Previously in this column we looked at what appeared to be the start of a new trend of M&A in the property sector, following the bids for Market Tech and Kennedy Wilson Europe. However, the trend has in fact not materialised.
It seems that investors would rather acquire individual assets that meet their investment criteria, than acquire a REIT that is effectively a property conglomerate. It is not because there isn’t enough capital around either. The amount of private capital bidding for London assets alone has been enough to buy out the listed REIT sector, according to Great Portland.
Investment volumes were weak in 2016, falling 41% to £42bn, but that is only 20% below the value of the entire REIT sector. London investment halved to £19bn last year. Outside London the market was more resilient, with more deals completing. There was a clear slowdown in the second half of the year after the Brexit vote, with a fall of 27%. However, even the first half had seen weaker volumes in the run up to the referendum.
So, although investment has been weaker, it is not a question of the outlook frightening off investors entirely. The acquisitions of trophy assets like the Cheesegrater and the Walkie Talkie prove there is demand for sector assets, at yields of just 3-4% and at prices above book value too. By contrast the companies that built them trade at wide discounts, because of a more generalised Brexit fear.
Obviously, listed REITs are more sensitive to market sentiment and have therefore reacted to post Brexit concerns and risk aversion. The REITs themselves have been cautious in their outlook statements, especially for the London office market, so perhaps it is no surprise that investors have shied away from the larger groups. Perhaps the REITs will need to show some faith in the market themselves, by investing more of their cash reserves, to tempt investors buy their shares.
However, the valuations are so depressed now that dividend yields rival the smaller specialist companies and alternative property funds. The discounts to NAV range from 1% for Segro to over 30% for British Land and INTU. That implies potential cuts in property valuations of 20-25% for those two groups.
Of the major REITs only Shaftesbury trades at a premium to NAV and that is partly because it is seen as a takeover target. As a result, both INTU and British Land now yield about 5%. Even the likes of Workspace and Segro offer yields of c.3% now, at valuations close to NAV.
This would be more understandable if the companies had learnt nothing from the last downturn. But this is clearly not the case. The major REITs have significantly reduced their gearing in this cycle, after the rescue rights issue experiences of 2008-9. The average LTV for the main REITs is now c.20%, with some as low as 11%. Even British Land, which is the highest, is below 27% after the sale of the Cheesegrater. The marginal cost of debt can also be as low as 2%, so it shouldn’t be hard to find value enhancing investments at that level.
Indeed, you could argue that some are so well positioned for the downturn they could have too much cash available to deploy if it doesn’t turn out as badly as expected. The current capital commitments of the leading REITs are little more than £1bn, despite a large potential pipeline. The available cash and resources of the six largest REITs are over £4.5bn, suggesting surplus cash of approximately £3.5bn.
In fact, some have been trying to reduce their cash piles recently. Dividend payouts have been increased by a number of REITs, on the back of the strong cash generation of the past two years, when rents and letting demand were strong. We have seen increases as high as 35-40% from Workspace and Kennedy Wilson Europe. On top of the annual dividend increases there have been special dividends this year too. Great Portland paid out £110m after the sale of Rathbone Place and Derwent London paid 52p on top of increasing its annual payout by 21% to 63p. Then this week British Land announced a £330m share buyback.