Marcus Phayre-Mudge of BMO and Adrian Elwood of Clerkenwell Capital tells Property Chronicle that there are plenty of alternatives to back beyond shopping
Investors in listed European property companies may feel at a disadvantage. A significant part of their possible universe of investments is retail, particularly on the continent, at a time when that sector is struggling.
“A secular revolution has been augmented by a cyclical downturn driven by consumer behaviour. We are accelerating in the move from buying through physical stores to buying online,” says Marcus Phayre-Mudge, fund manager of TR Property Investment Trust, which has £1.3bn of net assets.
He says physical sales are flat at a time when online sales, which already make up 17% of total retail sales, are growing between 10% and 15% annually. Recent Christmas trading confirmed these trends, already well advanced in the UK, are set to advance across the continent too.
“Things are going to get materially worse as UK consumers pull back,” he says. “His or her house is not going up in value anymore. There is some nominal wage inflation but not real wage inflation. Stuff is getting more expensive as sterling depreciates amid insecurity regarding Brexit.
“That is going to have an impact on consumer behaviour. Retailers are trying to restructure their businesses but they are faced with a cyclical downturn at the same time.”
By necessity Phayre-Mudge’s portfolio of European listed property companies has a fair proportion of companies with retail exposure such as shopping centre owners Unibail-Rodamco-Westfield and Hammerson as well as Carnaby Street owner Shaftesbury and Land Securities, which owns Bluewater.
How these and others cope with the retail revolution will have an impact on TR Property Investment Trust and other investors in the listed sector, such as the Clerkenwell Matterhorn Fund, managed by Adrian Elwood.
“Retailers have reached a tipping point after a period of managed decline for a decade. Companies that have adapted have done OK. Everyone else is being really badly found out as people with a long tail of shops can’t get out of them fast enough,” he says.
“The problem that we have as investors in the listed sector is the importance of this part of this retail market to us. Shopping centre operators have played a get out of jail free card by expanding into food and leisure but now those areas are struggling too.”
LOOKING AHEAD
The stock market has sold off these companies on fears their valuations will drop as overall yields from these buildings rise and prices decline. The Royal Institution of Chartered Surveyors has recently urged those valuing retail portfolios to consider their future potential and not just rely on historic transactions.
“The certainty of that income stream has disappeared. Today on the market a very large supermarket in a good location will sell for a record yield as it is RPI secured, deemed internet-proof and the bond curve has dropped. But a sub regional supermarket, which is not part of the online fulfilment structure, may close and so valuation becomes uncertain,” says Phaye-Mudge, who does not believe valuations have bottomed out for retail yet.
Elwood agrees. “Everyone is underweight as much as they are allowed to be. The marginal trader is probably a short seller and no one wants to take the other side of that trade. We will not see that change until shopping centres are freely traded and that will require a cut in values, probably a substantial one.”
“Transactional evidence is crucial,” says Phayre-Mudge. “Neither of us thinks shopping centres will go dark but tenants will pay less rent. The real crime of Hammerson and [fellow shopping centre owner] Intu was increasing leverage in the face of the last few years as online became an emerging threat.
“They should have hunkered down but the temptation was to buy more sites and gear up to increase earnings, until the roadrunner shot off the end of the cliff. This was a very blunt and unintelligent response to the market.”
The issue came to a head last year when Unibail-Rodamco merged with Westfield but Hammerson pulled out of a bid for UK rival Intu, who then failed to complete an alternative sale to major shareholder John Whittaker backed by Canadian group Brookfield and Saudi investor Olyan. Earlier Hammerson had, last April, rejected a tentative approach from French rival Klepierre.
“Shareholders voted with their feet regarding Hammerson’s merger with Intu. Leverage would have been higher. The board of Hammerson must be feeling quite uncomfortable about pushing Klepierre away when they did,” says Phayre-Mudge.
The story is the same in Europe. Since the Westfield deal was completed, Unibail-Rodamco’s shares have been hit hard and are trading at a discount for the first time ever. However, the retail woe has at the same time led to a logistics bonanza.
“Looking at the other side of the coin there are benefits in logistics and urban industrial markets. Sheds are the new shops,” he says.
Elwood agrees. “We need 10 million more square feet every year more or less forever to accommodate this shift online. That’s a positive trend.”
BIG BOXES
One company that has played this trend well is Tritax Big Box, a REIT which is now valued at over £2 billion.
It has just agreed to buy db Symmetry, an owner of 2,500 acres of land earmarked for development into warehouses, for £370m. This is being funded partly by a £250m placing and open offer at 130p a share, a discount to both the share price recently and the last net asset value per share of 143.75p.
Phayre-Mudge has taken up the offer and backs the plan to move into development. “It’s a great area but you need to try and source it out of the listed space. Previously Tritax have paid the developer’s profit to someone else but now they are buying land, getting planning and building the big boxes themselves. Yields on the finished product have gone as low as they can go.”
Elwood is also a supporter of the company. “Tritax can now take on development risk. Before it was not appropriate. The dividend yield on the stock is nearly 5% and growing. What is not to like?”
Both say the emergence of such a focused player so quickly puts the old warhorses of the UK listed property sector, British Land and Landsec, to shame by making their policy of sticking to retail and London offices seem distinctly pedestrian.
“The boards of British Land and Landsec should be asking: how did Tritax create this business and company under our noses? What were we doing? Obsessing with competing with each other,” says Phayre-Mudge.
“They stayed in their tramlines while others have emerged under them,” says Elwood.
Phayre-Mudge says such conglomerates should take a lesson from the US market, where most REITs are specialised, focusing on a particular asset class and sometimes relatively small geographic locations.
Elwood is also encouraged by the development of specialist REITs alongside the two UK diversified majors.
“I’ve seen a number of real estate cycles and what you tended to get by the end of each cycle is a group of emergent new companies – like the developer traders of the 1980s, which challenge Landsec and British Land but then disappear in the subsequent downturn,” he says.
“This time the sector is more robust. Segro is now the biggest listed company, by market cap, reflecting the growth in the distribution sector. Retail is getting smaller and there are lots of specialist companies like Tritax, Unite, Workspace and Big Yellow which have grown rapidly but remain moderately geared.”
Across the sector leverage has dropped. “Shareholders have decided if you need higher leverage than something else may be wrong with the business,” says Phayre-Mudge, adding that Europe was quicker to adjust gearing levels after the crisis, by refinancing at lower rates more quickly than UK companies.
LOWER LEVERAGE
Overall bank lending has dropped significantly in recent years for central London property, he notes.
“It is interesting how little speculative office development there has been in London. None of the last three major towers built in London – the Shard, Walkie Talkie and Cheesegrater – used any external bank finance,” he says.
That indicates banks are not that willing to lend on speculative developments. Phayre-Mudge says some parts of Europe are more active, such as Stockholm and Germany’s six biggest cities. “Rents have never really grown in Germany but we are starting to see that.”
Landlords are responding by making leases shorter and more flexible. That trend does not concern Phayre-Mudge. “If you have the right building in the right place you can be confident of reletting it and maintaining earnings. You are now closer to the performance of the building. In the past “you let and forgot”.”
Elwood says the trend for flexibility emerged after the financial crisis as leaner businesses started up in the technology and other sectors. “We have been far too focused on financials services but it has barely grown since 2008. Facebook and their ilk have taken enormous amounts of space in London and continue to do so post the Brexit vote.”
Phayre-Mudge says a disorderly Brexit would hit the London office market but more so in the medium term. “London is very international. But the banks have indicated while they may move capital to the EU not many bodies will move at first.”
Lack of residential property might also put employers off moving staff away from the UK too, reckons Elwood. “London is not the only place with a housing crisis by any means,” he says noting that Dublin is also very crowded after an influx of multinationals employing people there.
Both see potential for institutional investors to become more widely involved in the private residential sector.
“Housing stock in the UK is valued at £7 trillion but at the moment most of the open market rented stock is owned by buy-to-let mom-and-pop landlords, who are being discouraged by tax changes. The build-to-rent sector could grow substantially over the next cycle,” says Ellwood.
“German residential REITs Deutsche Wohnen and Vonovia barely existed ten years ago. Why can’t we have them here in the UK too?”
Phayre-Mudge singles out PRS REIT as an “exciting” prospect since it is building houses rather than flats. “These are less volatile market with single family units where tenants stay in one place for some time.”
Overall, investors in listed real estate have plenty of alternatives to back beyond the retail gloom.
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Marcus Phayre-Mudge has been managing TR Property Investment Trust since 2011 and is a partner at Thames River Capital, now part of BMO Global Asset Management.
Adrian Elwoodestablished the Clerkenwell Matterhorn Fund in September 2012. It has an absolute return mandate across the European listed real estate market.
What are the chances of Jeremy Corbyn becoming prime minister?
Phayre-Mudge: 10%
Elwood: 10%
What are the chances of more quantitative easing coming in?
Phayre-Mudge: 75%
Elwood: 75%
Where will the Bank of England base rate be in a year?
Phayre-Mudge: flat
Elwood: lower
Where will cable (sterling-US dollar) be in a year?
Phayre-Mudge: flat
Elwood: sterling will strengthen
Will Donald Trump be re-elected as US president?
Phayre-Mudge: Yes
Elwood: No
Will a member of the euro leave the single currency?
Phayre-Mudge: No
Elwood: No
Will London be bigger, smaller or the same in 10 years?
Phayre-Mudge: Bigger
Elwood: Bigger
Is Mike Ashley right, wrong or mad?
Phayre-Mudge: Right at the right price
Elwood: He is an opportunist
