Property is a cyclical business. Occupational (tenant) demand is strongly correlated with economic growth and property development activity lags demand, usually causing an oversupply when demand is turning down. In the current cycle, however, developers have been very cautious and the supply pipeline is consequently very small. The risk and consequences of tenant default from liquidation or receivership (we are talking about office, retail and industrial occupiers) is, even in a recession, not as significant as might be imagined. Most property company portfolios are reasonably diversified and, even if a tenant does go into liquidation, only part of the investment value of the property is lost – the building reverts to the landlord. In that aspect, property investments could be argued to be more secure than (unsecured) corporate bonds or debt, but there is still the matter of the downside risk of the end value of the property.
From the 1960s to the early 1990s, there was a reverse yield gap (gilt yields were above property yields). Since then, the situation has been reversed, and gearing has enhanced not just returns but also cashflows. Property companies are normally highly geared, with a sector average of about 80% - but there is a wide range. Often the debt in property companies is fixed at historically high rates; a note to the balance sheet (as required by FRS13) shows the market value of the debt and arguably provides a fairer picture of the liability of the company than the balance sheet figure.
The equity market does not find very high levels of debt to be acceptable; gearing (debt over NAV) of 150% is perhaps considered to be a reasonable limit. Gearing, of course, exaggerates the performance of a company – causing it to be better when property values are rising, and poorer when they are falling. But private companies can secure bank debt to generate gearing of up to 300% (or even more). This is one of the facilitators for publicly-listed companies being taken private. With a rising property market over the last few years, a number of property have quit the quoted sector – causing it to shrink in numerical terms.
Contrary to popular belief, property values (and NAVs) are not very sensitive to interest rates. This is partially because instructions (who are the other large holders of commercial property) do not use debt financing and even the property companies have the majority of their debt at fixed rates. More importantly, however, it is because the main determinant of property values is rental value growth expectations. Interest rates are typically being raised when economic growth is strong (ie when rental values are rising) and that typically raises property values.
Unlike virtually every other sector, property companies are traditionally valued on the basis of their net asset values (NAV) and not on their earnings. This is because the growth in NAV encompasses both the retained earnings and the revaluation of the property assets, and the latter (which can be significant) does not flow through the profit and loss account. (A DCF is occasionally employed by some analysts, but this is not yet common.)
The pricing of the individual stocks is, consequently, at a discount or premium to NAV. There are a number of arguments that suggest the ‘natural’ level is at a discount – and, indeed, the historic average discount is around 16% - but there is a very strong correlation between historic/expected growth in NAV and the discount to NAV. The discount/premium changes dramatically over time – reflecting both relative interest in the sector and the property market performance prospects. Because of the greater liquidity of property stocks than property investments, company share prices normally lead property values.
The company’s quoted NAV/share (the normal measure of NAV) will often be different to the Balance Sheet NAV/share. This is a reflection of the different account treatments. In particular, some property (awaiting development or trading) will be shown in the Balance Sheet at cost, but revalued for the purposes of calculating the NAV/share. Conversely, most companies capitalise their interest on developments and revalue their developments in progress. Accounting treatments now vary much less between companies than previously.
Traditionally, the standard UK property lease was 25-years long; today 10 or 15 years is more typical. There are rent reviews every five years – to ‘open-market value’, with the important proviso that the rent cannot fall. This provides property with much of its defensive quality. A property in which the passing rent is below the market rent (prior to the next rent review) is said to be ‘reversionary’, and most property portfolios are currently reversionary. The effect of this is that rental income may rise (at reviews) even if the rental values are unchanged or are falling gently. A large or prolonged fall is, of course, the danger.
In normal times, property companies do not compete as fiercely as companies may do in other sectors – because properties have unique qualities and price is only one factor. But the barriers to entry (access to capital and expertise) are also low, and this has meant that the return on capital has also been low compared to other sectors. Under pressure from shareholders, and reflecting the yield gap investment advantage as well as the more subdued development cycle, there are strong reasons to suggest that this might be different in the future.