The real estate market has had its ‘Cinderella moment’. Midnight has struck, exposing the REIT ‘pumpkin eaters’ left holding unsaleable assets at high valuations. Retail values cracked but REITs portrayed this as a one-off.
Intu said that its shopping centre yields rising 62bp “have done their stuff” and the investment market “wouldn’t remain asleep forever”, but this probably isn’t the end of the beginning; rather the beginning of the end.
The fast-casual dining and flexible office booms have extended this cycle but are less able to soak up excess retail and office space respectively, which has sustained headline rents. Real estate leases are losing their defensiveness as they shorten and security is debased by CVAs, WeWork leasing via SPVs and Regus handing back the keys at Stockley Park.
Valuations of shopping centres were weaponised after the RICS valuation notification telling appraisers to wake up and smell the coffee. A new industry has grown around tenant cashbacks to camouflage effective rents and maintain synthetically high headline rents.
The valuation burden of proof has shifted to REITs with their shares on average trading at 36% discounts to NAV. The ‘big four’ accountancy firms segregate audit and advisory work and estate agents might need to unbundle their valuation departments, while the new IPSX trading platform could give capital markets instant building valuations.
The retail debate now is: when will the falling meat cleaver hit the kitchen floor and will it be safe to pick up? The UK could be over-shopped by up to 40% of floorspace and repurposing it into housing, hotels or hospitals cuts losses rather than makes money.
The central London office market is also rolling over. Agents quote $8 of overseas capital chasing every $1 of stock available, but values are flatlining. London offices are seeing steady take-up for prime space but Glencore’s 54,000 sq ft pre-letting at Great Portland’s Hanover Square scheme was at a rent only marginally ahead of the letting to KKR a year ago.
Office ‘densification’
London office ‘densification’ has seen average space per office worker shrink from 100 sq ft to 80 sq ft over 20 years with more to go. The relationship between job growth and London office take-up is no longer linear, and when you factor in flexi-space, home-working, hot-desking, Crossrail and technology spelling the death of distance, then formerly fringe locations from King’s Cross to Battersea and Hammersmith to Whitechapel are now viable.
REITs had good start to the year (+13%) and are pricing in a soft Brexit with an extension date to 31 October. Our hierarchy of risks is: April tax changes, which froze Chinese investment in 2018; the bottomless pit that is retail; another run on open-ended property funds; and of course our ‘known unknown’ of shadow banks behind a quarter of commercial property’s £200bn of debt as banks scale back lending to retail and real estate.
REITs have been marking their own homework with property values under-reading in a growth cycle and over-reading in a downturn, leading to REIT premia and then discounts to NAV. REITs keep trying to fit square-pegged inflationary strategies into circular-shaped deflationary holes that are getting smaller. REITs remain over-costed, over-indebted and over-owned, with buildings often held fractionally or via offshore structures all needing discounting, so REITs still look expensive to us.
REIT kinetics are deteriorating with management increasingly seen as middle-aged men in tin hats hiding in their basements and moving from the initial denial phase to the next, which is regret. The NAV fashionistas are still looking in the wrong place as dividends come under pressure.
Earnings dilution
REIT EBITDAs might look stable but cutting debt means selling assets yielding much more than the free ‘QE’ money they were bought with. That means earnings dilution and self-inflicted dividend cuts, which we warned of two years ago when we ditched balance sheets and income statements in favour of operating cashflow analysis, which pre-empted Hammerson’s and intu’s dividend pressures.
In our latest REIT quarter memorandum ‘The Pumpkin Eaters’, we downgraded some REIT earnings forecasts and concluded that British Land and Hammerson were at risk of having to cut their dividends. The backstop is M&A but why pay 70p for £1 that could soon be worth 50p? That’s not a glass slipper that is going to fit.
Mike Prew is managing director at Jefferies
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