First published on 21st February 2021

As stock markets seem to hit a pause, the implication is either that they are too richly valued, so the marginal client will not buy, (perhaps the Tesla case), or that everyone who wants to buy has already done so, so there is no demand at any higher price, (the UK value stock case).

One I suppose is active, yes, we want it, but the appetite is not here just now; the other passive, no, and not here, as we are already satiated.

So as investment performance comes from either accruing income gains or from prices rising, we are looking for new places to make a return. We are therefore asking ‘when does property become attractive again’?

Being driven towards property?

Property as an asset is largely about demand; as an expensive item buyers usually only acquire the rights over a space in order to then utilise the asset. So that comes down to rental demand, where in theory you will rent a space if you can make more money by so doing. Otherwise, why bother?

Developers meanwhile will add to available stock as long as the cost of doing so, less the costs of funding, plus the resulting discounted rental stream, is greater than zero. Simple economic theory.

Yet this is one market area where taking a thirty-year view on valuations, which of course allows you to fully discount 2021 and even 2022, seemingly just does not apply. Those earlier years are instead looming very large over current prices even for long life assets.

Another problem is that a lot of stock is still being held off the market, but not used for various reasons. Some is the inequity that landlords can leave a property empty, refuse to assign the lease and then demand an uncommercial surrender premium.

If you are the landlord, that seems fair, to everyone else it looks monstrous. More advanced legal systems, such as in France, effectively ban the practice.

Is suspending evictions effectively seizure of private property by the government?

Then there is the equally odd suspension on evictions and the extended mortgage holidays, which is in essence the government seizing private property, without compensation or due process, and requiring it to remain either empty or non-income producing.

This happens to be a curious feature of this health crisis, but one that they are happy to keep extending. I am looking forward to the inevitable litigation on this, and I suspect a rather large bill to HM Treasury will inevitably follow (so that’s one payable by us).

In some areas (warehousing for example) by contrast this is not an issue, demand is strong. In others, like residential, enough of the market still operates to give pretty good price indications anyway, although the impact of empty property levels from an extended mortgage holiday, or voids that can’t be repossessed, may still be significant in some areas. While other areas, like Central London, where high priced short tenure deals had become too common, (also known as Airbnb) the flushing of the system came quite quickly.

Nevertheless, I think the end of tax incentives, plus the release of frozen stock, plus builders using the summer to restock (a number of housebuilders saw stock levels swing alarmingly low, as restocking stopped last spring, in the peak build season) will cause excess supply, for a while, later this year. However, such is the extraordinary level of excess liquidity and the pace of household formation, it does not feel a significant threat to residential sector pricing overall.

Office and retail sector – commercial property

So, what about offices and retail demand? Well, when we have looked at these areas, we have simply said they are uninvestable, like cinemas and airlines, we know far too little about the end of lockdown. There is a great deal of valuation angst about high priced office developments and clearly some distress in the over-priced short tenure deals, (so WeWork and its precursors). But there is relatively little sign of extensive non-payment of rent, certainly compared to retail, where an effective rent strike is visible.

Meanwhile retail tenants are well aware that they will be able to pick and choose prime sites in future and that landlords have a slim chance of finding a bigger fool, to take on their current inflated terms. While the judicial innovation around the CVA option, has allowed courts to ignore the future rental income stream as a valid current claim by property owners, on the rather logical grounds that the service has yet to be provided (so it can’t be current).    

Valuations of office space

So, pressure on office values will come from excess supply still arriving (this stuff has a very long lead time) and a mix of non-renewal of leases (which takes some time to work through) as well as downsizing, is likely to follow as bosses realise that hiring their employees’ spare room for free is a good scheme: no business rates either, nor season ticket loans.     

I think this is the office pressure point, that is ‘where is long term demand going to settle’? On that I tend to be optimistic, London with far fewer commuters, tourists, and also cheaper rentals, seems a rather nice thought, just now. It will take time, but from my experience post crisis London, once the coffee shops reopen, has always been rather attractive. Whether it was caused by the Luftwaffe, the aftermath of Big Bang, Irish Republican terror attacks, the Dot Com bust, the GFC – all of these saw life improve in London after the smoke cleared.

 Retail premises

Which leaves retail and retail services as the ‘unknowns’.

Now that is driven by footfall, and by the ability of online to undercut the physical stores. Here I do see the online world as slowly hitting more and more problems.

Much of its delivery advantage has been attacked this week by the UK Supreme Court, in typical countercyclical fashion, just as we are desperate to create more work and revive the economy, they have ruled the flexible, self-employed workforce involved in on-line retail, are actually high cost, inflexible, unsupervised employees. Nice one. Zuckerberg has also decided to delete Australia, (and China to ban the BBC). While even without that pressure on media content and advertising and on delivery costs, there is a lot of unprofitable cap ex chasing a finite on line market.

So, some retail still looks oddly shaky, stocks like Shaftesbury and NewRiver were stock market darlings, but now look very subdued, and oddly much more so than their typical tenants; both rely heavily on the restaurant trade for instance, but seem to have done worse than a typical volume operator in that sector, like Wetherspoons. Or indeed the discount grocery sector, which currently seems fine.

Commercial property – property investment trusts

The problem one assumes is that the commercial landlord’s costs barely move, but the tenants have been able to not pay business rates, and to furlough staff, turn the heating off, stop marketing, and stop paying rent. Indeed, in Shaftesbury’s case, the one fixed cost that mattered, finance, has rather gone the other way, interest rates have risen and “covenant repair” costs are rather high, as their creditworthiness apparently slips.

While putting this all together, property investment trusts, like TR Property, are therefore sitting well below pre COVID levels, the vaccine recovery trade has yet to arrive for them. Their prices were pretty flat from June to November last year, before a spike up in November, which both in their NAV and share price, has now just dissipated.  

Yet so much is now in their apparent favour, compared to in June 2020, we must be much closer to the end of the COVID recession, or at least vast areas of the stock market are saying so. Property does also have that bit of gold dust, a solid yield well above inflation. But no, the property investment trusts (PIT) are apparently stuck at this level.

The blight over the sector is the NAV, of the underlying stock of REITs (Real Estate Investment Trusts) which are not the same thing, but a classic piece of passing off, but that’s another story. Anyway, a PIT largely owns REITs, just to be clear.

So even as valuers take a big slice off values in the worst sectors (about 20% is not uncommon) no one knows if that’s really it. They have been slicing those retail values for a while now. They don’t trust the few actual transactions, claiming new tenants are exceptional cases (for which read fools with too much cash). They don’t trust the lenders, as nearly every interest coverage covenant is blown, and they know new supply is immense (from slowly finishing development and rapidly collapsing store groups), and so the answer is just no.

In other words, they really have no idea where values are. Or if they do know, the stock market simply does not believe it.

How long will this be true for? Indeed, is that a rational market position? I suspect it is mainly the unknown part of this that currently holds prices down, whilst if you think you can see through all of that confusion, or you do trust the valuers, you might take another view.

In particular you might do so, if you can find areas not so exposed (or even benefiting from) the Amazon firestorm.     

Charles Gillams

Monogram Capital Management Ltd