Henry Dixon, fund manager at Matterley, looks at whether the real estate sector is displaying value.
In this country, probably above all others, we have an obsession with the underdog. From a stock market perspective this translates into a morbid fascination of trying to catch falling knives.
The real estate sector has been a sharper and faster falling knife than most. From its peak in December 2007, fuelled by the excitement surrounding the advent of Reits, the sector has fallen by two thirds as overvaluation and stretched balance sheets became brutally exposed by the recession. Stock market history however would caution us against catching falling knives as sectors overvalued in the past can take more than just one market cycle to perform again.
The technology sector is a good example of this as it had a remarkable year in 2009, rising by over 100%, but this was after almost exactly 10 years in the doldrums. The key to the technology sector’s success in 2009 though was not its precipitous fall from grace, but rather that it finally exhibited value as single digit P/E ratios were accompanied by many net cash balance sheets. The key debate therefore for real estate should not surround the size and speed of the fall but rather whether it is now displaying value.
Doing the sums
To make a conclusion on this it is important to put some numbers to paper. Using the five FTSE 100 real estate companies as an indication of the sector as a whole and indexing their total assets to 100 the following picture can be built of the average real estate company. 100p of assets is offset by on average 52p of debt leaving net assets of 48p.
Today the market is willing to ascribe a small premium to this net asset figure meaning our imaginary real estate company is trading at around 50p today. The 100p of assets is supported by an average rental stream of around 6.5p. This initial yield of around 6.5% attracts many given the low interest environment we find ourselves in. It is important however to realise there are some material drains on this rental income. Interest on the debt is the main component. Assuming 6% interest rates on the around 52p of debt means that around 3p is lost. Then there are a multitude of other costs, such as depreciation of fixtures and fittings and maintenance, which roughly takes off another 1p from the rental income.
So, after all is said and done 6.5p is quickly reduced to 2.5p. 2.5p divided by your average share price of 50p gives you an earnings yield of 5% and under Reits 90% of this is paid out in the form of a 4.5% dividend. So there you have it, our average real estate company is trading on just over one times net assets, 20x earnings with a 4.5% yield.
Does this represent value?
We would caution against this view for the following reasons. Despite material rights issues there is still too much debt. Every £1 you invest in a real estate company exposes you to on average £1 of debt whereas this figure for the market as a whole is nearer 20p. The ultimate irony of Reits is, because of the enforced payout ratios, companies cannot payback debt themselves but will either have to sell assets, most likely at the wrong point in the cycle, or come back to shareholders for more capital. 20x earnings is close to a 50% premium to the market and while the yield of 4.5% is attractive it is worth noting that if the market as a whole adopted a 90% payout ratio then it would be yield slightly over 7%.
Many may however disagree with these views on valuation citing the sector as the perfect hedge on the inflationary world we seem to be entering. Perceived wisdom is in this environment you should expose yourself to debt, as it will be eroded in value, and physical assets, as they will appreciate in value.
Real estate offers an interesting combination of both but we would infinitely prefer the expose ourselves to just the asset portion of the balance sheet as opposed to the debt element owing to the greater margin of safety. Gauging downside risk is key in making any investment and as we run scenario analysis for the real estate sector we are concerned.
Firstly, the starting point of a premium to assets is unattractive in our view. Furthermore, given the sizeable debt positions, the risks to the asset values are very real in the event that rental income disappoints. Using the example above of our theoretical real estate company any fall in rental income will be amplified by a factor of two when it comes to calculating assets. Also given the fixed nature of the outgoings in the form of interest and costs all that is required is a 35% fall in rental and there will be no distributable income for shareholders.
In our view therefore the real estate sector represents an unattractive risk reward from a valuation perspective. Its unattractiveness is further demonstrated by the fact cheaper asset plays are currently available within the market and many of them enjoy materially better balance sheets. Certain house builders for example stand at meaningful discounts to assets with little or no debt.
Within the leisure sector we can find shares of a hotel company standing at close to a 50% discount to assets, again with only modest levels of debt, and a conservatively financed pub company on a single figure P/E ratio, yielding around 6% and at a around 25% discount to net assets. Finally within the food retail sector we can find certain shares trading at a small discount to true asset values supported by a P/E of around 14x and a yield of 4.5%. It is this combination of an unattractive starting valuation, combined with better asset and yield plays elsewhere, that lead us to believe the prospects for the quoted real estate sector remain poor in 2010.
Henry Dixon, manager of the S&W Matterley Undervalued Returns fund
