Feet of clay cannot keep walking

The shares of the UK large REITs now trade at around a 30% average discount to the net worth of their balance sheets and equity valuation just got a lot more complex. The equity market is riding high, with the FTSE 100 at 7,300; Brexit relief could now be overtaken by general election risk and there is the ongoing ‘shop-astrophy’ in retail property.

For those sheltering in London offices, think again. The ‘marmalade dropper’ in our latest sector note is that WeWork is the fox in the proverbial henhouse of the London office market, where we suspect rents are artificially high.

Our thesis is that co-working operators have bid up rents to unsustainably high levels in exchange for longer rent-frees, to buy extra time to fill these office-hotel assets.

This will be, we think, the capital market trigger for a de-rating of London office values, in much the same way that degrading shop rents are undermining shopping centre and retail park prices.

These disruptors are distorting the market ratios, which otherwise look sturdy. WeWork operates 5% of London offices, has driven 30% of leasing at peak and suppressed vacancy rates to 5%, but built on an increasing asset/liability mismatch with ‘feet of clay’. As London’s largest private landlord, WeWork is affecting the rental structure of London offices irrespective of its valuation.

The deferred IPO staunches WeWork’s capacity to soak up secondhand space. These ‘soufflé rents’ don’t tend to sag by 5% to 10% but slump by 10% to 20%, and a little yield shift on 4% goes a long way.

‘Shop-quake’ worsens

The ‘shop-quake’ just gets worse. Estate agents are hyperventilating at the weight of stock to clear and no foreign money to close the bid-offer spread, with the UK institutions out of the market. Shopping centres that were desirable, fit for purpose and profitable are not anymore. The value at risk is more in the shiny mega-malls owned by REITs, with customer ‘experiential’ strategies overexposed to mid-range fashion rather than value community retail.

Malls’ surviving footfall draws, such as prime retailers Next, Primark and H&M, are using their leverage to typically negotiate rents down by around 30% and lease terms down from 10 to five years. High and rising shop rents capitalised at low single-digit cap rates are a thing of the past in the shift to total occupancy cost (TOC) leases.

Under TOC terms, tenants pay business rates and service slab charges, while the landlord gets a 10% to 15% slice of turnover. REITs become a subordinated retailer with less to capitalise and fewer private equity-backed pizza joints and burger flippers to fill the empties. It is a risk that shops are increasingly being owned by the banks and debt recovery will likely trigger a waterslide in valuations.

With interest rates possibly turning negative, it’s back to our ‘three Cs’ mantra of collect (rents), compound (dividends) and compress (returns). We prefer shares with 4% dividend yields growing sustainably and organically at 2% per year to match inflation and a stable NAV.

Portfolios need to earn their keep and an uncovered dividend is really just a slow-motion liquidation. Beds, meds and sheds balance sheets are still regularly transacted, so NAVs are more reliable than 1m sq ft shopping centres and £1bn skyscrapers, but even in these sectors liquidity is thinning.

Inflated valuations

REITs continue fighting hard to keep lease terms hidden because, we believe, valuations are still an overly generous multiple of rents. The UK has become a property world leader in camouflaging rents, with multi-year rent-free leases peppered with break clauses and contributions to fitting out, and are supporting artificially high headline rents with weakening economics.

Stripping out these cashbacks to a lower effective rent means lower property valuations and a lower ‘V’ in ‘NAV’, which governs public equity access and the ‘LTV’ calculation of leverage setting the rates charged on real estate loans. The cost of capital of the public real estate market is dictated by the unobservable inputs of the valuers’ RICS Red Book, which needs to change.

Mike Prew is managing director at Jefferies