July 19, 2016
MARKETWATCH | By John Coumarianos
Published: July 19, 2016 8:28 a.m. ET
After Brexit, are there any bargains among U.K. real estate investment trusts?
The recent vote in the U.K. to leave the European Union has slammed British real estate. Funds that invest directly in property have frozen redemptions, but more liquid shares of publicly traded REIT companies have tumbled as well in Brexit’s wake. The FTSE NPRA/NAREIT UK Index is down 15.63% in British pound terms for the year through July 11, with most of that decline coming over the last month. Meanwhile, REITs including British Land (BLND), Derwent London (DLN), Great Portland Estates (GPOR), Hammerson (HMSO), and Land Securities (LAND) down anywhere from 13% to 24%. Moreover, the declines have been more severe when measured in U.S. dollars because of the pound’s slide. The index’s 16% swoon amounts to a 29% loss in dollar terms.
So are U.K. REITs now a bargain?
Ryan Dobratz, portfolio manager of Third Avenue Value Real Estate Fund, TAREX contends that they are. In fact, after reducing the fund’s investments in the U.K. over the past year, Dobratz and co-managers Michael Winer and Jason Wolf are REIT shopping again.
Specifically, the trio started buying the U.K.’s largest REIT, Land Securities, when its shares experienced pre-Brexit jitters earlier this year.
In a telephone interview with MarketWatch, Dobratz noted that shares of Land Securities trade at “a cap rate north of 6%.” A “cap rate” consists of measuring a company’s or a property’s net operating income versus the market price of its assets. Paying a price that equates to a cap rate above 6% for high quality, fully-leased properties in a low interest rate environment is considered attractive.
Land Securities owns office properties in London and retail centers in other parts of the U.K. As Dobratz and the fund’s other managers noted in their second-quarter shareholder letter for the period ended April 30. Land Securities’s office portfolio, located in the Midtown and West End submarkets of London, is 95% leased on an average term of more than eight years. The firm’s regional malls in urban centers as well as its highly desirable central London retail locations are 96% leased.
Dividends are low for U.K. REITs by U.S. standards, but are relatively higher compared to the 10-year U.K. government bond, or Gilt, which yielded around 0.8% as of July 11. Based on Land Securities’ 2015 33 pence-per-share dividend and the stock’s recent 1,057 pence price tag, the yield is around 3.1%. Land Securities’s cash flow is adequate to cover the dividend. The firm, according to Dobratz, is producing funds from operations (an American accounting convention to approximate a real estate company’s cash flow) of 37 pence per share. And this doesn’t include new projects that are expected to be completed soon.
Dobratz says the spread or difference between Land Securities’s yield and that of the 10-year Gilt can’t continue. Investors will find Land Securities’s yield too high to resist. Yields may also look attractive to foreign investors seeking pound exposure. Third Avenue has not hedged its currency exposure in the case of its U.K. holdings, including Land Securities, because the pound is at a multi-decade low relative to the dollar. Dobratz wasn’t able to say specifically if he had increased the fund’s position in Land Securities or retail REIT Hammerson (another Third Avenue holding as of April 30), or initiated positions in other U.K. REITs, but he indicated generally that he and his colleagues had boosted the fund’s exposure to the U.K. market.
As the Third Avenue managers wrote in their pre-Brexit letter: “Should weakness in property stocks persist, the Fund is likely to gradually increase its U.K. exposure (currently 7% of net assets). If prices fall further with heightened sensitivity around the referendum or an outright Brexit materializes, leading to further declines, the Fund may ultimately double its exposure (two years ago the Fund had 15% invested in U.K. property companies).”
Of course, risks abound. In the aftermath of Brexit, London could be dethroned as a global financial capital, which would affect Land Securities’s portfolio adversely. Financial job relocation estimates run as high as 100,000, according to Dobratz. Much depends on whether London is able to remain the clearing center for derivatives and other securities and whether English businesses are able to maintain trade with the rest of Europe easily.
The “passporting rights” issue — whether U.K. financial services companies can export services to Europe without setting up branches there — is crucial. Swiss banks, for example, do not have passporting rights because Switzerland is not a member of the EU. And Swiss exports of financial services have trailed those of the U.K. for the past 15 years.
Moreover, the pound could get weaker still, hurting foreign investment in the U.K.
Nobody knows for sure whether prices have dropped enough to justify the impairment London real estate might withstand. Still, London will likely remain an integral part of the global financial system. It’s difficult to envision another European city replacing London as a center of finance. And Dobratz says current prices are discounted enough to make owning buildings a profitable proposition.
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Specifically, the Team started buying the U.K.’s largest REIT, Land Securities, when its shares experienced pre-Brexit jitters earlier this year.