eAll those who called the bottom of the property market at the end of last year got it horribly wrong. Commercial property continued to slide as the economic malaise deepened and managers now face falling capital values, declines in rental growth and even more reluctance on the part of banks to finance property deals.
The UK market has lost 24 per cent since the start of the year, the US is off 11.9 per cent, and Japan is 22 per cent down, but even so these figures are a lot better than Asia, where Singapore and Hong Kong are down 49 per cent and 54 per cent respectively.
Many managers believe the worst is not over, predicting no respite until the back end of 2010 or beyond.
“In this market it is hard to be a contrarian,” says Dirk Molenaar, manager of F&C Global Real Estate Securities fund, which is bubbling under the funds in our table by size and would be ranked 15th.
A nervous market
“The market is extremely nervous and focussing on the direction of the economy and the length and depth of the financial crisis. We definitely expect risk premia to rise and that demand for office space will face more pressure. Widening credit spreads have impacted on borrowing costs and transaction volumes,” he says.
“As economic data continues to disappoint, such as the recent US job growth figures which have now been negative for nine consecutive months, we expect further downgrades,” explains Mr Molenaar.
Molenaar is picking off property stocks in the Netherlands, Hong Kong, Sweden and selectively in the US, focussing on balance sheet strength, availability of capital, limited refinance risk and solid cash flows.
Many managers believe that the UK and the US could lead any recovery, and that US REITs are particularly defensive as they caught the downdraft from the credit crunch early on.
Stocks not bricks
As equities attempt to price forward and led the sell-off, it is thought that property stocks (rather than bricks and mortar) will also front-run on the way back up.
“It’s been a very volatile sector for three years, and difficult to tell where the lowest point in the cycle will be,” agrees Romney Fox, investment manager at Aberdeen Property Fund, one of those managers looking to UK stocks with attractive valuations for their rebound potential, in preference to their peers on the Continent.
The importance of a good yield as the bedrock of sound property investment is reclaiming centre stage, as managers focus more closely on the quality of income generated and management’s ability to grow that income.
Dividend growth
This renewed emphasis on strong dividend growth will be an emerging trend in fund management, says Richard Phillipson, head of investment practice at consultancy Investit. “I think there will be a big trend back to appreciating dividend growth funds as capital values have been shown to be volatile, while dividend growth has been solid over most long-term periods,” he says.
Property stocks have been increasingly held by general funds that are mandated to allocate to financials, points out Jakes Ferguson, a partner at Sarasin & Partners LL.
“Managers of general mutual funds are attracted by the property sector’s long leases, healthy dividends, 15-20 per cent discounts to NAV and conservative balance sheets with no gearing issues or need to refinance debt,” he explains.
The appeal of the sector’s income streams may be further highlighted if Governments freeze the payment of bank stock dividends in return for bolstering their balance sheets.
In such an uncertain market, cheap is not necessarily best, adds Mr Fox, pointing out that in the UK the sector’s four giants together account for 40 per cent of the benchmark, and that all bar Hammerson offer an attractive yield.
Land Securities, which pays out 5 per cent, offers not only long leases and prime tenants but also restructure potential if it succeeds in spinning off Trillium, its property outsourcing arm, and demerging its property portfolio into two separately quoted specialist companies focused on retail and London property.
Development activity remains thin on the ground, however. In most of Europe the last construction boom was in the 1980s, with the exception of offices in the late ’90s, partly because construction costs have been high and financing became expensive.
The real cost of debt has now surged to around 7.5 per cent plus, higher than yields earned on offices at around 6 per cent and retail property at 6.5 per cent. Sooner or later this will have consequences.
“One upside is that the big pull back from property lending has reduced new stock coming onto the market, so 3-4 years out there will be an undersupply,” says Gerry Ferguson, head of the £998m Scottish Widows Investment Partnership property trust.
