Chaos in Washington and dollar weakness, combined with the Macron win, has had a major impact on markets. For a sterling investor, the global real estate sector is flat YTD, but the Americas is down 6% compared to Europe up over 8% including the UK up c. 7%. But the UK sector performance has been credible in spite of on-going Brexit concerns and only slightly underperforming the All Share up 7.5%. Results from British Land and Land Securities have been robust, particularly from Lands which is demonstrating good earnings growth even though it has been selling non-core assets and reducing its development exposure while remaining debt neutral ahead of an anticipated change in the demand-supply dynamic in the London market. Meanwhile, capital markets have been open with IPOs and equity issuance back on, including a PRS REIT, and more issuance from the Tritax paper machine. And for a dollar investor, the performance has been enhanced, with the UK showing a total return of over 12% YTD. The perennial bears of the UK sector must be feeling a touch uncomfortable!
London: a two-tier market
The London office market is proving resilient. The vacancy rate is gradually rising (4.7%) but the development pipeline keeps being deferred and the wave of potential new schemes which was concerning Rob Noel (CEO of Land Secs) two years ago keeps being pushed back (7msf deferred to date). However, a two tier market is emerging as the amount of second-hand space available increases and the weakness in Grade B space rents starts to come through. This has several implications; developers of good quality space at mid-market rents (Derwent and GPE lead the way) should continue to let space and see their development pipelines achieve good surpluses and profits, but investors in secondary assets with shorter leases and smaller suites may see values steadily decline, particularly in the City. As the investment banks start to relocate EU deal-makers to Paris and Frankfurt, the impact will become more significant. The question is whether this will provide an investment opportunity in repositioning Grade B into Grade A? I believe so, but I suspect the market leaders are happy to remain patient.
At the same time, WeWork and others have made a major splash in the London market and even though they will not be immune to softer demand, they are well positioned for the structural changes taking place in office markets around the world. Many smaller businesses, and in particular the creatives which need to be mobile, now see co-working environments as standard and in some cases mission critical. This could have a negative impact on the traditional small suite office market and multi-let secondary offices could see meaningful obsolescence. And it is very interesting to see British Land dip a toe into the flex-space market with 80,000sf being prepared, and another 80,000sf earmarked. The issue BL faces is how to compete efficiently given they have few economies of scale in serviced offices and no global co-working network. Investors worry this new venture will require investment in services while having to live with shorter income streams from this space. The concerns may be overdone, and I can see why an element of co-working space can be highly desirable and productive either for a large multi-let office or a campus-style office environment. The other aspect to co-working space which surprised me when I ‘door-stepped’ several operators last year is the high percentage of multinationals taking flexible space. It isn’t just SMEs.
Retail: a new (old) threat
Just as retail landlords are coming to terms with internet sales and how to position their portfolios for the seismic change towards on-line shopping and distribution via logistics, they have a new threat to deal with: inflation. We have seen all the big mall REITs around the world (SPG, General Growth, Westfield, Unibail and others) make radical changes to their portfolios in anticipation of the growth in e-tailing and decline in any retail asset which lacks dominance and experience. Land Securities has made huge changes to its mall portfolio in the last 3 years, and only just in time, improving the quality and its orientation towards entertaining the shopper with a strong leisure offer. But even the best UK retail portfolios will struggle as the effects of inflation start to bite. Thankfully the oil price has not worsened the situation, but just the impact on food prices for example (and I mean Pret, not Sexy Fish!) will affect discretionary spend, and this is before any interest rate increases.
For investors who believe property is a good hedge against inflation, think again! During periods of rising inflation, bond yield tends to rise and in the near term destroy value in the sector. It can take several years for inflation to come through into rental growth and rent reviews.
Alternatives: the new core
The concern for the UK listed sector is that a high percentage (around two thirds) of underlying exposure relates to traditional office and retail, much of which face challenges to prospective returns, and I fear in the case of retail this will remain the case long term. Thankfully the UK has always enjoyed a strong mid-cap sector where entrepreneurs can raise capital for the new and winning property trends. In recent years we have seen billions pour into student accommodation (Unite), self storage (Big Yellow, Safestore), primary care (PHP, Assura), and more recently logistics (Segro, LondonMetric and Tritax). And now we are seeing the first new private sector (PRS REIT) and social housing (Civitas) REITs launched, orientated to income investors and their thirst for yield. I worry in some cases the quality of IPOs is mixed, and the aggressive use of private client brokers who surely are not resourced to do thorough DD, but if dividend cover can be achieved with modest leverage then I am hopeful more capital will find its way into alternative asset class REITs.
The other advantage of new REITs is their ability to create businesses free of legacy assets, legacy debt and legacy cost structures. BL announced an £8m reduction in its admin for last year, but unless the major REITs can set out a compelling investment case of shrewd capital allocation and added value, they will have to refocus towards income rather than total return, and with higher earnings and payouts should come lower volatility and better share ratings. Tactically I am happy to be underweight retail, underweight the majors, but selectively overweight mid-caps with income focus, modest leverage, and managements who can add value in businesses free of legacy bear traps!
