The bricks in property's wall of money: Tom Stevenson looks for hard evidence that the sector's unprecedented slump is over

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The Independent Online
HE MADE a killing from the currency markets, so the recent return of George Soros to UK property, via a joint venture with British Land, made the sector sit up and take notice.

More than any number of bullish statistics, renewed interest from an investor with his reputation for timing suggested the longest slump since the war had finally come to an end.

Having been badly burned, however, investors are looking for more than anecdotal evidence of recovery. Here are some of the questions they are asking:

Now it is over, just how bad was that property slump?

That depends to a large extent on which part of the country you are looking at. Figures from the Investment Property Databank show that capital values and rents have fallen in all three divisions of the property market. Falls in the South-east, where speculative building was at its most frenzied in the late 1980s, were much steeper than in the rest of the country.

The slump in the office market far outweighs the declines in retail and industrial properties, with rents down by a quarter and capital values 38 per cent lower than at the top of the market. The value of retail properties has fallen 18 per cent while industrial sites, where less oversupply was created during the 1980s boom, are still worth within 10 per cent of their peak value.

These declines are unprecedented and were reflected - until last September - in a dramatic underperformance by the shares of quoted property companies.

Having reached 1,400 in 1989, the FT-Actuaries Property Index had reached a low of 464 by the watershed of Black Wednesday.

What exactly happened to change sentiment last September?

The withdrawal of sterling from the exchange rate mechanism opened the floodgates for property shares. Lower interest rates, the prospect of inflation reviving property's role as a hedge, and hopes for economic recovery all contributed to a dramatic re-rating of the sector.

Historically, the sector has always moved dramatically after a turn in sentiment. This time the effect was exaggerated by high borrowings at property companies, which mean that even a small rise in property values can have a significant impact on assets per share.

Property shares have outperformed the rest of the stock market by 58 per cent over the past 10 months, doubling in absolute terms. That has taken shares up to and in some cases beyond their underlying asset values - last seen in the heady days of 1988.

Is that the reason for the recent wave of rights issues?

A flood of rights issues since Slough Estates raised pounds 150m in March has been the inevitable result of buoyant share prices. Companies have realised that they can raise funds at a cost of less than 5 per cent (the price of paying a dividend on the new shares) to invest in property that yields almost twice as much.

The total raised by quoted property companies since Slough's cash call is now more than pounds 1.25bn. Not all that money is earmarked for investment in property - some has been used to repair shaky balance sheets - but it is a large contributor to what some observers see as a 'wall of money' getting ready to hit the direct property market.

Share prices have risen, but what are the signals from the real world?

The health of the market is measured in three main ways: the volume of transactions, the level and direction of rents, and rises and falls in capital values.

Figures from Jones Lang Wootton, the property agent, suggest that annual rents for prime buildings have bottomed out at about pounds 40 per square foot in the West End and pounds 32.50 in the City. The firm believes that rent- free periods are likely to disappear.

According to Jones Lang, vacancy rates fell during the second quarter of the year, which should at least arrest the fall in rents. Transactions worth more than pounds 1bn during the first half compare with only pounds 509m of deals in the comparable half year.

Capital values also appear to have turned the corner, according to Richard Ellis, a rival agent. In June its monthly index rose 2.4 per cent thanks to a change in the yield demanded by investors. A fall in yields of about 0.5 per cent was encouraged by the return on property recently rising above that of government securities.

Who is buying property now?

The so-called 'wall of money' is approaching the property market from three directions. Most important are the investing institutions. According to Smith New Court, the broker, up to 51 institutions plan to invest up to pounds 4bn in the sector. Some 22 per cent of them want to increase their holdings 'materially'.

The second source of funds is the pounds 1.25bn already raised by the property companies themselves. With more gearing, Smith New Court thinks that could rise to pounds 1.75bn. Finally, there has been a resurgence of interest from overseas investors.

During the boom, the Americans, Scandinavians and Japanese tried their luck in UK property and, in the main, failed to make any money. Many had their fingers burned. Now, with Britain emerging from recession ahead of the rest of Europe, and with the added appeal of unusually long leases with upwards-only rent reviews, the market is increasingly attractive to foreign buyers.

Do rising property values mean more development is on the way?

Not for some time, no. Financial deregulation and the relaxation of planning controls in the mid-1980s led to an unprecedented boom. There is now 25 per cent more office space in the City than in 1986 which means that demand will have to rise considerably before the slack is taken up.

When that will happen depends on the extent to which tenants turn their noses up at older, secondary property. It also hinges on how fast economic recovery increases employment levels and how fast rents improve to a level at which new development is worthwhile.

James Capel thinks shortages will start to appear in the West End at the end of next year and in the City in 1995. Only then will development start up, which means that new space will not be available until 1996. This is a relatively optimistic view.

What does all this mean for property company profits?

Sadly not the boom that the rapid rise in share prices might suggest. While property owners are protected from falls in rents by upward-only, five-yearly rent reviews, they are unlikely to see any rise in income while market rents remain below those being paid by most tenants. Rents might not catch up for several years.

A second depressing factor is the lack of development activity, which means interest payments that could previously be capitalised must now be taken against profits. The combination of those two factors is bad news for dividends, which are only just covered in many cases by earnings.

So are property shares overpriced after their recent run?

That depends on how much you think property shares are driven by earnings and dividends and how much by asset values. The distinction is important; while profits are likely to stagnate for some time, there is a strong case for thinking that asset values will carry on rising.

Smith New Court estimates that the leading property companies' portfolios yield between 9 and 10 per cent. Those returns compare favourably with 10-year gilt yields of 8 per cent, which themselves are expected to fall to 7.3 per cent by the end of 1994.

If bond yields fall and property yields follow suit, then Smith New Court believes underlying asset values per share could rise by 20 per cent. That would return share prices to meaningful discounts, even taking into account reduced confidence in the real worth of asset values. That may give the sector a final fillip, but most of the good news is already in the price.

(Photograph and Graph omitted)

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