Real estate share prices have been implicitly forecasting property declines that are yet to materialise – what’s going on?

The most noticeable impact of the EU referendum in June 2016 upon the UK real estate sector has been the sharp contrast in demand (and as a result valuations) between the listed sector and the underlying assets themselves. 

The share prices of the leading UK REITs traded down 20–25% immediately on the announcement of the referendum result. While commercial property values (with the exception of Q3 2016) improved, and occupational demand for industrial and London office space remained robust, the sector languished. It still trades at discounts to underlying value (NAV) of 30% for office-based REITs and >50% for retail-based portfolios. 

This contrast in fortunes cannot be completely explained away by the decline in the value of sterling (making UK property assets more attractive to overseas investors) and the timing difference between forward-looking (ex-ante) share prices and backward-looking (ex-post) property valuations. 

Typically (as last witnessed in the global financial crisis of 2007–09) real estate share prices lead the change in movement of property values (both up and down) by six to nine months. Historically there have been longer lags of 12, even 18, months. This time round, however, share prices have been (implicitly) forecasting property value declines of 10–15% – which, for over two years, have failed to materialise. 

Does this signal the end of the connection between the public and private markets, and the usefulness of REITs as an implicit forecasting tool for real-estate valuations in the UK? I believe that the relationship still exists, but there are reasons why the lead/lag relationship has been both longer and more divergent.

Why was it different this time?

There are five factors in particular that added noise to the pricing signals from the listed market and distorted the accuracy of future property value predictions. These are:

• Increased short selling.A number of activist investors/hedge funds have taken (occasionally aggressive) short positions in UK REITs – thus exacerbating share price declines and valuation discrepancies. UK real estate stocks are (predominantly) exposed to UK assets, so have among the most ‘pure’ negative exposure to potential economic damage from Brexit. As a result, with a two-and-a-half-year (and counting) gap between the referendum result and any potential exit deal, the sector could offer little in the way of positive catalysts over that period, and has been an ideal hunting ground for short sellers. 
• The growth of passive funds.Passive funds (i.e. index funds and ETFs) now represent roughly the same percentage (~30%) of REIT shareholders as specialist real-estate investors, who actively manage their portfolios in accordance with their forecasts of the direct market. As passive funds have no interest in valuation – merely allocating according to inflows and outflows – valuation ranges of REITs can become more extended, mean-reversion becomes less powerful, and the disconnect between public and private real-estate pricing expands.
• The lack of public to private transactions.Historically, if there are significant discounts prevailing in the listed sector, private real estate market buyers (such as Brookfield) would acquire the listed companies as a way of getting hold of the underlying assets at a discount. However, because of the political and economic uncertainty surrounding a post-Brexit UK, credit and investment committees have been unwilling to underwrite these transactions – so the discounts have prevailed.
• Uncertainty over future rental income streams. During the global financial crisis the main concern was breaching banking covenants due to value falls rather than being unable to pay interest bills due to a loss of rental income. This time the well-documented woes of retailers have led to genuine concerns regarding the sustainability of cash flows on retail assets, while the largest takers of space in the office sector are (loss-making) serviced office companies taking advantage of rent-free periods. For a listed REIT – which has to pay out 90% of its taxable property rental income as dividends – if there is a concern that its dividend payout may be under review, there are extremely negative implications for the equity valuation.
• Property valuation lag.In the absence of transactions, valuers are often reluctant to mark down the value of assets as significantly as share prices might imply is necessary. This may change, particularly for retail assets.

In combination, these factors have led to a prolonged disconnect between the public and private markets, which are only likely to re-establish their relationship if, or when, the following occur:

• the economic and political certainty caused by Brexit ameliorates
• valuers start to mark down assets to reflect a genuine transactional clearing price 
• the noise from the equitymarket pricing signals begins to dissipate.