UK real estate is offering attractive opportunities, but investors are right to be wary of the increased risk of tenant failure as the country's economic recession takes hold. George Tindley explains how to conduct a thorough analysis of tenant risk, via a robust assessment process
The UK's position within the global economy, its strength in financial services and high growth in the use of personal and commercial debt over recent years makes it disproportionately vulnerable to the fallout from the credit crunch. While this has generated a substantial buying opportunity, it also makes a thorough analysis of tenant risk all the more necessary for investors in UK real estate.
The UK has entered its first recession in 16 years and the current global economic malaise looks set to continue. However, recessions have historically been short. Investors should monitor signals that may mark a reversal of economic fortune, especially in light of a response from UK policymakers that has been decisive and swift. This article seeks to explain some of the indicators that investors who are looking for opportunities can use in the current conditions, while keeping a tight control on their risk exposure.
A robust approach to evaluating tenant risk is not only required when reviewing tenants at the acquisition and leasing stages, but should form a significant part of the ongoing assessment of portfolio performance. In the current turbulent economic climate, any covenant assessment must take into account not only how a company has performed in the past, but it also should explore and assess indicators of future performance as far as possible.
An important part of income analysis is at portfolio level, as a portfolio can offer a diverse and balanced income stream. Investment Property Databank (IPD) offer an income analysis tool called IRIS (IPD Rental Information Service), which enables the analysis of the income by a variety of factors, including lease structures, expiry profiles, covenant strength (factoring in Dun & Bradstreet credit ratings) and income concentration by sector, to identify exposure to potential sector-level issues.
It also enables the comparison of tenant income security relative to a sector-wide benchmark. Another major point for performance purposes is that the tenant should not be viewed in isolation; the building it occupies can have an important influence. For example, even before high street retailer Woolworths went into administration, four of its London stores were assigned to Waitrose, and there are undoubtedly other strategic sites in the portfolio that will provide opportunities for other occupiers. In Germany, leading department store Hertie has gone into receivership.
Our team in Munich had been monitoring its performance with market knowledge, press reviews and credit ratings, as they were considering the acquisition of a shopping centre with an adjacent Hertie store. From their analysis they concluded that with Hertie vacating the property, there would be potential upside due to strong retailer interest.
Past performance can be analysed via examination of corporate accounts and credit ratings, but, looking forward, analysis should take into account sector and industry trends and peer group performance in general. Media searches can provide valuable insight into both the tenant and peer group, while an interview the finance director can provide additional information on the current standing and future business growth.
Equity analyst reports and corporate bond ratings also contribute to an overall picture of the tenant. This picture is driven by financial and industry information, but it should not be forgotten that a heavy dose of common sense is also required.
With covenant strength becoming increasingly important, as tenant default concerns rise to the fore, corporate bonds can be of use in identifying company and sector-level trends regarding implied risk (see above) and investor confidence in future performance, and therefore covenant strength.
It is possible to evaluate earnings quality at a portfolio level by attributing bond yields to tenant strength, income length and - where available - any fixed/inflation increases. This can be compared to the price or current value of the property to identify the split between income and residual value. However, bonds also price in wider investment sentiment and therefore such an approach must form part of a comprehensive covenant strength analysis.
Despite concerns over the UK property market, investors should still find encouragement in the fact that the UK authorities reacted swiftly to the economic situation by cutting interest rates rapidly. They should also bear in mind that the UK remains one of Europe's core commercial property markets, thanks to its scale, transparency and unparalleled quality of the income streams available.
Recent short-term changes in pricing should not deflect investors' understanding of the relative attractions of investing in this market over the medium to long-term. The pricing changes are now presenting value unseen in recent years and this presents relative opportunities for investors. Not only has UK property attractively repriced against its European peer group, but it has done so also against other asset classes - most notably at this time fixed income (bond) assets, with which it shares similar investment characteristics.
An analysis of relative pricing against a number of other measures points to the possibility that the UK market is entering a ‘buy zone'. Firstly, the IPD monthly index has repriced markedly. The capital values from UK property have deteriorated by around 35% from the peak in June 2007. Actual price falls are likely to be more extensive even than this by now, meaning UK property is now at highly attractive valuations relative to long term averages.
Secondly, the pricing of low-risk fixed income bonds implies an opportunity gap between themselves and fixed income-oriented property. Such is the distress from some vendors that we are seeing substantial discounts to such fixed income properties amongst corporate occupiers.
For example, Cordea Savills has identified a long-leased industrial property in London let to one of the UK's largest retailers. While the company has a high financial rating, the property is being priced at a discount, at a net initial yield of 8% or higher. This yield is higher than that which is available on the company's bonds.
This situation is mirrored extensively elsewhere, presenting opportunities to the informed investor. While analysis of comparative yields can be a good indicator of whether an investor should pull out of a property investment, the implied risk premium we have frequently seen in the market is too wide and indicates there will be a movement of investor money from pure bond assets to their property equivalent, leading to price rises.
Considering real estate as a fixed income asset also provides three potential advantages over fixed income bonds:
Concerns regarding economic outlook and consequent market rental prospects are the key risk, but the prudent investor will avoid such danger, strategically favouring investment in long and secure fixed income assets. The tactical focus should not be at a sector or necessarily geographic level at this time.
Rather, it should be to seek the highly protected income quality from secure investments that are well defended on all grounds, seeking little compromise on the quality of tenant, lease length, building and location quality.
George Tindley is director of investment at Cordea Savills in the UK