08:30 Mon 08 Feb 2010
Charles Cade: Where to find the re-rating opportunities in listed property
Last year was a volatile period for both direct property and listed property fund valuations in the UK. In Q1 2009, a combination of declining capital values, rental income and high gearing resulted in falling dividends and wide discounts to net asset values (NAV) among property investment companies (PICs). However, Q2 saw a dramatic turnaround in sentiment towards the asset class. With interest rates at historic lows, investors were attracted by the high yields and cyclically low valuations.
Real estate specialist CBRE reported a 3.3% capital value increase in its UK commercial property index in December, the largest monthly move in its history. The rise since mid-2009 was 10.3%, with the strongest growth being in retail warehouses and central London offices. This reversed most of the falls in H1 2009 and capital values fell by just 2.1% over the year as a whole, with a total return of 4.0% including rental income.
Strong demand from overseas investors and renewed flows of money into UK property funds have been the key drivers of the recovery, with limited availability of good quality assets to buy. Looking forward, we expect UK property values to continue to rise moderately in Q1. However, we feel this is already reflected in PICs' share prices, which rallied by 64% on average in 2009.
Much of this performance was driven by a re-rating, and average discounts to NAV of the PICs narrowed from 50% in January to an average premium of 11% in December. In part, this reflects a lag in published NAVs, though factoring in expected NAV growth for Q4, we estimate the sector still trades on an average premium of about 2.5%.
To some extent this premium can be justified by positive capital value growth and a relatively attractive dividend yield. The sector currently yields 7% on average with varying levels of cover. However, we believe that fund managers will seek to take advantage of premiums by issuing new stock, thereby limiting further share price upside. For instance, UK commercial property is currently seeking to raise up to £150 million through a secondary issue.
While the near-term environment appears supportive, we believe that there is a risk of correction in H2 2010. An uncertain economic backdrop, structural issues in the debt market and rising voids remain real issues for the sector. The UK economy has been boosted by low interest rates and quantitative easing, but we are concerned about the impact of any tightening in monetary policy on an already fragile occupier market.
Coupled with a potential increase in the supply of assets coming on to the market from banks, this could lead to a correction in values in H2. Over the medium term, we prefer funds with relatively healthy dividend cover, such as Standard Life Property Income and ING UK Real Estate Income, or strong income enhancing prospects, such as UK Commercial Property.
Charles Cade is head of investment company research at Numis.
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