Originally published October 2022.
But this writer believes there’s plenty of hope for landlords.
The sector had a tawdry H1 with significant underperformance against the All Share Index for all the obvious reasons. As interest rates have risen sharply, the major concern has been that borrowing costs for the sector are now higher than the initial yields on many REITs portfolios, implying an upward ‘re-basing’ of property yields with a commensurate reduction in portfolio values. However, with mixed messaging from the Fed and other national banks, the UK sector has staged something of a rebound over a quiet summer. Having been down by 20% at theend of June, the sector is currently down a less embarrassing 13%. Investors are looking through the current interest rate cycle and putting their faith in inflation being brought under control at some point within an investable time horizon and if it’s the rising cost of capital that drove the sector down, then the hope is the opposite may be true.
“Some commentators have suggested there are echoes of 2007/8 and this prompted a brief but meaningful sell-off right at the end of the half year”
The summer months are normally subdued and this year is no exception. A number of investment transactions in the direct market, notably in the logistics sector, appear to have either stalled or been put on hold with a pricing standoff between ambitious sellers and chipping buyers with a better feel for pricing perhaps being established when the holiday season is over. Some commentators have suggested there are echoes of 2007/8 and this prompted a brief but meaningful sell-off right at the end of the half year. I certainly don’t see that. Lessons have been learned. Back then the loan-to-values across the sector were above 50% ahead of capital values, falling by over 40% in a calendar year. At the simplest level, the UK sector now has about a 27% LTV, a current average debt cost of 2.5% with a seven-year average duration and nearly 80% of total debt costs fixed. It could be a lot worse of a position.
While a rise in property yields is inevitable, I don’t expect it to be on anything like the scale of the GFC and it may even be just about viable – through rose-tinted spectacles – to suggest that while NAVs will certainly stall for many and decline for some, for the moment there is an off-setting and beneficial item called rental growth and strong letting activity in key sectors. Recent results have borne this out and while results are by definition backward looking, I see nothing over the intervening couple of months to suggest that occupier demand has declined in both the office and logistics sectors. In fact, there’s half an argument that it’s strengthened.
The London office specialists all recorded record leasing with their last full-year results and while that may not be repeated this year, the dearth of suitable and available office space in central London has led to what one CEO has described as an “acute” shortage emerging. The reason? EPC, or energy ratings, allied to the oft-forgotten fact that there are always lease expiries and never more than now have tenants with lease expiries approaching been faced with the need to occupy only the very best-quality office buildings, both to comply with proposed energy efficient requirements and to provide the quality of space that employees now demand.
“Rents may not grow much this year, but as any new space that is available continues to be absorbed, landlords may just be able to exert some upward rental pressure”
So far this year, take-up in the City of London and the West End is meaningfully above the 10-year average and there have recently been a swathe of high-profile lettings to further boost the figures. Paddington Square is now fully spoken for (350,000 sq ft), Blackstone is committing to a new London HQ for occupancy in five years’ time and One Berkeley Street reports a slew of high-profile lettings. There are other new requirements reported as well and for any tenant looking for over 100,000 sq ft of space in the core locations, then good luck, because roughly 50% of committed office schemes are either pre-let or under offer. Rents may not grow much this year, but as any new space that is available continues to be absorbed, landlords may just be able to exert some upward rental pressure on prospective tenants.
As for the logistics sector, then the ‘Amazon has over-expanded’ shock-horror story may have routed the shares of those companies involved in the sector earlier this year, but the occupier market points to a rather more positive story, as indeed have recent results from Segro and, on a global scale, comments from Goodman. The latter owns a global portfolio valued at nearly $70bn and stated that it doesn’t have a vacant shed in its portfolio! Well, it does, but at 99% occupancy I’m not splitting hairs. There’s strong inflation-beating rental growth and no apparent easing for the moment of tenant demand.
It’s much the same story from Segro, with recent interim figures. All the key metrics, profits, earnings, dividend and NAV grew by a figure greater than the current rate of inflation. Perhaps as importantly, the group stressed that current supply/demand (im?) balances point to further rental growth to come, as well as capturing a mammoth level of portfolio reversion aided and abetted by a significant development programme which is over 80% pre-let. While the equity market has been focused on the fact that the initial yield on the portfolio is below its most recent cost of funding, I’d rather focus on the fact that the portfolio’s equivalent yield, ie, after capturing the in-built portfolio reversion, is just above the current funding cost for a Grade A rated company – and the fact that the group is getting a yield on cost of over 7% on its development programme.
As I’ve been heard to say elsewhere, if the sector is going down this year, then it’s going down fighting, that’s for sure!
