Portfolio listed The predictive power of property securities pricing in forecasting property value movements is examined by Fraser Hughes and Alex Moss
The standard valuation metric for European, and particularly UK, real estate securities is the discount/premium of the share price to externally appraised NAV. It is important to distinguish between those markets such as the UK where REITs have regular, external valuation, and those that do not, such as the US, where a multiple of adjusted funds from operations (AFFO) is the key valuation tool.
1) Historical relationship between price and NAV. How does this change post UK REIT conversion?
Before 2007 listed property companies had contingent capital gains tax (CGT) liabilities that were not netted off their stated NAV figures. This liability led to a high level of discounts being attached to UK REITs before January 2007's conversion. On average the CGT liability equated to around 15-20% of the NAV, which explains the average discount to NAV between 1989 and 2007 of 18%. When looking at current valuations and pricing relative to NAV it should be remembered that post REIT conversion these liabilities have been extinguished via payment of a conversion charge. Therefore, ceteris paribus, the sector can be expected to trade 15-20% closer to NAV.
2) Do unlisted funds exhibit the same pricing patterns as REITs?
How do REITs trade relative to unlisted funds? Using data provided by JLL, we show the correlation between the two. What is noticeable about this graph is the strong correlation (81%) in pricing between the two sectors in the period September 2006 to October 2009. But why did the relationship break down until recently, when it has resumed? The answer reflects that the more liquid REITs were subject to all the macro influences affecting equities during 2010, while the unlisted funds pricing remained more narrowly focused on the outlook for commercial property values.
3) Relative liquidity levels
Given that the benefit of liquidity comes with the cost of higher price movement, what are the relative liquidity levels? According to Ashley Marks of JLL, there was around £1bn (€1.13bn) traded in the secondary market in 2010. This was evenly split between transactions executed by brokers and those executed principal to principal. Activity has picked up over recent years, and IPD is set to provide a new investible fund index benchmark that will comprise only those funds open to new investors. The liquidity in the REIT sector should not be underestimated. Using British Land as an example, in the week that Lehman Brothers went bankrupt (15 Sept 2008) the average daily value traded in British Land securities was above £50m, and that the total value traded in British Land shares in 2010 was £4.5bn. The current annual velocity of British Land free float shares is approximately 95%. On average, velocity of the constituents of the FTSE EPRA/NAREIT Europe Index was in the range 70-100%.
4) What is the predictive power of REIT prices in forecasting movements in their underlying NAV, and thus the direct property market?
We have split our analysis of the UK into pre- and post-REIT conversion, using a single stock example (British Land) to show how accurately the prevailing share price was forecasting future capital value movements, via the NAV. For the period 2000-06 we analysed the average discount to the actual NAV in 12 months on a monthly basis (= 41.9%). This high discount reflected the fact that there were contingent CGT liabilities, but also for at least half the period the sector was out of favour. We have then multiplied the share price by the reciprocal of the discount to see what NAV the share price is forecasting. Finally, we compared the implied NAV outcome with the actual, as shown below, and performed a simple regression analysis. The relationship is very good, with a correlation of 93%, and indeed only shows a disconnect during 2006, as the sector reacted positively to forthcoming REIT legislation.
The shortcomings of the accuracy of forecasting were clearly the variance of the discount over time, and the fact that companies would have different levels of contingent CGT in their portfolio. Post-REIT conversion, the exercise becomes simpler. Assuming that, inter alia, the REIT price is anticipating the NAV in the next 12 months, and given that there are no CGT issues, it can be assumed that the discount/premium of the share price to the current NAV reflects the level of value change anticipated in the NAV + 12 months. Therefore we plotted the discount/ premium to current NAV and plotted this against the rolling 12-month change in the underlying NAV. For the period from December 2010 (the last stated NAV) we have taken Macquarie forecasts. The equity valuation is an extremely accurate predictor (90% correlation) of the eventual NAV outcome.
5) What is the relationship between dividend yields and both government bond yields?
The other metric in terms of pricing signals is the level of dividend yield to the local government bond yield. We show the long-term trend for the UK: as can be seen the long-term average is for property securities yields to trade below government bond yields. Notwithstanding the unprecedented downward movement in government bond yields as a result of QE, when dividend yields start moving above the long-term average, it gives an indication that declining capital values, and dividend reduction is imminent. The current situation reflects the expectations that bond yields are set to rise from their current level of 3.5-3.7% to a ‘normalised' 4.5-5.0% in the medium term.
6) Is listed debt a viable investment option?
In Europe, the capital raised since H2 has been focused on the corporate bond market rather than equities, taking advantage of low benchmarks. The listed debt element of the four quadrants is therefore increasing in importance as an investment option. In Europe we estimate that the size of the bond market, based on the constituents of the FTSE EPRA/NAREIT Europe Index, is in the region of $30bn (€20.5bn), or over 120 separate issues. European bond issuance in 2010 almost matched its 2006 high and we expect this trend to continue, as the private debt market remains difficult.
The top 20 corporate bond issuers comprise approximately half of the total market ($14bn). The weighted average coupon of the top 20 is 4.7% with a current weighted average yield of 4.25%. The weighted average maturity is 2020 with a modified duration of 6.1. All of the bonds are rated by one of the major agencies, with the exception of the British Land debenture issues. We believe that a portfolio of corporate bonds issued by the major real estate companies in Europe offers investors many opportunities.
Fraser Hughes is director, EPRA, and Alex Moss is head of Macquarie global property securities analytics