UK real estate investment trusts (Reits) are at risk of a sharp downward re-rating relative to the wider equity market, as the cost of property versus shares hits its highest level since the bubble of 2006.
Following the sharp downward equity correction of the first week of August, the FTSE is trading at a forward price to earnings (P/E) multiple of 11.1x, while the chase for yield has pushed Reits to a 10% premium to assets.
‘Something has to give, and the last time it did, it moved sharply,’ said Evolution real estate analyst Alan Carter. ‘Real estate has not been this expensive versus the wider market since the commercial real estate peak of late 2006.
‘Logic [dictates] that the discount/premium on Reits should in part, a rather large part, be influenced by the valuation of the broader equity market. When the market is on 17x, the sector ought to be trading on a lower than average discount, and when it’s on 10x it should be on a wider discount. We’ve had a cheap-looking equity market, or at least a lowly valued one, and very expensive Reits.’
The sharp falls in the wider equity index that have pushed values to the current levels have come as analysts predict the easy capital and income recovery gains from the market bottom are over.
‘Our forecasts for commercial property, excluding central London, suggest that average rental values should level off this year and see a very modest rise next year,’ wrote sector specialist GVA in its Q3 update.
‘Thereafter, growth should accelerate as supply shortages begin to emerge, but growth is forecast to reach only 3% per annum by 2015.’
Like other real assets and income investments, property has recently been charged by the search for safe havens and yield – arguably, beyond the fundamental case that can be made for them. Several property investment trusts have recently traded near a double-digit premium.
‘The discount/premium is aggressive when compared with the underlying level of capital growth, which is becoming entirely reliant on Reits’ “self help” rather than broader property market conditions,’ added Carter.
‘Also, if capitalisation rates have stopped coming down, then why on earth pay par for what by definition has to be a rental growth story. Really? In this market, against this financial backdrop? You’re taking an awful lot on trust.’
While the FTSE EPRA/NAREIT UK Index has dropped 16.8% from a post-crash high of 1,327 in June to 1,103 last week, this remains below the wider FTSE 100’s 17.29% recent peak-to-trough correction.
According to data provider IPD, UK property capital values fell 0.5% over Q2, led downwards by secondary property sites falling 0.4%, as the UK high street took a body blow from lower spending. While prices have risen 20.5% over the past two years from the market bottom, growth was heavily loaded to the initial bounce, with momentum grinding to a halt through the first half of 2011.
Much of the income case for secondary property has been eroded over that period, as void rates have crept up alongside retail failures and branch closures.