the industry’s ability to keep valuations high. They are like spilt ketchup – very sticky.
Aggressive income recognition contributed to a slew of corporate collapses, but are REITs the subject of aggressive asset value recognition? Auditors’ and appraisers’ claim accounts and property valuations aren’t intended as the basis for financial forecasting, but they are and both have the same relationship with their sponsors as credit rating agencies did in 2007.
The larger REITs’ shares have traded at 30% below their net asset values for three years now. It’s that déjà vu of standing on the crumbling cliff edge at previous cycle peaks in 1990 and 2007. ‘Gapologists’ have been buying shares at 10%, 20% and 30% discounts and losing money, as the stock market has done 30% better since 2015.
REITs’ balance sheets are an unreliable guide to value and income statements can flatter to deceive. But cash can’t lie and operating cashflows are weakening, leading to dividend concerns. We think prime City of London office effective rents have fallen from £65/sq ft to £48/sq ft and it is worse for retail assets, where CVAs are biting.
Retail ’house of horrors’
The retail house of horrors continues with Debenhams’ trading issues. The department store accounts for 1.3% of Hammerson’s, 3.0% of intu’s, 3.5% of British Land’s and 5.6% of Capital & Regional’s rents.
To make matters worse, 1.6% of British Land’s rents were impacted by CVAs from House of Fraser, Poundworld and Mothercare in May, a figure that rises with incentive write-offs.
Next closed 17 stores last year and renewed leases at 40% lower effective rents; in 2018 it expects to close a further 29 and 23% of Hammerson’s and 27% of intu’s rent rolls have an option to break or are expiring by 2020. Hammerson spent £12m on advisers’ fees and shareholders are being offered a 5.1% dividend yield, which doesn’t seem enough compared with GlaxoSmithKline yielding the same.
Hammerson’s new strategy has weakened its share price as it seeks to sell £1.1bn of retail warehouses in weak markets. Cushman & Wakefield has been continually valuing the Hammerson portfolio since 2002 while other REIT majors have been rotating their valuers and its net assets are worth £6bn, but are valued at £4bn by the stock market.
The contradiction is that Hammerson is de-gearing to a 35% loan-to-value ratio with a stable balance sheet so far, while intu is sanguine with a higher 50% LTV level, when the three valuers marked its assets down by 6% in June.
“The big REITs risk being sucked into an involuntary gearing cycle, with values falling quicker than retail assets can be sold”
It is nonsensical to broadcast what is for sale before it is sold and it seems premature for Hammerson to spend £300m of the proceeds on a share buy-back before it has the cash, given that British Land’s shares have fallen 9% since May despite a £200m share buy-back programme.
Intu owns six of the UK’s eight super-regional malls and Hammerson has none, but intu needs to jettison £4bn of grade-B malls into a vacuum. Land Securities’ and British Land’s portfolios are half retail and the opportunity cost of holding fading retail stars has been to miss the ‘sheds and beds’ boom. The big REITs risk being sucked into an involuntary gearing cycle, with values falling quicker than retail assets can be sold.
The canaries in the coal mine include Brexit and taxing overseas owners of UK commercial property in 2019. The US economy is over inflating, there is the risk of trade wars and the Chinese renminbi has devalued. Into this maelstrom, we think British Land, Hammerson, intu and Land Securities need to sell £10bn of retail assets with high book values, which won’t be pretty.
Mike Prew is managing director, equity research, real estate at Jefferies International