TR Property Prelims

Some highlights from the TR Property Investment Trust (LSE:TRY, TRYS) prelims out today: http://www.londonstockexchange.com/exchange/news/market-news/market-news-detail.html?announcementId=11212440

Always worth reading, for anyone with an interest in the property sector (esp. commercial) as the fund manager generally "tells it like it is". There's also some useful stuff about retail trends there too (see below), and some very useful background on property debt: a huge factor in the Euro crisis.

...

Although property companies' share prices fell over the 12 months to March, their earnings did not and it is pleasing to announce both record revenue earnings and significant increases in the final dividends in both share classes.

 The management fee has been re-negotiated giving a slight reduction over last year....

...The Board is proposing to shareholders an Ordinary share class final dividend of 4.20p which compares with the previous year final dividend of 3.70p...

That puts the shares on a yield of 4.6% @ 142.5p

...One consequence of the current turmoil is a greater divergence of returns across countries, sectors and inevitably at the company level...

...Unfashionable as it may be to offer an upbeat message I would like to draw your attention to the revenue results and outlook. Our earnings are dividends and in the Ordinary Share Class these are coupled with some direct property rental income. Quality property companies are continuing to benefit from high levels of tenant occupancy coupled with low short term debt rates and there is no sign of the ECB raising the reference interest rate. Our larger investee businesses also have access to a broad range of funding sources which continues to ensure lenders remain competitive. Borrowing margins are stable for the most secure companies. Whilst rental growth will continue to be hard to come by, most of our Continental European property companies' income is also invariably index linked. Tenant delinquencies also remain surprisingly low by historic standards. Therefore, whilst there remains enhanced volatility in equity prices, the revenue outlook currently appears much more stable....

...We began last year's Managers' Report by highlighting the extreme polarity of property markets, in which good property rose in value and poor property declined. The twelve months to the end of March 2012 has seen a continuation of this theme. Demand for prime office and retail properties in Central London (especially the West End) has rarely been stronger. Both anecdotal evidence and research produced by London's property consultants shows that London remains one of the most highly sought-after locations for domestic and international capital. Conversely, investor demand for Dutch or Belgian offices is scant and prices have been falling throughout the year.

 This disparity between the best and worst is mirrored in the significant differences between sovereign, corporate and consumer environments both within Europe and beyond. We see no signs of this situation changing. It will remain a feature of our investment markets for the foreseeable future...

Interesting disparity in views there with First Property (LON:FPO) 's managers. The latter's view is that shrinking yields on prime property are unsustainable, and that a bubble in (for example) London property is inflating. In this instance, I tend towards FPO's view. Talking about market perceptions remaining unchanged "for the foreseeable future" is always dangerous and smacks of the "greater fool theory", leading to an eventual sharp collapse. Surely there comes a point where tenants find that the better rents for secondary properties are too tempting, and smart investors realise that they can pick up bargain properties with big rental yields in that sub-sector?

...Property company revenues have proven to be remarkably resilient over the last few years. Whilst UK GDP fell by over 7% peak to trough and the revenues of all listed companies in the UK fell similarly between 2008 and 2009, the revenues of the largest listed real estate companies remained broadly flat over this timeframe and outside the UK average revenues actually increased. ..

That's why I want exposure to this sector (currently 8% weighting, mainly through TRY, FPO and British Land Co (LON:BLND) - haven't yet analysed the latter's recent results, it's on my "to do" list!. More attractive now that some REIT deleveraging has taken place and recapitalisation risks for the big REITs are IMO lower.

...A glance at the portfolio exposure statistics contained in this report demonstrates that both portfolios are currently heavily exposed to London offices and German residential companies...

Hmmm... well, in the light of my "greater fool" comments, perhaps I'll be reducing my exposure to TRY - happy with the German residential side, though.

Well's here's TRY's rationale for London:

...Cross border investment continues to be intensely focused and as a consequence is fuelling capital value growth in the key 'city states' within our universe - London and to a lesser extent Paris. London has the necessary conditions for long term capital growth (or at least capital preservation for the more bearish) of relatively fixed physical supply combined with the deepest property investment market in Europe (£3.3bn of transactions in Q1 2012). Importantly it is outside the Euro. Whilst this theme has been running for several years it shows no signs of abating. In fact the geopolitical events of the last twelve months have merely strengthened it. Between 2007 and 2011 London experienced inward investment of cross border capital of £52bn, almost five times as much as Manhattan, New York and more than double the nearest rival Paris. This capital has been invested in both commercial and residential markets. Knight Frank estimate that prime residential values rose 11.2% in 2011 and 2.7% in Q1 2012. It is not just investors; occupiers are also increasingly aware of the scarcity of the best space. International luxury brands are paying record rents on Bond Street and the largest listed retail property landlord in Covent Garden, Carnaby and Soho (Shaftesbury) has vacancy of less than 1%. Grade A office space availability is 5.1% in West End and 7.1% in the City of London. In Paris, office rents rose in all submarkets (except the inner suburbs) last year. Vacancy across Greater Paris is 7% and supply is very tight with only 376,000 sq m (circa 1% of stock) being delivered in 2012 and 2013 and two-thirds of that is pre-let. These markets are not immune from the wider economy. However, the diversity of tenants is ensuring steady demand. In the City, it was the insurance and fund management sectors as opposed to traditional banking that dominated take up last year whilst in the West End, technology, telecoms and media dominated rather than the traditional private banking and hedge fund occupiers.  

Still smells bubbly/fashion driven to me. The question in my mind is, what happens after the Eurozone denouement (which could be close)? What happens when the dust settles and investors (and businesses) start to metaphorically dust themselves down and take a less panicky view?

Here are some useful facts:

Offices

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 In last year's report we identified London, Paris, Stockholm, Oslo, Warsaw and Geneva as office markets experiencing a recovery in demand and a decline in vacancy. Whilst the list has not grown much we would add most of the major German cities, Vienna and Gothenburg. In certain cities, such as Helsinki and Frankfurt take up has been good but high vacancy persists. Scandanavia and Germany with their strong export markets have seen employment levels rise and this is reflected in office demand. However demand is very focused on high quality space. Advances in air handling, wireless technology and business practices have led to much more efficient use of office space. As occupation densities have risen, tenants can afford to pay for quality. Even in these top tier cities, take up is at best merely ensuring modest increases in rental levels. However with growth both anaemic and concentrated the outlook for the remainder is bleak. With double digit vacancy persisting, net rental values are still drifting lower in Amsterdam, Brussels, Dublin and Madrid. Central European cities, with the exception of Warsaw continue to suffer from oversupply with rental values falling.

Now, the middle part of that is really interesting. More efficient use of prime space could justify continuing demand, despite higher rents. This ties in with with the rationale I heard at Premier Oil (LON:PMO) 's AGM last week for retaining their London Victoria base: transport links for staff & visitors make the location worth paying a premium price for. Perhaps I should take the "hub effect" into account when considering the value of prime property, together with the impact of new technologies on business practices & space usage?

London is a good example of just how focused office demand is. The M25 market surrounds Greater London and has an office stock of approximately 130 million sq ft with a long term average annual take up of 2.6 million sq ft. Over each of the last 3 years it has been 2.1 million sq ft and 2012 is showing no sign of improvement on 2011. All a very different story to Central London. However the lack of new development has seen vacancy fall from 8.7% to 8.3% and those markets showing signs of rental growth are both closest to London and tightly focused in the western quadrant; Uxbridge, Chiswick, Staines and further afield Guildford, Reading and Maidenhead. Indeed, offices were the only sector to show rental growth (+2.7%) in the IPD quarterly data for the twelve months to March 2012. The data highlights that Central London offices had rental growth of 5.4% hence rents continued to fall elsewhere in the country, including the South East (ex London).

 

Retail

 As ever in retail it is about customer draw - the winners have been supra regional shopping centres, big box out of town with excellent communication infrastructure and luxury brand pitches. The lack of wage growth, spending cuts and rising cost of living (particularly food and petrol) has resulted in shrinking disposable income. Rapid evolution in e-tailing is changing the way we all shop. In the UK, the 17.6m internet enabled mobile phone users registered in 2011 was double the 2009 figure. Internet sales are now 10% of all retail sales (ex food) and year on year growth was 20%. Increasingly the retail offer is becoming a leisure experience with high quality food offerings amongst the complete retail mix. The consequence is that dominant centres continue to win market share. At the other end of the retail spectrum, convenience shopping is also critical and retail pitches in densely populated areas are also faring well. It is mid market products and sub regional centres which are being squeezed.

 

Now this bit's really worth studying and considering:

Debt and Credit Markets

The availability of debt for real estate investment remains at low levels compared to historic averages. Nonetheless, fears that high debt refinancing needs between 2012 and 2014 would lead to further sharp falls in property values have so far proven to be unfounded. On the whole, banks continue to take a pragmatic approach to their loan portfolios, reducing exposure as and when opportunities arise. Disposals of loan portfolios have increased over the last twelve months, as have the number of joint ventures between banks and investors. Many of these disposals are taking place at significant discounts to the original loan values. That is not to say that these discounts mark a further downturn in property pricing. What is apparent is that market pricing of property shifted to clearance levels some while ago whilst the banks have continued to hold assets at inflated levels. This is why we have often described the current overhang of debt refinancing as more of a problem for the banks than the real estate market.

The problem is particularly acute in Spain, where banks' exposure to commercial real estate totals approximately €340 billion or €400 billion including construction loans. Approximately half of the €340 billion may be problematic according to the Bank of Spain and it is by no means clear that Spain's smaller lenders have sufficient capital to meet losses.

Banks have been supported in their approach by continuing low interest rates and ongoing support from the Bank of England and ECB. Most recently, the 3-year Longer-term Refinancing Operations mounted by the ECB pumped a trillion Euros into the European banking system, boosting bank profit margins and helping to hold down sovereign and corporate bond yields. It looks likely that interest rates in the UK and Eurozone will remain low for at least another 24 months, although this will partly depend on what happens to inflation. Based on financial market pricing, expectations of inflation over the next 5 years are for 1.9% per annum in the Eurozone and 3% per annum in the UK. Of course, these are averages of a great many individual views, both higher and lower than the mid-point. It is therefore by no means certain that anybody actually believes in them. For now, therefore, inflation remains yet another medium term risk to our outlook.

This broad overview of debt markets obscures what is a relatively benign situation as far as listed real estate companies are concerned. As referred to in our introduction, listed real estate companies have proven time and again that they are able to refinance at attractive rates. It is not just bank debt that is available to the listed real estate companies. Corporate bond markets remain open and we are seeing increasing involvement from insurance companies. Most recently, Big Yellow, the self-storage operator, secured 15 year debt from Aviva at an average interest rate of 4.9% and Unite Group, a provider of student housing, secured 10 year debt from Legal & General at an average interest rate of 5.05%. Both these deals demonstrate that it is not just traditional assets that are attractive to lenders at the present time.

Note the phrase I've emboldened: that's why i'm continuing to steer clear of the financial sector: at some point there are more major writedowns to be taken.

Outlook

The macro situation in Europe remains difficult. Few of us can remember such a prolonged period of negativity towards the region from those both within and without and most forecasters remain decidedly bearish. It doesn't help that the UK has slipped back into technical recession and that much of the Eurozone will almost certainly follow, nor that recent elections in Greece and France have changed the terms of the debate from a focus on austerity to strategies for growth, clouding the issues for governments. Nonetheless, the situation is better than it was twelve months ago, even if it does not always feel like it. The ECB has taken important steps to inject liquidity into the European banking market that have had a similar effect to quantitative easing in the UK and US, boosting asset prices and increasing the velocity of money. The main rescue funds within Europe (the European Financial Stability Facility and the European Stability Mechanism) have effectively been merged and made semi-permanent and the IMF has seen its balance sheet, and therefore firepower, strengthened. Bank regulation and oversight also continues to improve and bank balance sheets are slowly being cleansed of toxicity. Risk is concentrated in certain countries and institutions - one has only to consider the precarious condition of the Spanish regional banks to realise that major hurdles remain. However, the fact that we know where the risk resides and what form it takes is in itself a major step forward.

Beyond the macro issues, our main investment themes have not changed since the half year report to shareholders. As stated in our introduction, we are broadly positive about the overall trajectory of earnings, dividends and asset values. Similarly, we see that listed real estate companies generally benefit from sound balance sheets, favourable access to capital and long average lease terms.

Nonetheless, we expect significant dispersion of returns between the best and worst markets and the best and worst property companies. Plainly, companies with exposure to markets such as West End of London offices and shops or Berlin residential, where demand from both tenants and investors is strong and rents and capital values are therefore rising, will continue to outperform. Conversely, those companies with exposure to poorer markets such as Netherlands or Belgian offices will suffer. Some of these latter companies may be faced with the need to issue new equity.

Successful real estate investment is not a passive activity. The best property companies are led by entrepreneurial and creative business people who are able to manufacture returns from the raw material at their disposal. We remain of the view that the best management teams will be able to outperform over the long term and that seeking to identify these teams is therefore an essential aspect of our management of the Trust. We believe that the current portfolios contain numerous examples of such companies and that given time they will demonstrate their ability to generate strong returns.

 

Well, I think I'll try to prusue a balanced approach.