The reputation of commercial real estate stocks among retail investors is sullied. With the possible exception of the internet and technology sector at the beginning of the decade, never has an industry been held in such low esteem by the investing public. But does the old adage about the retail money and smart institutional money always flowing in opposite directions hold true: is there value in European property stocks?
The stock market began to anticipate problems in the commercial real estate sector before the worst news appeared. "The listed UK property sector fell by around 40% from January to November 2007, by which time [investors] appeared to be pricing in a worst-case scenario and then some," notes John Perry, head of pan-European real estate research at Deutsche Bank in London.
To some extent these falls were merely mirroring the reality in the commercial real estate market. IPDs UK index fell 3.6% in November and 3.7% in December the largest falls ever recorded (the previous largest fall was 1.8% in May 1990). However, while the speed and severity of the falls were spectacular they must be considered in context.
"The scale of the falls reflects a fundamental change in the way in which valuations are conducted," says Perry. Whereas previously third-party valuations depended on transactional evidence which in a weak market was scarce and therefore led to slow and lengthy falls in values that undermined confidence now they are allowed to factor in market sentiment. "The effect is to accelerate falls in values and help us find a bottom sooner," he says. "Its probably a healthy change."
Moreover, the implied yields and portfolio value declines of many stocks indicated that a severe early 1990s-type recession/property market crash was imminent when the economic indications and fundamental market conditions pointed to nothing of the sort. "As such, we took the view that the sector offered value," says Perry. The market appears to have shared this view, having rallied by 20% since.
So is there any value left in real estate stocks or has the market already priced in a recovery? Some stocks certainly still appear to be being punished by the market. When British Land announced its third-quarter results at the beginning of February it wrote off £1.4 billion, or about 9%, from the value of its portfolio.
"However, we estimate its share price implies a further 17% fall in the value of its portfolio, which if the growing view that the worst is behind us holds true could be seen as excessive," says Perry.
However, some analysts remain pessimistic about the broader market. A report published by HSBC at the beginning of February titled "UK Reits wake up to a false dawn A triumph of hope over cash-flow reality" notes that the UK commercial property market is in the midst of a 25% to 35% correction, which the bank predicts will be followed by an extended period of sub-inflation rental growth.
The report notes that cashflow analysis exposes UK Reits weak return on capital, economically value-dilutive development programmes and structural erosion in rental pricing power. "We believe that the sector bounce in the year to date has exacerbated significant downside opportunities," it says, before downgrading price targets for Land Securities, Brixton, Segro (formerly Slough Estates), Hammerson, British Land and Liberty International aggressively.
Nevertheless, there is evidence that investors are returning to property stock just as retail investors desert the asset class in droves, as is usually the case. "Towards the end of 2007 and into 2008, we have started to see an increased level of interest from generalist investors and decreased shorting activity, indicating that sentiment is improving," notes Perry. With the IPD monthly index for January registering a total return of 1.6% a significant slowing in the rate of decline from November and December it remains to be seen whether this new investment is smart money pre-empting the bottom of the commercial real estate market or merely the triumph of hope over reality, as HSBC believes.