Recession more likely - shorting causing volatility

Each quarter Reita publishes an Expert Panel Survey and follow-up thought piece to give an authoritative property industry view on key issues and current market sentiment.

read the Reita Expert Panel survey results
watch Reita Chairman, Patrick Sumner, interview

Further to the expert panel research, Patrick Sumner, chairman of Reita (and head of property equities at Henderson Global Investors) led the Reita market review panel discussion, which examined some of the experts’ findings in more detail:

Update – since last quarterly perspective

Investment conditions have continued to deteriorate, according to more than 75% of the property industry leaders in the Reita expert panel survey conducted for this quarterly market review. Almost a third of the experts questioned felt that conditions had deteriorated significantly, while another 44% reckoned there had been a slight deterioration. 

These views are backed up evidence from IPD, whose monthly index of direct commercial property performance continued its negative trend with a fall in capital values of 3.5% in the three months to the end of July. This was only partially offset by an income return of 1.5%.

For the year to the end of July the fall in capital values was 20.5%, with an income return of 5.5%, i.e. a total return for the year of -16%. The three commercial sectors (retail, office and industrial) performed broadly in line.
 
The capitalisation rates used by valuers have moved out on average to an equivalent yield of 6.9% overall, compared with 5.4% at the peak of investment market in June 2007.

Patrick Sumner, chair of Reita and leading the quarterly review,  also highlighted movements in property stocks which fell by around 25%, from the end of April to mid-July,  but then rallied strongly by 17% after the oil price began to fall back, the US Fed announced restrictions on the short-selling of financial stocks and some better-than-expected results from US banks. 

What’s happening today…?

Rental income growth remains positive, albeit slowing. The slowdown is due to weakening tenant demand in all sectors, but UK landlords benefit from long leases with upward-only rent reviews that limit the risk of rental income actually falling.

Weak City office demand has resulted in the postponement of at least one major development, with British Land announcing that they are “reviewing the timing of construction and target completion" for their development at 122 Leadenhall Street (“The Cheesegrater”). However, having completed the foundations, the developer is in a position to respond quickly to any improvement in demand.
 
The performance of UK property companies, including REITs has been volatile. After range-trading for the first four months of the year, property stocks (but not housebuilders) tracked the decline in financial stocks as growing worries about inflation, interest rates and recession dogged the market.
 
The activity of short-selling in the sector is at the root of this unprecedented volatility. The property sector as a whole is not very liquid, especially in the small and mid-cap names exposed to higher leverage or development that have been the target of some aggressive (and indiscriminate) shorting. In the long run such volatility is not a concern, but it is certainly unsettling in the short term.

The future – Reita viewpoint

The tone of the recent Bank of England statement was notably more pessimistic than previous statements and the threat of recession has increased significantly, a view also reflected in the  Reita’ expert panel survey, where almost half the industry leaders now expect a recession, compared to less than 30% in the previous survey in May.

However, at the same time the 5-year swap rate (the benchmark for property investors) fell sharply from a peak of 6.2% in June to around 5.3% today (14 August), perhaps building in expectations of better conditions, or at least interest rate cuts ahead.

Share prices are likely to reflect capital market concerns, rather than the fundamentals of tenant demand and security of income. It is fair to assume that pricing will overshoot on the downside, just as it overshot on the way up. However, one only knows where the bottom was in retrospect. It may turn out that 15th July 2008 was the low point, but then we thought that 10th January was as well.
 
The property market is subject to the same hopes and fears as the general economy. It suffers when starved of capital, but it suffers more when it is seriously oversupplied with space, as it was in the early 1990's. That is not the major problem in this downturn. It is lack of investor and tenant activity that is depressing the market. Both these factors can turn rapidly, but there may be some further squalls to weather first.

Looking further abroad… 

For signs of positive investor activity it is worth looking at the US market, where the inflows into REITs have reached $3.5bn so far this year, ahead of the same figures in 2007.

Further Reita Expert Panel survey findings:

• Just over half of the experts’ organisations use property derivatives in one form or another, reflecting the rapid growth in this market which is this year predicted  to overtake the direct market, in terms of the total transaction value.
• Almost 85% of the industry leaders polled were concerned by the impact of the removal of empty property rate relief, providing strong support for the campaign being led by the BPF for government action to reverse the decision to impose this harmful tax.

The Reita Expert Panel includes representatives from 24 of the leading property and investment organisations, including some of the largest UK REITs, EPRA, NAREIT and the London Stock Exchange. The panel is surveyed on a quarterly basis about the key issues facing the property investment industry today.