As Simon Elliott, head of investment company research at WINS, points out in its most recent review of the market, ‘Over the past 12 months, no sector has been subject to more bearish sentiment than property, and the derating of direct property funds in the closed-ended fund sector has been severe. The sector average discount among UK direct property funds is now 37 per cent, while European direct property funds are even wider at an average discount of 59 per cent, reflecting their higher gearing levels.’

Rewriting the rules
Now, under the usual rules of the game, such discount levels would have bargain hunters swarming all over the property funds sector. But in the distinctive world of property investment, the ground rules are a little different.

Nick Greenwood, head of investment trusts at Midas Capital, observes that ‘These things are not being rationally priced. There is a distrust of net asset values (NAVs) because they can be rather opaque. You have to remember that NAVs are historic – i.e. they look backwards – and we are in a market where asset values are falling, so you may have to reduce the NAV figures quite significantly. For example, if you are ten per cent geared and assets have fallen by ten per cent, you will need to take 20 per cent off the NAV.’

With a fund investing in shares or bonds, or any other easily realisable asset, getting an accurate figure for the real value of a fund’s assets is relatively easy. But the illiquid nature of property investment muddies the waters considerably.

Nick Sketch, investment trust analyst at Rensburg Sheppards, points out that ‘The disadvantage with property trusts in general is that, like private equity trusts, whatever the headlines, if things get really bad you can’t easily sell the underlying investments, so there is always that element of risk.’

Chris Turner, manager of TR Property, one of the longest-established and most consistent trusts investing in property company shares, argues that ‘The problem with the rush of new funds is partly the fact that they all appeared at the same time and the market has had difficulty telling one from another. In addition, the gearing levels are extremely high in some cases.’

He also points out that ‘A lot of these funds are over-distributing. They are sticking with the dividend policies that they set at the outset, and these dividends are not covered by earnings, so they are going to have problems when they come to renegotiate their loans in a year or so’s time, at much higher levels than they are currently paying. This means that the dividends will fall and investors will start to scrutinise much more carefully what is actually being held on the books.’

Questions of credit
Nick Greenwood opines that ‘We are probably looking at further falls in commercial property values. It is estimated that there has been something like £250 billion lent on UK property, when the banking system can only comfortably cope with around £150 billion. This is a key reason why property prices will fall further and the market will get back into equilibrium as a result.’

Chris Turner adds, ‘I would go along with the estimate that the property sector needs to raise an extra £100 billion to bring bank borrowing down to sustainable levels, but an awful lot of real estate needs to change hands for that to happen. The problem is that the UK economy has been getting soggier and soggier. Rental values have been falling in all the main commercial property sectors.’

Then there is the effect of gearing – effectively borrowing to enhance returns. Most of the new wave of property trusts are heavily geared, usually through borrowing from banks.

The standard argument in favour of gearing is that it magnifies performance so that, although it might amplify losses when fund values are falling, it will similarly enhance returns when the investment company recovers. However, Nick Greenwood suggests that this might not necessarily be the case with some of the property funds.

‘The worry this time is that, although you get the gearing effect on the way down, you might not get the benefits on the way back up, because the banks will force these funds to sell off assets. So if we do get another ten per cent fall, the banks will just call in the loans.’

Followers of fashion
Ian McBryde, manager of the ISIS Property Trust, confirms that ‘Asset classes go in and out of favour, and property is certainly out of favour at the moment. Currently, the discounts on some of these funds are very large, but the variations are also quite great.’

He adds, ‘The starting point would be for a UK commercial property portfolio with no gearing, which would typically be on a discount of 15 per cent. Then there are trusts with a little gearing, which would be around 30 per cent. However, there are other trusts on enormous discounts, often with very high levels of gearing, and the worry about some of these funds is that the gearing will eat into the capital until there is nothing left.’

Patrick Sumner, manager of the Henderson Global Property Companies fund, agrees that ‘The fundamentals for the UK property market are still weak. We think that, in the UK, we are looking at another ten per cent fall in ungeared property portfolios. If they are geared, then you are looking at falls of 15 to 20 per cent.

‘However, if you are trading at a 35 per cent discount already, that probably suggests that you are being undervalued by the market. For a long-term investor, that clearly represents an investment opportunity, but if you are only looking on a six- to 12-month view it will be much less appealing.’

McBryde suggests that ‘It is a risky ride. The rationale behind these funds is to give a good level of income, with some capital growth and rental growth. So it is not the best story out there at the moment, because capital values have gone down. But if you are looking for income, then these funds are still a pretty good place to start. You are buying these things for income, and if you are getting eight or 8.5 per cent gross yield in, say, a pension investment, that is quite an attractive return.’

And Nick Sketch adds, ‘It is worth remembering that companies tend to pay rents long before they pay dividends, so if you think that we have really tough times coming, you would want exposure to the rental stream in preference to the dividend stream, and there is very little downside to all this, at these valuations.’

Security of returns
However, investors focusing on the yield figures should consider how secure this income stream actually is. Chris Turner feels that ‘These huge discounts look rather tempting, but what they are telling you is that dividends are too high and will have to be cut. In many ways, praise should be given to those who cut their dividends first, because at least they are living in the real world. The leverage on some of these things is frighteningly high, and another problem is that when they go to sell, the market will see them coming.’

Nick Greenwood agrees that ‘The market is more efficient in these matters than it is often given credit for. So instead of the 20 per cent markdown you were expecting, you might have to cope with 40 per cent, which, again, the banks might not be terribly happy with.’

However, even allowing for the downside risks, there are undoubtedly some attractive opportunities out there. Nick Sketch points out that ‘If you take the 30 June NAV figures and compare them with the share prices, allowing for the level of gearing adjusted for cash, and then allow for a further 20 per cent fall in UK property values and 15 per cent in Europe, you get figures for discounted NAV. If you then set a target share price at 15 per cent below that level – i.e. a 15 per cent discount to discounted NAV, then on that very conservative basis, companies like British Land are looking at a fall of nine per cent and Land Securities one of 15 per cent.’

He adds, ‘But on the same basis, Invista Foundation still has a 23 per cent capital upside, and has a high running yield in the meantime, while ING would have a 17 per cent capital upside and, currently, a 14 per cent running yield. Most impressive of all, Invista European is 30 per cent ‘cheap’ on that basis, and will maintain its yield.’

Just like before
Sketch argues ‘It is like the reaction to splits all over again. Everybody thinks the market is shot to pieces, so these things are being marked down much too far, which suggests that they are starting to represent some serious value. My figures put in a markdown that would be twice as bad as the one we saw in the 1980s, and this is when we have already had nine months of quite dramatic falls.’

He says, ‘History tells us that, if you keep buying cheap things, as was the case in 2002 and 2003, then you eventually get repaid several times over. If you look at these numbers they seem very clear. If Land Securities is being fairly valued by the market, then some of these things are seriously undervalued.’

However Sketch admits that ‘Of course, these are not low-risk calls, and you have to see where they might fit into your portfolio in terms of risk. But we would argue that you don’t put all your eggs in one basket. Nor can you have a fixed-time horizon which says that it has to come right by X date, because, as we know, markets can remain irrational for a very long time.’

Chris Turner feels that ‘The simple fact is that there is too much debt out there and not enough equity. We will see quite a lot of distressed selling this autumn as the banks are getting tougher. There is money out there that people want to invest and, as you see UK base rates fall over the next few months, property may become a much more attractive investment option than cash.’

Nick Greenwood confirms that ‘There are people out there who want to buy property, but not at these prices. And if you get a 20 per cent fall after a 15 per cent fall, then the current valuations for the property funds don’t look all that cheap after all.’

Patrick Sumner’s view is that ‘We can’t change the market. We are seeing a longer, slower correction this time and the recovery will also be slower. This scenario is probably priced into the market, with the result that you can expect to make very good returns over the next three to five years, but it will be very volatile over the next 18 months.’

And Ian McBryde concludes ‘If you are buying these funds for the long term and if you are taking a five-to-ten-year view, then you are getting the income in the meantime, and looking to build up capital, growth and rental growth over that period. Having said that, I don’t expect there to be much rental growth over the next year or so, but it will pick up again at some point.’