Raising your capital in torrid times

Mar 4 2009 by Andrew Miller, The Journal

FOR the first half of this decade, commercial real estate was the asset class to invest in, outperforming equity markets annually and delivering a strong performance relative to lower-risk assets.

It is unsurprising then that both retail and institutional investors were heavily exposed to the asset class due to the combination of strong returns and the tangible nature of bricks and mortar – a major source of comfort for many investors who had lost faith in equities following high-profile corporate failures .

A further positive for property was its lack of correlation to returns from traditional assets like equities and bonds.

However, the past 18 months have been torrid for real estate. While valuations may now appear attractive relative to other income-producing assets, we do not believe that real estate's fortunes are likely to improve in the short term.

Over the past 18 months we have been using a simple valuation model to gauge the long-run fair, or equilibrium value of commercial property to guide our underweight recommendation in this asset class.

Following the recent falls in the commercial property market, values are now in line with our equilibrium estimate, hinting at the need to shift our assessment. However, continued downward price momentum suggests a period of undershooting in the short term.

As an example of the problems faced by UK commercial property, the two real estate companies in the FTSE 100 have between them announced rights issues totaling around 22% of their market capitalisation.

As they are in danger of breaching loan-to-value covenants imposed by their banks, they have been forced to raise capital.

One option is to sell assets, thus realising losses in the process and further driving down capital values of real estate due to the lack of liquidity in the market.

The other is to turn to shareholders to raise capital. While rights issues are the preferred option at the moment, there is only limited scope for these and disposals may well increase in the near future.

Another useful valuation measure is to compare property yields to those of ‘risk-free’ 10-year government bonds. Property yields have risen to almost 400 basis above those offered by gilts.

This is 25% higher than during the recession of the 1990s. Nevertheless, such a high-risk premium suggests that investors remain wary of further capital depreciation, as well as decreases in rental income in commercial real estate.

All in all, we remain comfortable staying underweight commercial real estate for the moment, but we do recognise that the case for doing so is becoming less convincing as the needed readjustment in valuations is occurring.

Andrew Miller is regional office head of Barclays Wealth