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Comment: Are capital values nearing the bottom?


New Star property fund manager Marcus Langlands Pierce reflects on British Land’s report last week and what it means for UK commercial property investors.

New Star property fund manager Marcus Langlands Pierce reflects on British Land’s report last week and what it means for UK commercial property investors.

British Land’s update on February 7 was fairly well received, although many commentators chose to focus on the cut in its portfolio valuation for the final three months of 2007. We believe that the figures need to be taken into context. Firstly, the key point to remember is that they reflect historic information.

Everyone already accepts that the credit crunch is a fact; the expansion of yields across property is a fact; as is the subsequent weaker pricing across the sector. A bigger surprise would have been if British Land had not reduced the value of its portfolio, when clearly its share price, that of its rivals and the net asset values of property funds were saying something altogether different.

The interesting part of the report is the outlook. Investors in property have already taken a hit to their wealth in 2007 and they want to know what the future holds for them. In this regard the fairly upbeat outlook from British Land is reassuring. Chris Gibson-Smith, the company’s chairman, went as far as to say that while there may still be some declines, ‘the worst should now be behind us’. His comment on the attractiveness of rents was similarly illuminating: ‘The exceptional quality of prime property cash flow is again representing clear value.’

Property offers an increasingly attractive income…
It is clear that the rental income from property is looking increasingly attractive. The initial yield on commercial property – what property is paying today in rents – was 5.19 per cent at the end of December, according to Investment Property Databank, but we expect the January figure from IPD to be even higher if capital values have slipped further.

The average yield on the direct property within the New Star UK Property Unit Trust was 5.78 per cent at the end of January. This is an attractive level of income and beats the dividend yield on the FTSE All-Share (3.33 per cent as of January 31) and the yield on the benchmark 10-year gilt (4.47 per cent).

Cash may offer protection against capital falls ,but the income levels generated by cash are trending south. The Bank of England’s decision on Thursday to cut the bank rate to 5.25 per cent represents the second of potentially several rate reductions that are expected to lead to increasingly poor returns for cash savers. We anticipate property yields well above 5 per cent to look increasingly attractive as 2008 progresses.

…and is relatively secure
A useful feature of commercial property is that rental payments tend to be quite secure, particularly if the properties held are high quality with solid tenants on long-term leases, as is the case with the UK Property Unit Trust. In more challenging economic times, companies are far more likely to cut their dividend payments than forego their rent and risk losing their premises.

As to corporate bonds, if a company defaults on its payment it may not be so easy getting the money back even if you are toward the front of the queue of creditors. With commercial property, if a tenant defaults you are not left holding a paper claim on an asset, rather you have a tangible asset in land, bricks and mortar that can usually be re-let.

With the average lease length weighted by income excluding breaks on the UK Property Unit Trust at 11.5 years, any recession would have to be exceptionally long and deep – akin to the 1930s depression – before it would seriously jeopardise the income of the fund.

But what about capital values – is that a repeat of 1990?
This is a valid concern and it is worth exploring the facts. First, what makes this period different from 1990 is the severity of the fall. It has been very swift, and we believe this should prevent it from being a protracted downturn.

Secondly, the monetary authorities are actively seeking to reflate the economy – they are not waging a war against high inflation. so interest rates are coming down in the US and the UK, not going up as in 1990. This is important because it means that financing costs are falling. In fact, five-year swap rates are now at 4.97 per cent (as of January 31), which is below the initial yield of 5.19 per cent on property and considerably below the 6.19 per cent equivalent yield, which takes prospective rent increases into account.

At these levels the mathematics of buying a property become very sensible, so it is no surprise that opportunistic property funds are emerging. The only problem is arranging the financing, since banks are still reluctant to lend. There is, however, increasing evidence of genuine interest in commercial property. Irish and German buyers are circling, and a Middle East consortium has confirmed its will to go ahead with the Shard of Glass development on the south bank of the Thames in central London.

Property outperformed in January – is this the bottom?
Eagle-eyed market watchers will already have noticed that quoted property companies outperformed the wider equity market in January. The FTSE Real Estate Total Return Index rose 4.79 per cent, against a fall of 8.67 per cent in the FTSE All-Share Total Return Index.

Anthony Bolton, the retiring fund manager, may perhaps be celebrating after suggesting real estate was one of his favoured sectors for 2008, but we would be cautious on calling the bottom of the market. One month’s performance, like the proverbial swallow, does not a summer make.

We stated in our outlook for 2008 that we expected a challenging market in the early part of the year and an improvement in the second half of 2008, and we stand by that view. There are still some potential hurdles for commercial property in the coming weeks, not least a number of leveraged funds that are close to breaching loan-to-value covenants.

Happily, this is not a concern for investors in the New Star UK Property Unit Trust, since all the properties held were bought outright with no borrowing. Some of the leveraged funds may, however, be forced sellers and this could weigh on sentiment in the near term.

Secondly, some of the headline data may make for uncomfortable reading. We are not too concerned by further declines in the Investment Property Databank index in the next few months; in fact we fully expect them. It has been clear for some months that the index has been playing catch-up with real world events.

In December 2007 valuers marked down the direct property within the UK Property Unit Trust by 8.20 per cent. This compares with a fall in capital values of 4.17 per cent in the IPD. As such, in January the valuers for the UK Property Unit Trust marked down the direct property in the fund by only 0.80 per cent. We expect the January IPD figure to be considerably worse and for this to be a feature of the next few months.

The IPD figures may provide fodder for newspaper headlines, but the reality is that the forthcoming figures are already largely priced into the net asset value of the UK Property Unit Trust. We believe the impact on the valuations of the direct property in the fund should therefore be minimal.

So is there value in commercial property?
Following the correction in values, commercial property is in our opinion exhibiting the strongest fundamentals of the three main asset classes – sensible valuations, high income yields, the potential for income to grow, and the reassurance of owning a tangible asset.

There may be a few temporary setbacks in the coming months, but we anticipate capital values to be nearing the bottom. For commercial property to fall considerably further from here would take a full-blown recession, the consequences of which are likely to be felt even more severely on the equity markets.

We have always stated that property provides useful diversification for a portfolio and its relatively strong performance in recent weeks against a background of volatility and weakness in the equity markets underscores this claim. Investors should recall the fundamental benefits of commercial property – namely an asset with a relatively secure and growing income stream that provides a platform for potential capital growth over the medium to long term.

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