British property stocks suffered a bad year but several factors – including lower interest rates – underpin a revival. Meanwhile, global property, especially in Asia, offers much to excite investors.
There is no doubt that British property stocks have had a poor year. Yet there are several factors that could underpin a recovery. For more intrepid investors, there is plenty to get excited about in the global real estate investment trust (Reit) market. British property stocks may be weak, but Reits in the Asia Pacific region are powering ahead.
The statistics speak for themselves. With the Epra/Nareit UK index down by more than 28% in 2007 so far, British property stocks have suffered. The euphoria that characterised the sector in the run-up to the conversion to Reit status on January 1, 2007 – with the stocks rising by 32% in the six months leading up to the change – was quickly eclipsed by the pessimism that has hit the commercial property market. Investors have become concerned about falling property values and the wider effects of the credit crunch as property companies partly finance their acquisitions with debt.
What factors could underpin a revival in listed property stocks in the coming months? First, property stocks now look to offer better value than the direct property market. While few commentators expect property values to fall by more than 15%, the listed market is implicitly pricing in falls in property values of about 22%.
Second, the hefty discounts to net asset value that Reits display are fuelling talk of public-to-private transactions, restructuring or share buybacks. For example, takeover speculation has affected the share prices of Minerva and Quintain. Such activities will be more realistic when the banks are more willing and able to finance them.
Third, the weakness of property stocks is encouraging companies to take steps to enhance shareholder value. Most notably, Land Securities has announced plans to split the group into three separate quoted entities, each of which will concentrate on a particular part of the market – retail, London offices and property outsourcing. This is a conscious imitation of the sector-focused Reits that characterise the American and Australian markets. In theory, highly focused, flexible Reits will be better able to boost returns than larger Reits or sprawling conglomerates, which need to participate in large projects to boost performance.
The fourth source of value could come from a lower interest rate environment. Although five-year swap rates have come down by almost 100 basis points since June, this effect has been wiped out by the rise in spreads following the credit crunch. Uncertainty in bank lending could ease in the coming months, as we expect the Bank of England to cut rates in 2008. This could help tackle uncertainty in the market and restore confidence to valuations. With the underlying occupier market still in relatively good shape, with healthy demand for space and rising rents, the long-term fundamentals underpinning the property market are still good.
Although there are factors that could support a revival in property stocks, any sustained recovery is unlikely to take place until events in the direct property market have played out. Given the direct market is going through a process of readjustment – with the exact fall in capital values far from being clear – it could be some time before this takes place. This strengthens the short-term case for diversification away from the British market to the global Reit market. There are also long-term structural shifts in the global market underway that make a compelling case for investing in global Reits.
In performance terms, global Reits have had a better time in 2007 than the British market. For example, the benchmark Epra/Nareit Global index had fallen by 3.1% in the year to the end of October against Britain’s fall of 28%. Furthermore, the overall figure for the global market masks considerable differences of performance across the regions making up the index. While European property stocks have had a poor year – with negative returns of 21.3% over the same time – returns were 17.9% for the Asia Pacific region. Hong Kong posted returns of 60.3% and Singapore 23.6%. So by diversifying away from British Reits into a global fund, investors benefit from geographical diversification.
The short-term strength of Reits in the Asia Pacific region points to a longer-term trend: the growing weight of this fast growing region within the global listed property market.
The dynamism of the Asia Pacific listed property market reflects the region’s strong economic growth – as seen by the growth in the number of Reits in Hong Kong and the strong demand shown for initial public offerings or secondary offerings, some of which provide exposure to the fast growing Chinese property market. As the region continues to enjoy strong economic growth, it is inevitable that the region’s weight within the global Reit market will increase at the expense of the more established listed property markets, like America and Australia.
A second trend that will condition the global Reit market is the growth of Reits within the property market as a whole. Their introduction to a market gradually leads to a structural change in the ownership of real estate. In Australia, more than 65% of the market is held by Reits.
In most other countries this proportion is far lower, but there are forces at work – such as the increased popularity of sale-and-leaseback deals – that are changing this. Either way, the trend is clear: Reits tend to absorb a greater proportion of the total stock of real estate over time. This is reinforced by the introduction of Reit-like structures in more countries. Germany and Britain introduced Reits in 2007 and other countries, like Italy and Finland, are expected to follow suit soon.
Although there are several factors that should boost the subdued British listed property market in 2008, this process of recovery is likely to take some time. In the meantime, there are distinct advantages to be gained from diversifying into global listed property securities.