Commercial property has become an important part of investor portfolios over the last few years. At the turn
of the millennium the average pension fund had around a 5% exposure. In more recent years that figure is
closer to 10%.¹
It’s easy to see why the asset has been seen as attractive. Rents are often linked to inflation, which is
useful for long-term investors. Property provides income, which has become valuable as interest rates
have fallen. The combination of lower interest rates and increasing rental income has led to strong returns
for the sector. What’s more, this has been achieved at lower volatility than the market as a whole.
RENT’S DUE
The COVID-19 pandemic and accompanying lockdowns have made things tough for many “physical”
businesses, and are putting landlords under pressure. Several businesses have gone into administration.
Businesses are engaging with landlords to reduce rents, as evidenced by Company Voluntary Agreements
(CVAs). Even tenants that are fairly well positioned will be seeing this as an opportunity to reduce rental
outlays.
Rent collections usually happen a week before the start of the quarter. The data for Q2 was bad. The
numbers for Q3 were even worse. 24 June marked the rent collection day for the quarter to 30 September.
We saw a slew of data releases from Real Estate Investment Trusts (REITS) showing what the collections
looked like:
- British land – 88% of office rents and 36% of retail²
- Land Securities –81% for offices and 29% for retail³
- Hammerson – 16% of rents, from a predominantly retail portfolio4
This data focusses on the office and retail sub-sectors – which make up the majority of UK commercial
property – and what we are seeing is that conditions in the sector are very tough.
VALUATIONS LOOK INEXPENSIVE, BUT DON’T TELL THE WHOLE STORY
From a traditional valuation standpoint, things may look quite attractive. In the UK, British Land and Land
Securities trade around half of their price to book ratio. Hammerson is valued at 0.2 its book value.
However, we believe these valuations are somewhat misleading.
To assess valuations, we first look at the company’s assets, which are completed properties, properties
under development, stakes in joint ventures, and cash. Then we deduct the debts and other liabilities, and
make adjustments for intangible assets. That gives us a net asset value, or book value per share.
This data used to value companies has become much less reliable. The first place one might look at when
assessing a property is comparable transactions. However, transaction volumes have slowed dramatically.
Another method would be to estimate the rental value of a property, then use discounted cash flow analysis
to value the property. With lots of void periods, CVAs and uncertainty around appropriate discount rates
these methods are a lot less reliable.
Some open-ended property funds have had to halt redemptions due to valuation uncertainty and the lack of
transactions causing problems with liquidity. In closed ended structures – like REITS – there are material
uncertainties in the valuation of properties.
Share prices are also indicative of the potential for financial distress in the sector. REITs are less leveraged
than they were coming in to the great financial crisis of 2006/2007. For example, British Land had a debt to
equity ratio of 47% in 2007 versus 28% in 2019.
5 Debt holders expect management teams to adhere to a
range of financial covenants. Leverage covenants – e.g. loan-to-value – could be challenged by falling
valuations. Interest coverage covenants – e.g. can you pay debt interest from cash flow – may be
challenged by poor rent collections.
WE KNOW CHANGE IS COMING – BUT WHAT KIND OF CHANGE MATTERS
We believe COVID-19 will prove transitory, and that the economy will recover. Commercial property is a
heterogeneous sector and investors have to be selective. We expect that some sectors of the commercial
property market will have a quicker recovery than others, while some areas will see long-term changes.
When investing long term, the most important question we ask is: “Are the changes we are seeing acute,
cyclical or structural?
- Acute – do they only relate to COVID-19?
- Cyclical – do they follow the wider economy? Will it reverse once the economy gets back on track
- Structural – do they represent a long-term shift in the allocation of society’s productive resources?
In retail, we see a high probability that this is a structural change which will remain a headwind. Physical
retail was already facing competition from online retail before we came in to this crisis. We think the
digitalisation of retail sales has been accelerated by COVID-19. For online retail, this is a self-reinforcing
virtuous circle; as route densities improve, logistics costs per unit drop and improve competitive advantage.
In offices, we have become more cautious as we see a reasonable chance that there are negative
structural elements at play. A significant proportion of the professional services world, which accounts for a
large proportion of office lettings, is able to work remotely whilst maintaining productivity. Office costs are
not the biggest line item in most businesses’ operating costs, but the exogenous shock of COVID-19 may
well act as a catalyst for more working from home. All other things being equal, this would result in a
reduction in demand for office space, and lead to lower pricing power. Before COVID-19 we saw the
benefits of offices – particularly London West End and City – due to a structural undersupply of large
spaces desired by big firms. We’re now less certain that these owners/developers will have this pricing
power. One positive for offices is that they typically have long leases (10 years+).
We believe industrials will probably see cyclical reductions in demand, but once the economy gets firing
again we expect this segment to come back. We expect the biggest beneficiary of COVID-19 to be
logistics. Warehouses on the edge of major population centres are likely to be in demand. The supply of
land for new warehouses is constrained and we think that the acceleration towards online retail will
generate pricing power for these assets.
We believe student property is a heterogeneous sector. We see opportunities in segments such as
student living, particularly for properties attached to the largest universities.
IN SUMMARY
Commercial property is changing, and our view is that investors have to be more selective. We look for
specialist names on what we consider to be the right side of big structural trends, rather than hunting for a
bounce in deep value territory.
For those clients who have access to My Brown Shipley you can check your portfolio valuation online. If you
have any questions, please contact your usual Brown Shipley adviser.
Author
Jonathan Chitty //Equity Research Analyst
1 The Economist. “Investors’ love affair with commercial property is being tested.” 27th June 2020
2 British Land “British Land Operational Update.” 1 July 2020
3 Land Securities “Update on June Rent Collection.” 3 July 2020
4 Hammerson. “Debt, liquidity, and rent collection update.” 1 July 2020
5 Company data from Factset
