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PwC Valuation IndexAre the shares of major listed property companies undervalued?
www.pwc.co.uk/valuations
July 2012
2 PwC Valuation Index
Welcome to the sixth edition of the quarterly PwC Valuation Index series. We look at the valuation of Real Estate Investment Trust (REIT) shares in this edition.
Our headline Valuation Index stands at 99 as at 30 June 2012. The outlook is highly uncertain, as the path to Eurozone stability remains unclear. Low bond yields are being compensated for by higher equity risk premia, maintaining the overall level of equity risk. All this means that investors are likely to be looking to long-term fundamentals to price investments as the short-term outlook remains volatile.
UK Real Estate Investment Trusts (REITs), for the most part, trade at a discount to their Net Asset Value (NAV). While the application of a discount to NAV is not controversial, the justification for the quantum that is often applied is open to debate. Investments in REIT shares offer a number of advantages over direct property investments, especially in the current environment. These include: easier access to prime property; acquisition and asset management expertise; and diversification of risk.
Our team has looked at the issues in some depth and have drawn comparisons with what has been happening with commercial property prices over recent years.
I hope you find it interesting.
Our analysis implies UK equities are trading in line with long term fundamentals
Richard Thompson Partner Head of Valuations
Welcome
Implied vs. Actual PE ratio
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Continued uncertainty in the Eurozone, the imminent return to QE in the UK and an anticipated reduction in Chinese growth figures suggest that the first half of 2012 has not been the tale of recovery that many had
hoped for. With the Governor of the Bank of England himself stating that we might only be halfway through the crisis it seems appropriate to reevaluate some of the key long term assumptions that underpin this index.
1
As ongoing uncertainty encourages firms to hold onto a greater proportion of their earnings we have decided to reduce our expectation of the sustainable long term dividend
payout ratio. Revising this assumption increases the Valuation Index from 84 at Q411 to 99 at Q212 (maintaining the original assumption results in the index marginally increasing to 85).
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The alignment of market and fundamental value, following this latest period of uncertainty, suggests that investors are returning to the safe
haven of fundamentals when making their investment decisions.
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Focus on real estate: Summary
Source: IPD and PwC analysis
The UK commercial property market is flat-lining with IPD (Monthly Index, May 2012) reporting an all property rise in capital values of only 1.09% over two years. At the same time debt remains relatively unavailable and expensive; and it is only for prime properties that demand has remained strong.
In the UK, many of these prime assets are owned by Real Estate Investment Trusts (REITs). Although the shares of these trusts generally trade at a discount to Net Asset Value (NAV), on account of a number of factors including lack of investor control, they have a number of advantages over direct property investment. These include:
Enhanced access to opportunities and finance; •
Asset management and development expertise and experience; and, •
Diversification of risk over a wider variety of assets. •
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Figure 1: Weighted Average Premium/Discount to NAV for REITs, annual movement in NAV of REITs and IPD Index movement rebased to 1999
While the adoption of a discount to the NAV is not controversial, these factors have led some commentators to question whether the discount to NAV should be lower?
Our analysis suggests that in the current environment it is worth re-considering the quantum of discount applied to NAV. We calculate the current value of the discount to NAV for REITs to be approximately £3bn.
Performance of share prices against commercial property
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Are REIT shares undervalued?
IntroductionIn any one year, the PwC Real Estate valuation team reviews in excess of £100bn of UK property valuations. This provides us with an opportunity to work with many of the leading property companies, institutions, property fund managers and their valuers; and gives us some valuable insights into how the market is behaving.
At an asset level the overall performance of the market has been subdued with low level capital value growth over the previous 2 years. But this hides a much more varied picture which has seen values for prime assets and those in the south east hold up, and in some cases increase; while demand for secondary properties and those in the rest of the UK has fallen away. This ‘flight to quality’ has been driven by the continuing economic uncertainty in which investors have sought security (in many cases value preservation) and bank’s have remained reluctant to lend on anything but the most prime assets. The UK’s status as a “safe haven” on account of the transparency and perceived stability of London as a global city means that some of this demand has been driven by sovereign wealth funds and Far Eastern investors. Weak occupier demand outside of London has exacerbated this polarisation which has seen out of town regional office and high street shops in secondary town centres record significant falls in value.
We have analysed the way in which a sample of the largest REITs have performed in the context of the current market. This has led us to question whether the current level of discount to NAV being applied by investors is appropriate.
Figure 2: Annual total NAV versus total market capitalisation
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Source: PwC analysis
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In our view, there are 3 key factors which the market is not currently taking full account of in applying a discount of this level to REIT shares. Each one of which carries particular advantages in the current economic climate. They are:
1. The asset management and development experience and expertise of these companies. i.e. the ability to improve the value of an asset through active management (examples of which would be development /refurbishment, lease restructuring etc). This is very much the stock-in-trade of property companies;
2. The likely continuing volumes of demand for prime assets. Traditional buyers of property interests (i.e. those reliant on substantial levels of debt) are unable to pay the prices commanded for these assets and will only have access to limited (and expensive) debt finance. While in the heady days of 2005/2006 it was possible to obtain close to 100% of purchase price (particularly buyers with access to mezzanine “top –up” finance”), current buyers are unlikely to achieve better than 60%-65% Loan to Value at an expensive 300 to 400bps over base rate. These buyers will then require a higher return on their equity investment usually leading to pricing positions at a disadvantage to Sovereign Wealth and Far Eastern purchasers. Listed property companies however, have been able to compete using their size and track record to raise finance at preferential rates to some other investors in the market.
In addition, due to their status, property companies are likely to have access to better acquisition opportunities as they come to market; and
3. A more diversified risk profile. In the current market transactional volumes are low, especially in the secondary markets. The impact of this will be greater volatility around future income steams and lower levels of evidence on which valuers can base their opinion. As such valuations will be more subjective and more uncertain. By investing in a larger number of assets and predominantly those that are prime, REITs have a more diversified portfolio and one that is less susceptible to sharp movements in the values of individual assets. With no upturn in the volumes of transactions predicted (particularly in the secondary market) these are expected to remain issues for property investors for the foreseeable future.
We now consider these points in more detail.
To illustrate the point we have analysed changes in asset valuation against the discount to NAV over time. This highlights the potential quantum of “lost value” over time.
The most recognised index for monitoring changes in commercial property values is the Investment Property Databank (“IPD”) index which tracks changes in direct property valuations held by UK property companies and institutions.
Over the 8 years between 1999 and 2007 commercial property values rose. This growth however was eclipsed by the uplifts in NAV of REITs.
During the credit crunch, when values of commercial property fell 44% (peak to trough between July 2007 and March 2009) this trend continued and the NAV of REITs, despite falling, continued to outperform the wider market In part this resilience can be attributed towards their prime properties, which held their value better than more secondary assets.
The “flight to quality” to prime assets owned by the property companies can be demonstrated by the relative growth in values from 2009 onwards.
Yet, throughout this period, REIT shares have continually traded at a significant discount to NAV (apart from one short period in 2006) the value of which currently stands at c.£3bn. It is our hypothesis that this represents a potential mispricing in the current uncertain market. With seemingly no let-up in the market preference for prime assets, the continuing level of discount to NAV for REIT shares could be overstated.
Discounts to NAV
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Asset Management and DevelopmentAfter the unprecedented 44% fall in values discussed above, values rose by 17.8% in the period July 2009 to October 2011 (although only 1.2% of this growth occurred in the year up to October 2011); since that time values have fallen by 1.64% (up to May 2012).
Given the relatively flat performance of the property market (in terms of capital growth) asset management and development have become key activities. But these activities are not without risk and rely on access to finance and significant levels of specialist expertise.
We would identify the REITs as those best placed to realise value though asset management. We say this as:
REITs have access to funding sources established over many • years of successful financial relationships; most have war chests established from the plethora of rights issues that took place in the market in 2008/2009;
REITs have established asset management and development • platforms and proven asset management and development track records;
With some exceptions, REITs diversify their risk through owning a • range of assets across the traditional commercial property sectors (office, retail and industrial – although many are diversifying further into “alternative investment classes” such as hotels, self storage, nursing homes etc). While this diversification is not necessarily recognised by the analysts there would seem to be good sense in holding a diverse portfolio.
Asset management expertise taken into account?
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Figure 3: Capital growth for retail, office and industrial sectors by region in 2011
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Industrial Office Retail Total Capital GrowthIndustrial Office Retail Total Capital Growth
Source: IPD
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Access to opportunity and financeDemand for prime property remains high particularly for assets in London and the South East as the UK property market is often described as a “safe haven” (as discussed earlier) and includes the most attractive assets (particularly to foreign investors who will seek “reputational” properties). This situation is exacerbated by the Banks who have (despite external pressure) concentrated their lending activity on prime assets.
The bank lending conundrum can best be demonstrated by the fact that over £80bn was lent into the UK property market in 2007 alone (the year of peak lending) while new lending in 2011 was just c£20bn – nearly all of this was targeted on the prime markets.
REITs however have been able to use their size, track record and experience to acquire debt at more competitive rates than many of their competitors.
Consequently the definition of “prime” property has polarised to an extent probably never before witnessed in the UK property market. Properties which were once considered prime (particularly in the regions) would now be described as “secondary”. Examples of these would be regional office buildings and well located industrial/warehouse estates (even those with good fundamentals in terms of tenant quality and lease length).
So, as the definition of “prime” property polarises, competition for these assets will usually be fierce with multiple bidders for openly marketed properties. It is a sign of the times that properties that could be described as “super prime” are often offered discretely to a limited number of bidders as sellers are confident that competitive tension in the bidding process can best be exploited in this manner. REITs with their high market profile and track records are well placed to get access to the bidding where this occurs.
Investing in REIT shares is a way of gaining access to these opportunities as the REITs can use their market network, profile and reputation to procure properties that may not be available to other investors. This could be because they are not being sold on the open market; or because they are large development sites which due to their size and risk are not open to many other property investors.
Diversified risk profileShares in REITs offer investors access to a wider variety of different properties. This by its nature offers a diversification of risks because the investment is spread over a wider variety of assets, across a number of different sectors.
Levels of risk are also linked to the levels of market activity (Figure 4). Unsurprisingly, when property is performing well there will be more demand for assets; but, conversely a point is reached when market activity disappears below a critical level when questions emerge about the availability of sufficient market evidence upon which to base robust valuations. Agents Lambert Smith Hampton report that investment activity in Q4 2011 was 16% down on the same period in 2010. Most investment is targeted at London (46% of investment was in the capital). That investment activity in Q4 2011 was 16% down on the same period in 2010. Most investment is targeted at London (46% of investment was in the capital).
Is better access to acquisition opportunities and finance taken into account?
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Figure 4: UK Investment market activity against IPD Index annual performance
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Figure 5: Regional Investment Activity (£m)
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Source: IPD, Lambert Smith Hampton and PwC analysis
Source: IPD, Lambert Smith Hampton
8 PwC Valuation Index
Diversified risk taken into account?While most REITs have better access to prime assets than smaller investors, they also provide a comparatively attractive vehicle for investing in the secondary property market on a highly selective basis.
Many of the secondary properties that will be acquired by REITs will be on the basis of their development potential.
The secondary market is surrounded by greater uncertainty and values can be extremely volatile. For these reasons, it is difficult to secure finance on secondary properties and they have become the focus of REITs who, in the medium to long term, are able to escalate the assets up the value chain.
Why are secondary assets more volatile? In our valuation review work we have identified:
There are fewer transactions available upon • which to base a robust valuation and so the valuations are subject to a wider margin of error. In an active market a 10% margin of error is a commonly held metric for valuation accuracy; in a market where transactional evidence is harder to come by this range could be as broad as 20% and even wider for assets where a significant degree of subjectivity has to be applied (such as development sites);
An “event” in a particular property will have a • significant effect on value. For instance, most valuers are justly conservative in assuming the time it will take to re-let a property once it becomes vacant; for instance, if a valuer assumes that a retail unit in a regional location will take 3 years to let then once a tenant is identified (albeit with the benefit of a lengthy rent free period) the impact on valuation will be significant.
While valuation volatility can contribute to a discount to NAV, the purchase of an indirect interest in real estate through the ownership of REIT shares will help to iron out the volatility inherent in the valuation of secondary properties.
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The authors
www.pwc.co.uk/valuations
There has always been an argument that the shares in REITs should trade at a lower discount to NAV because they offer a number of advantages over direct property investment including: better access to prime stock; a more diversified risk profile; and, asset management expertise. In the current market the case seems more compelling than ever.
There is also no sign that these conditions are going to change with the IPF UK Consensus Forecast (May 2012) for 2012/16 predicting capital value growth of 0.1%.
Low GDP forecasts and output levels do not foretell an increase in demand for occupational property either and, in the case of secondary retail and regional offices traditionally occupied by central Government related operations; this lack of demand could be structural.
There is nothing in the market place to suggest that any more debt will be available in 2012/2013 than there has been in recent years and what is available will continue to be expensive. During the course of 2011 major property lending banks such as Eurohypo and Societe Generale withdrew from the market altogether; other banks may well be forced to reduce their lending as new Basel III rule on capital ratios take effect. Some banks have large portfolios on their own loan books which will have to be released into the market at some point – the timing of these releases of secondary property on the market could have significant effects on value if their introduction is mis-timed.
The UK property derivatives market (albeit a very small sector) is pricing a 6% fall in property values in 2012 (and smaller declined in the 3 years after that).
On a more positive note, there is the potential for some of the UK insurance companies to enter the lending market although, at present, this market is untested.
While we have witnessed a “flight to quality” at asset level, we have yet to see a similar trend toward property shares. In our view there is significant evidence to suggest that the pricing of listed property company shares is open to debate.
Further thoughts
Simon HarrisT: +44 (0)20 7804 9413M: +44 (0)7841 490 [email protected]
Sam Wright (Real Estate)T: +44 (0)20 7804 8454M: +44 (0)7718 339 [email protected]
John Bilad (Real Estate)T: +44 (0)20 7212 2047M: +44 (0)7546 682 [email protected]
Craig Davies (Real Estate)T: +44 (0)20 7213 4575M: +44 (0)7802 [email protected]
Nick Croft (Real Estate) T: +44 (0)20 7212 6729M: +44 (0)7764 [email protected]
Romil RadiaT: +44 (0)20 7804 7899 M: +44 (0)7930 573 [email protected]
Listed property company shares, undervalued?
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