Posted on 10 Apr 2014

Towering Returns


As the UK’s economic recovery gathers traction the overlooked secondary property market could enjoy a good bounce. Mark Dunne explores the segment and highlights some interesting opportunities.

 Secondary commercial property is set to generate higher returns this year than prime assets for the first time since the financial crisis. As the UK bounces back this section of the real estate market, that is, property located in the country’s regional towns and small cities and dotted in and around London, should rebound from highly depressed levels.

Expert in the field DTZ forecasts 2014 total returns – being rental income combined with capital gains – of 12.1%, up from 5.1% in 2013. This beats the 10.1% expected from prime real estate, only marginally ahead of last year’s 8.6%. This is the start of a trend with the secondary market anticipated to achieve double-digit growth in the next three years, while prime returns hover in the mid to high single digits.

 

The rents generated by secondary properties have fallen 17.4% since the second quarter of 2009, while prime rents have continuously climbed since the crisis. Secondary’s re-emergence is understandable when you consider that the market outperforms prime when the economy is strong, while prime outperforms secondary when the economy is weak. That it fell so far only serves to underline the recovery potential.

 

Our preferred secondary property plays are Real Estate Investment Trust (Reit)Palace Capital (PCA:AIM) and CLS (CLI), with the latter exposed to the redevelopment of up-and-coming Vauxhall in South London. We also like low-end shopping centre operator NewRiver Retail (NRR:AIM) and Segro (SGRO), another Reit, as well as GP surgeries manager Assura (AGR).

Let the right one in

The improving economy, which the Office for Budget Responsibility (OBR) expects to grow 2.7% this year, has boosted the appetite for riskier assets. Office and industrial units are the most sought after secondary property, with retail and related warehousing at the bottom of the list due to oversupply, according to commercial real estate services provider Cushman & Wakefield. However, there is strong demand for all of the above in London.

Demand and yield – the annual rental income as a percentage of the property’s value – may have returned to the real estate sector but as with any opportunity investors need to do their homework. Handing your hard-earned cash to a secondary-focused property company because you’ve heard that total returns in the sector are set to grow may not bring the rewards you’d hoped. No two companies are the same and investors need to look for those led by managers with a strong track record of buying and managing such assets.

Portfolios with properties let on long leases are desirable. Sensible levels of gearing are also a must because as history has taught us, sometimes you never know when the market will turn. When looking to reduce risk, opt for commercial property where the tenants can continue to pay during tough periods. GP surgery landlord Primary Health Properties (PHP) is one example as the Government covers the rent, making a default unlikely.

Unfortunately, Primary’s prospective dividend per share (DPS) of 19.5p for 2014 is only covered 0.8 times by a consensus call for 16p of earnings per share. A more secure play on this sector is Assura, which also manages GP surgeries for the NHS but has greater cash reserves and whose 1.3p prospective DPS is covered 1.6 times by EPS of 2p for the 12 months to March 2015. Balance sheet strength is important in what is a cyclical sector, where it pays to ensure that rents are as defensive as possible, which is easier said than done in the regions. It is also important to consider that secondary properties tend to be over-rented and enjoy weaker covenants than those found in the prime space.

One of the problems in targeting the secondary market is that yields are typically higher to reflect the greater risks taken. It is a good idea, therefore, to add some prime exposure to your portfolio too. Shaftesbury (SHB) is a good play here due to the mix of office, leisure, retail and residential assets it owns in London’s West End, all segments that have tended to remain strong no matter how the wider economy has performed.

 

The real attraction of prime commercial property is its long track record of rental growth. Rents from offices in central London are forecast to grow 2.5% on average between 2013 to 2016, expects DTZ, while rental growth from prime retail is also expected to be strong in cities such as London, Manchester and Glasgow.

Low interest rates and uncertainty in the capital markets make bricks and mortar an attractive investment. Property can provide a regular income while investors can also make a capital gain on their original investment. Economic decline following the financial crisis and uncertainty about the developed world’s recovery, mixed with low bond yields and depressed interest rates has prompted wealthy investors to search out safe havens for their funds.

These investors have turned to prime property assets in major cities, such offices in central London for income and protection, in the knowledge that rents are dependable. This has pushed up prices making them more expensive and widening the yield gap between prime and secondary assets. Meanwhile, secondary rents have struggled to recover from the double-dip recession in the past few years. Several UK prime occupier markets have been supported by a lack of new developments, whereas largely-oversupplied secondary markets have proved more vulnerable to the struggling economy. This weakness in secondary occupier markets mixed with the level of over-renting has further exaggerated the yield gap, although all could be about to change.

Mind the gap

Palace Capital bought a portfolio of 24 properties for £39 million last year (21 Oct ‘13) for a 13% yield and managing director Neil Sinclair says that today he would be lucky to get 7%. Yields have compressed as more investors and debt providers have entered the market, partly in response to them being priced out of prime and partly a reflection of their greater risk appetite.

Despite prices rising and yields falling, the secondary market, just like prime, still has plenty of road to travel. Secondary growth will be led by offices, driven by those in London. This is the only segment of the secondary market forecast to achieve positive rental growth in the three years to 2016 by 1.4% a year, according to DTZ. However higher-yielding secondary assets, such as industrial sites and offices outside of London have greater scope to narrow the yield spread and are expected to outperform from 2015 onwards.

 

Retail is anticipated to be secondary’s worst performer due to oversupply and as spend migrates online. This area of the market shrank on average 4.1% in each of the four years to 2012 and will contact by 1% between 2013 and 2016.

• Prime Buildings of the highest quality and specification in high-profile locations, such as the City and London’s West End

 

• Secondary Properties are let on shorter leases, have weaker covenants, are in lower-profile locations and are less liquid than their prime cousins

 

Assura (AGR) 43.0p

Market cap: £217.7 million

GP surgery landlord Assura (AGR) could be set for a boost if the NHS decides to invest in new properties as expected following April’s review of the Primary Care Trust sector.

The Reit has a £651 million portfolio, which it could expand later this year after creating a £25 million war chest to build any new buildings the health service requests.

The Warrington-based company generated £41.7 million last year in rent from its estate, which comprises modern health centres designed to ease the strain on A&E departments. This income is backed by Government funds on 25-year leases, limiting the chances of default if the economy slips into recession again.

 

The only major threat to these revenues would be if the state decides it wants to change the way it manages its primary care or wants to renegotiate the financial terms of the lease.

 

 

There is competition from Primary Health Properties and MedicX Fund (MXF), who could be used to drive rents down. To ensure that it is not building a property that it would struggle to find a tenant for Assura doesn’t send the diggers in until a lease has been signed

 

Between October and February it grew its rental income 2.5%, the result of rent reviews, and added new assets to its portfolio. Four new assets and three extensions have been completed since October, adding £1 million a year to its rent roll at a 6.9% yield on total cost. It is currently working on five further projects. Assura trades at a slight discount to its 42.2p net asset value (NAV) per share and is expected to generate a 3.6% dividend yield this year.

Broker Consensus

Consensus Value
Sell 0
Hold 0
Buy 1
Not Available 0

 

CLS (CLI) £13.03

Market cap: £565.6 million

European property investor CLS (CLI) is set for a boost as its Vauxhall re-development project is set to complete by the end of this year. The largest private landlord in Vauxhall, South London is playing a crucial role in the area’s transformation. The project’s centre-piece will be a 143,000 square metre mixed-use regeneration project which will add new residential properties, retail outlets, a hotel, student accommodation and a cinema.

 

This is part of CLS’ huge pipeline, the potential of which is enough to ease any fears over its NAV premium and debt levels. A strong share price performance means that while EPRA NAV per share improved by around 10% in 2013 to £12.68, the company still trades at a premium. Meanwhile, its debt pile stands at some £800 million.

 

CLS specialises in high-yielding offices and has a £1.1 billion portfolio, which improved by around a fifth last year. Its assets are spread across Sweden, Germany and France, with around half by value in the high growth London market.

CLS’ strategy is to invest in its assets by improving its long-term growth through re-development or refurbishment. It has also bought fresh stock, adding 34 mainly Government-let properties to its portfolio last year for £118.6 million (16 Sept ‘13). Commercial property investors have suffered in recent years as struggling tenants seek to reduce their rents or bail-out altogether. But CLS has increased its exposure to Government agencies, which stands at around half of its business, while blue-chip companies account for 27%.

 

A new face at the top could worry some, especially as the group’s shares improved 70% last year under Richard Tice’s leadership. He stood down earlier this year but the news should not disrupt operations as the developer is led by a tight group headed by executive chairman and 51% shareholder Sten Mortstedt. This looks like a case of business as usual.

Broker Consensus

Consensus Value
Sell 0
Hold 0
Buy 1
Not Available 0

NewRiver Retail (NRR:AIM) 281.0p

Market cap: £278.2 million

Retail-focused secondary property specialist NewRiver Retail (NRR:AIM) should do well into a recovering economy, but the firm’s strong pipeline means it is also the master of its own fate to a degree. The Reit is expensive, trading at a 26.5% premium to its 222p NAV. It has £600 million of assets and operates shopping centres at the value end of the food and retail market.

 

The total return from the secondary market, where all its asset sit, is set to outperform prime from this year, and along with improving valuations the London-based company has a £160 million war chest in order to add new properties to its portfolio. Part of these plans include a drive to re-develop 202 pubs it bought from brewer Marston’s (MARS) into retail units (28 Nov ’13).

NewRiver says it has already received interest from supermarket chains for some of the units, which are located in residential areas and it intends to convert into convenience stores and restaurants. Until a decision is made on when the work will start the pubs will continue to generate revenue under a lease-back agreement with Marston’s, generating a 12.8% yield.

The Reit enjoyed strong growth during the downturn serving the lower end of the market. Indeed, occupancy stands at 94%. Its focus on the lower end proved quite defensive as consumers tightened their belts and its £10 million debt appears manageable for a company collecting £8.5 million rent a year before the Marston’s deal was signed. If the wheels come off the economy then NewRiver should not be hit too hard, but it appears that the company needs momentum to build in the recovery to reduce its premium.

Broker Consensus

Consensus Value
Sell 0
Hold 0
Buy 1
Not Available 0

 

Palace Capital (PCA:AIM) 262.5p

Market cap: £31.1 million

Commercial property Reit Palace Capital (PCA:AIM) made a move that turned it into a serious player last year and it could fund a 6% maiden dividend this year. Palace announced a 2p a share interim dividend (27 Mar) after it bought 24 UK-wide commercial properties from Quintain Estates & Development (QED) for £39 million (21 Oct ‘13) on a 13% yield.

 

The deal turned Palace from a business with nine properties in Cheshire to one with more than 30 assets worth in excess of £45 million. Its assets are predominately based in city centres and should show some resilience if the economy stumbles. To help prepare for the worst the company is reducing debt with net borrowings declining to £18.5 million from £21.2 million in the six months to February.

One of Palace’s greatest assets is its core executive team of managing director Neil Sinclair and non-executive chairman Stanley Davis, who have several decades of property experience. The duo has proved to be tough negotiators in bringing assets into the business.

 

Negotiating favourable deals is only the start. Managing the assets is where Palace secures value and Sinclair and Davis have been quick to dispose of those sites considered too management and capital intensive. Palace paid £750,000 for a warehouse in Cardiff from Quintain which has since been valued at £900,000 by Cushman & Wakefield. The property wasn’t fully let and needed investment, but Sinclair and Davis decided it was better to sell and raised £1.1 million (26 Mar).

Segro (SGRO) 337.9p

Market cap: £2.5 billion

Industrial and office Reit Segro (SGRO) develops and manages warehouses, light industrial properties and data centres. A relentless focus on  portfolio management is driving growth and involves re-developing sites into higher-value uses. This strategy has seen the firm develop data centres, offices, car showrooms, R&D facilities and self-storage space. Meanwhile, around half its portfolio is invested in multi-occupier light industrial properties located in and around major conurbations where there is good road access.

 

Active portfolio management helped boost EPRA NAV per share by 6.1% to 312p during 2013, and the firm now trades at an 8.3% premium to this figure. This means that investors will be paying 8.3% more for the assets than they are currently worth, but with total returns improving in the secondary market this gap should narrow.

 

Segro works to position its portfolio in high growth but secure markets. Its portfolio is characterised by distribution centres for internet companies and other businesses with a logistical need are secured on relatively long leases, strong occupier covenants and limited ongoing capital expenditure requirements, while offering secure and attractive income returns.

The company has built such as strong business through disposing of selective properties to provide the liquidity to strengthen through acquisitions. These proceeds have also reduced debt, with net borrowings ending last year at £1.5 billion, equivalent to conservative financial gearing of 62% given £2.3 billion of shareholders funds.

 

Segro has also reduced its reliance on the UK economy, where a downturn can have a harsh effect on properties outside of the country’s major economic centres, such as London. It has built a real estate  portfolio across Europe in Poland, France, Germany, Belgium and Italy.

 Broker Consensus

Consensus Value
Sell 2
Hold 4
Buy 1
Not Available 0