The UK listed sector provides clear discounts over NAV. This includes REITs but the most skilled REIT investors will also consider funds from operations. Robin Priest reports
Property is unique: there is no other asset class where investors can acquire interests both in public and private indirect vehicles and in assets directly. This diverse investment opportunity set gives rise to anomalies between the direct and indirect markets. The most intriguing of these is that UK listed property companies and funds have tended to trade at a discount to underlying net asset value (NAV). Can this anomaly be exploited as an investment opportunity as the direct UK property market continues to correct? Or is it simply an academic conundrum?
The Merrill Lynch (ML) Majors NAV Index and the ML Majors Price Index show that there have been only rare occasions between 1981 and today when UK property stocks traded at a premium to NAV (and generally a modest one): during 1987, 1994, 1998-99 and 2006. The widest discounts to NAV were seen in 1993, 2000, 2003 and at the beginning of 2008.
The premia and discount timings are interesting compared to what was happening in the direct investment market both immediately before and afterwards. Over the last 27 years, it has generally been the case in the UK that the listed market has reflected a discount to NAV. The received wisdom has been that this discount was primarily a function of the market penalising property companies for the tax leakage they suffered. The REIT regime has repaired the tax leak for 19 UK listed property companies; but they still suffer an NAV discount.
An alternative hypothesis is that the NAV discount is illusory: in fact the stock market
reacts more quickly (and more markedly because of the turbo-charge of sentiment) to movements in direct property prices than do valuations that, particularly in a rapidly moving market, are out of date by the time they are published. If this were always true, property shares would out-perform in a rising direct market and under-perform in a declining market. Historical observation does not support this conclusion.
It is instructive to compare the change in value of the FTSE 350 property stocks, adjusting for the movement of the general stock market, with direct investment values per the IPD UK Monthly Index (see figure 1). For much of the bull market of the last ten years, direct markets have often appeared to lead the listed sector. But over the 20-year history of the IPD Index, this listed market measure has presaged all the major direct market turning points with a lead time of between six and 12 months.
In 2006, the FTSE Property Index rose 48%. Direct market yields continued to tighten, occupier demand was strong and lenders readily provided finance at high LTVs. The IPD Index reflected a 15% total return. In early 2007, the listed sector began to fall and by year end the value of the UK listed sector had dropped by over 36%: the bubble had burst. In the same period, the direct market IPD Index fell only 13%.
Since January 2008, the UK listed sector has rallied modestly while the IPD Index has continued to fall - though at a reduced pace in the last two months. On the hypothesis that listed stocks in the UK provide approximately nine months' notice of significant shifts in value in direct markets, this implies a bottoming out of UK property values in Q4 2008.
The implication is that, at present prices in the listed sector overall, anticipate further falls in underlying NAV. This general conclusion masks differences between individual stocks. According to KBC Peel Hunt (at 31 March 2008) discounts to most recent reported NAVs range from 1% (Big Yellow) to 72% (Minerva).
Based on the KBC Peel Hunt data, for those companies with a market capitalisation in excess of £500m, the average share price NAV discount is 26%. Among the sub-£500m (€620m) market capitalisation stocks, the average discount jumps to 41%.
The broker's forward projection to the companies' next reporting dates shows a reduction in the anticipated average discount for the larger caps to 16% and for the sub-£500m caps to 32%. The larger companies currently showing discounts to historic NAVs in excess of 30% are Quintain, British Land, Brixton and Land Securities. The smaller caps list comprises Town Centre Securities, Warner, Minerva, Capital & Regional, CLS and MWB. Using the forward NAV projection, the majors list is shortened to Quintain and British Land but the smaller cap list remains the same.
A number of stocks - particularly the smaller caps - appear to offer good value. The derivatives market is pricing a further fall of some 15% in UK capital values by year end 2008. The implicit drop in values reflected in UK share prices is greater than this. This general conclusion is too pat, of course; great care needs to be taken in respect of individual stocks given the diverse nature of the companies' activities, the specific sub-sectors in which they invest and the date of the last independent valuation of their portfolios.
The UK listed REITs seem to be as prone to NAV discounts as the non-REITs. However, REITs in longer-established overseas markets tend to trade at or near NAV. Over the past 25 years, US REITs have traded at an average premium to NAV of 4%. Perversely, this may be because this measure is of secondary importance to many investors. The key US REIT performance indicator is ‘Funds From Operations' (FFO) which is a measure used by REITs to define cash flow from operations. Historically, where FFO grows, the REIT share price has seemed inclined to follow.
The majority of US REITs are seen primarily as running yield investments as opposed to the capital growth play emphasised by most UK REITs. The advantage of the FFO approach is that base valuation is not a matter of opinion - FFO is fact. It is also easier to compare REITs properly since the timing of valuations is largely irrelevant.
For some UK REITs, a greater focus on FFO may lead to re-rating. As yield compression is unlikely to return for some time in the UK, focus has returned to asset management - how the property company will increase rental income from the portfolio without help from market rental growth or yield shift.
The conclusion is that the best value UK listed investment is that which optimally combines discount to NAV and FFO growth potential. And if I could tell you which that was, I would be a principal and not an adviser!
Robin Priest is lead partner, real estate corporate finance, Deloitte