If asked in a job interview where you thought you’d be in five years’ time and you replied holed up in my flat on Zoom calls, living on takeouts and waiting for a global pandemic to pass, you probably wouldn’t have got the job.
This year opens with the same debate as last year on REIT-style investing from 25% discount to NAV value stocks versus the growth in beds, meds and sheds that need more income momentum to support dividend growth with a big ‘G’.
Optically, cheap capital REITs probably aren’t good value and income REITs are beginning to stretch valuations as interest rates rise. Beds, meds and sheds with high income-to-earnings conversion rates have yet to see the big rotation of direct property funds out of legacy overweight, expensive-to-own-and-operate offices and shops into the alternatives.
We are still paying up for indexed income in businesses with structural support, but this comes with new decarbonising costs. In our ‘2 for ‘22’ outlook note, we advanced our ESG thematic and concluded that London office ‘upcyclers’ Derwent London and Great Portland Estates are mispriced and, thus, our top picks.
We aren’t ‘inflationists’, but concede that the Bank of England’s 2% inflation target is on ice and financial repression is designed to keep real interest rates low and erode the real value of debt, which is a sweet spot for real estate in a conventional cycle, which this isn’t.
High-grade credit occupiers want more rigorous zero carbon targets than EPCs band A to B
Governments have a natural tendency to overinflate their economies, with inflation and growth set to let rip in 2022 without the ‘normal’ rising interest rates.
The ending of free money may finally be here, but inflation is no longer good ‘demand pull’ or bad ‘cost push’ with multiple supply and demand drivers colliding, and ‘biflation’ creating unforeseen pricing ripples elsewhere in the economy.
Charts of real estate performance back to the 1970s – when the UK last experienced sustained high inflation, peaking at 27% in 1975 – are less relevant. The mechanics of inflation have changed and real estate markets have evolved.
Rising rates squeeze earnings, but then inflation erodes liabilities, which is a positive if tenants can absorb rising input costs and contain default risk.
The term structure of rates is a better guide, with an upward sloping gilt yield curve supportive, but the gradient has flattened from 0.8% to 0.25%, which is a dampener.
The stock picker’s ‘random walk’ assumes that all that can be priced into a share price has been. So there is a fair chance that if you sell last year’s leaders and buy the laggards you stand a chance of outperforming.
This topping and tailing, however, has not worked through restructuring of retail, which started in retail REIT shares in 2015 when we turned negative. It began to filter into NAVs three years later as valuers started marking shop rents down.
By 2030, the UK government’s green agenda will be based on Energy Performance Certificates (EPCs), which is a once-a-decade assessment of energy provision. They are like a car’s MOT and not a full service.
Less than a fifth of London offices are in band A to C, but investment-grade occupiers aspire to more rigorous net zero carbon targets such as BREEAM and GRESB measures. This raises the bar on design and build costs; Knight Frank reports a premium of 12.3% on BREAAM ‘Outstanding’ buildings.
REITs have disclosed low estimates of EPC compliance (eg Landsec £130m, British Land £100m) but the economics of building greenness is not just an ownership issue but triangulated by landlords, tenants and debt providers.
The economic crunch is that the high-grade credit occupiers want more rigorous zero carbon targets than EPCs band A to B.
Of the London offices currently empty, 80% are energy obsolete and the supply pipeline is largely committed, with 10m sq ft under construction to complete in 2022-25, and 30% are let or under offer.
Savills anticipates 7.8m sq ft of take-up in 2022, with pre-letting on a rising trend after accounting for 27% of leasing volumes last year.
We think there is a bottleneck developing, with the gestation period of supply of the top-class ‘clean and green’ offices unable to keep pace with demand. Thus we expect pre-letting volumes to boom.
Derwent London and Great Portland Estates seem best positioned to trade the margin between brown (EPC sub-band A to B) and green (BREAAM ‘Outstanding’) with medium-term pipelines being advanced on leasing terms moving ahead of underwriting, which is where the value is.
Mike Prew is managing director at Jefferies