Get out of UK commercial property
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Associate Editor
David Stevenson Feb 01, 2010
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Last week brought great news for fans of offices, shops and warehouses.
Sales of UK commercial property doubled in 2009’s fourth quarter compared with the year before, according to Property Data (PD). Property funds snapped up £3.3bn of new assets in what was dubbed the “return of the institutions” by PD’s Mark Pickering. And 41% of buyers of British commercial bricks and mortar came from overseas.
So does this raft of stats mean UK commercial property has really turned the corner, and it’s time to pile back in? Actually, no it doesn’t...
Sell out of commercial property now
From mid-2007 to mid-2009, UK commercial property was a horror story. Prices plunged by almost 45%, according to the Investment Property Databank. But over the last six months, there’s been a near-10% rebound in average valuations. Investors are getting more confident about the sector, says the Investment Management Association. There’s bullish talk about City office rents rising again.
It’s not just investment types who are feeling perkier. Two weeks ago, Britain’s biggest property developer Land Securities said it was soon starting a £655m London West End building spree, which will include the largest Oxford St development in 40 years. It’s the first such scheme to be launched since the credit crunch kicked in.
That’s confidence for you. And at face value, it could all be enough to get you buying property stocks again.
But don’t. Much of the recent hubris may prove to be a false dawn. In fact, you should be selling out of commercial property right now, not buying in. Here’s why.
Consumers face a tough 2010
The institutions may be splashing their cash around, but consumers aren’t. Despite all the upbeat talk we heard from retailers about surging shop sales over the festive period, harsh reality has now hit.
UK high street sales fell at their fastest rate for five months in January, says the latest report from the Confederation of British Industry. And the gloom is set to stick around for ages. The survey “reinforces the heightened concerns over the strength and sustainability of the recovery”, says Howard Archer at IHS Global Insight. “Households face still very challenging conditions… high unemployment, low earnings growth, high debt levels, January’s VAT hike and the prospect of further fiscal tightening ahead that will very likely include further tax hikes”.
Whoever wins the election – another uncertainty – the huge hole in our state coffers will need re-filling. If we’re all paying more tax, we’ll have less to spend in the shops. Add in the prospect of higher interest rates as inflation rises, which we recently discussed in our free daily investment email, and ‘disposable’ incomes will be squeezed on several different fronts.
This will put more strain on already cash-strapped retailers. In many cases, it will push them closer to the financial brink.
These days, most property companies are called Reits (Real estate investment trusts). But having a different name doesn’t stop landlords such as Land Securities and its peers from being hurt if more of their tenants have trouble paying their rent bills in full. And tenant problems aren’t likely to be confined just to the retail sector.
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Why corporate bankruptcies are likely to keep rising
Last week there was a chilling warning from R3, the professional body of the insolvency brigade. The UK has just about, growing at a measly 0.1%, emerged from recession. You might think this would be good for commercial property values. But it’s more likely the reverse. R3 expects the number of companies going bust this year to jump by 23% compared to 2009. And corporate bankruptcies are likely to keep rising for a long time.
Why the rise? Because so far, many creditors haven’t pulled the plug on near-insolvent debtors, because they’d have recouped very little from a forced liquidation. But even a slight pick up in the economy would persuade creditors to get more aggressive about collecting the cash they’re owed. They’d now have a better chance of getting more of their money back, even if their debtors went bust.
If creditors start playing hardball, that’ll push more companies to the wall. And lots of tenants going bust would be bad news for landlords. Obviously, it would hurt their rental income stream. But on top of that, it would create more vacant office, shop and warehouse space. And when empty buildings aren’t earning income, their valuation in landlords’ books has to be reduced. So property companies’ net asset values (NAVs) get a haircut.
In addition, more damage is done to a Reit’s NAV if its properties are financed, even partly, by ‘gearing’. That’s just another term for buying buildings with borrowed money. And as anyone with a fair-sized home loan knows, the amount of equity in a house moves up and down much faster than property prices.
The Bank of England has basically been rigging the market
There is another factor that can push up property values – a drop in yields. If investors are prepared to accept a lower yield when they buy a building, it means – assuming the income stays the same – the price of that building will increase. It’s a key part of the property bulls’ case. They point out that the difference between property yields and gilt returns is higher than the long-run average. So they expect property yields to fall, driving up prices.
Trouble is, the reverse is also true. Rising yields mean property prices fall. And gilt yields are artificially low right now because the Bank of England has basically been rigging the market. As Tim Price puts it in his Price Report newsletter, “the government has butchered the price mechanism by effectively forcing the Bank of England to buy gilts direct from the Treasury – the process known as quantitative easing. The Bank has become the buyer of Gilts of both first and last resort, crowding out many institutional investors.” But when this price-fixing finishes, as it will very soon, gilt yields will rise again. So yields on higher-risk properties won’t look anything like as appealing. If they start climbing again, down will go property values.
All in all, not a pretty picture for commercial property – or the sector’s share prices. Yet the FTSE Reit index has almost doubled from its lows of early March last year, and has outperformed the overall market by 20% in the process.
If you still hold some Reits, now looks like a good time to sell them.
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