Shareholders in Britain’s commercial property stocks got some good news last week.
Several landlords have just reported on their recent progress. Market values for their properties have climbed over the last six months.
That means the asset-backing behind their shares has improved. So shareholders can look forward to higher dividend payments, too.
So should commercial property shares now be part of your portfolio? Or are there better bets elsewhere?
Commercial property has rallied since the crash
The UK’s commercial property market – offices, warehouses and shops – has been a disaster zone for most investors in the last four years.
The recession has knocked the stuffing out of building values, which have plunged by more than a third from their mid-2007 highs. And the share prices of stock market-quoted real estate investment trusts (Reits) have done a great deal worse.
In January 2007, most of Britain’s major commercial property firms converted into Reits for tax reasons. Since then, shareholders have lost almost two-thirds of their money. Indeed, on balance, investors in the sector have made no capital gains since 1993.
However, over the last two years, the price of commercial bricks and mortar has picked up a bit. Average values in the sector have climbed almost 18% since their summer-2009 lows. Some areas, like central London office space, have enjoyed a purple patch. That’s why those property companies were able to report their good news.
But before you pile into Reits, a word of warning. This is about as good as it’s going to get for the sector.
The slowing economy will hit the prices of offices and shops
The pick-up in prices is losing steam fast. The last quarter saw the smallest climb in overall values since the recovery began. Over the last year, capital growth has slowed to an annual rate of just 1.7%.
And the outlook is deteriorating. Even the landlords whose estates have just increased in value sound pretty cagey.
Land Securities (LSE: LAND) is Britain’s largest listed Reit. It saw a 4% rise in its net asset value (NAV) over the six months to the end of September. But the company is worried about consumer spending – or to be more precise, the lack of it.
Why? Most UK store operators don’t own their shops: they lease them. So their landlords’ incomes depend on the ability of these tenants to pay the rent on time. If the country’s retailers are struggling to make enough sales to do this, property owners will also suffer.
The problem now is that Britons’ pay packets aren’t keeping pace with inflation. Consumers are spending more on the likes of food and fuel; that means they have less money to spend on everything else.
As a result, it’s likely that more retailers will go bust. That would hit rent receipts. With 45% of Land Securities’ portfolio in retail property, no wonder it’s worried.
On top of that, shops – along with other commercial buildings – are valued on what they earn in rent. If the latter shrinks, their valuations drop.
But what about the sector’s recent bright spot, central London?
One of the largest landlords here is Great Portland Estates (LSE: GPOR). Last week it also reported a slight rise in its NAV. But once again there was a sting in the tail.
Economic conditions and business sentiment have got worse since the summer, says the company. That means some firms are reining in expansion plans and are no longer looking for new office space. The fall in demand is putting downward pressure on rents.
The company pins part of the blame for this on the European sovereign debt crisis, which is undermining business confidence. But the net result will be the same as a retailer shakeout.
As Great Portland puts it, “secondary and overpriced assets [would] see a price correction as buyers become more discerning”. In simple terms, it’s another reason for property values to drop.
‘The cuts’ will take their toll on commercial property prices
This is all bad enough news. But there’s more. Banks are shedding staff, which will mean they’ll need less space. In addition, the full effect of government cutbacks hasn’t hit home yet. A drop in the number of civil servants will mean the state also needs fewer workplaces.
Sure, the public sector probably accounts for less than 10% of central London occupied office space. But as Kelvin Davidson of Capital Economics points out, “the cuts still to come could boost the Central London vacancy rate by up to 2%”.
It doesn’t sound like much, but we’re talking about a finely balanced market here. So even a 2% rise in available space could be enough to tip the balance and send rents down much further. “We expect renewed falls of about 5% in City and West End office rents, perhaps by 2012”, says Davidson.
And if even London is hit this hard, other parts of the country could suffer even more. As Davidson also notes, “regions such as the north east and south west appear much more exposed to the rationalisation of public sector office leases than London”.
Add it all up, and the impact on UK rents and property valuations could be quite nasty. Reit share prices have been falling somewhat faster than the overall market recently. This underperformance looks set to continue – we’d steer well clear of the sector.
But I’d like to end with a share that is worth holding. Last week life assurer Resolution (LSE: RSL) also reported on progress. It’s a company we’ve written about before, and all seems to be going according to plan.
The really good bit of news for shareholders was this: Resolution confirmed that the final dividend should be raised by 6.7%. That lifts the prospective yield for 2011 to an inflation-busting 7.2%. For income seekers, that has to be a good deal.
Category: Economics