The UK results season for the March year ends has not generated much investor interest – to the extent a frustrated senior equity fund manager confronted me as I walked past Mortons demanding ‘where are the Emerging Majors?!’ He was referring to an equity research note published over 20 years ago which set out the thesis that the UK Majors were ex-growth but that the Sector could offer excellent returns by investing in a select group of Mid-Caps which had outstanding managements, growth assets, strong pipelines, combined with robust finances. The list comprised Argent, Burford, Chelsfield, Frogmore and Pillar, while Core Smaller caps included Derwent, St Modwen and Shaftesbury. In hindsight, most were successful (some spectacular!) investments but not many are still listed!
The UK Majors today, with the obvious exception of Segro, suffer from legacy assets, and in particular disruption to retail markets, and legacy debt. They are of a scale where it is almost impossible for asset level activity to ‘move the needle’, but unable to fully capitalise on economies of scale. Segro’s leadership position in logistics one could argue is also a legacy, but it has taken full advantage of it’s good fortune and, in hindsight, the late Ian Coull’s acquisition of Brixton was one of the deals of the decade – buying ‘last mile’ assets around London on an effective yield of 9% off rental lows.
To be fair to the Majors much has improved, in particular the quality of the retail assets, and over time the average cost of debt has come down, and the importance of earnings and dividends in a REIT world is now recognised, while at the same time LTVs have reduced. But these improvements have been slow for investors who now face a period where yield compression is over and rental growth in retail and London offices is largely absent, while added value opportunities for the larger companies are hard to secure without taking excessive risk.
Thankfully the UK is still rich with entrepreneurial talent; the Emerging Majors of today have less development exposure than those of 20 years ago, but they do have opportunities to add value and grow earnings with modest leverage. In student accommodation Unite has a leadership position, in self storage investors have a choice of Big Yellow and Safestore, and in primary care PHP and Assura are both well placed. In logistics, LondonMetric has a more value-add model than Tritax Big Box but both have investor appeal. And in London investors have a choice in Derwent London, Shaftesbury, GPE and Workspace – although it remains to be seen to what extent flexible workspace is both an opportunity and a threat. In addition, Secure Income REIT offers an income play on leisure and healthcare assets; and there are more stocks one could add to the list including Urban & Civic (strategic land), St Modwen (regeneration) and Grainger (transitioning from a Regulated to a PRS play). The combined market caps of these mid-cap stocks exceeds the market caps of the four retail/office majors, highlighting how the composition of the sector is materially changing.
British Land is clearly trying to find new sources of growth, for example the move into flexible workspace is interesting, although there remains a lack of detail – achieving rents at 48% premiums to ERV has little impact without numbers on additional capex and operational costs, together with estimates for tenant turnover, expected voids and depreciation, Perhaps BL is being coy due to commercial sensitivity, or simply being cautious as ‘Storey’ is still in start-up (both understandable reasons), but investors will want to know the operational metrics sooner rather than later, particularly now the losses at Wework are publicly available in their bond prospectus. The most interesting aspect of the BL results came in Q&A when it emerged that BTR/PRS could represent 10%-15% of the business in 5 years time. This was a revelation, but also lacking in guidance on prospective returns.
Meanwhile, the UK sector performance YTD (+1.5% total return) has been resilient in spite of bond market volatility, economic uncertainty and the structural challenges in core real estate sectors. This is partly down to the growth of the Mid-Caps above, and partly due to a growing perception of a ‘Soft Brexit’. Importantly we are not seeing material new supply coming through (in contrast to the US) – for example the London office specialists point to potential shortages of Grade A office space from 2020 onwards so that, providing tenant demand remains close to average take-up levels, the developers of quality space should make reasonable returns in spite of the lack of value in the investment market. Indeed perhaps the most significant statement in the results season came from Landsecs who will consider building spec from April next year once Brexit and the London office cycle are hopefully clearer! But in contrast it would appear (more or less) business as usual for the Emerging Majors.
