Commercial property: The contrarian view

… The global recession has hit commercial real estate companies hard, with capital values falling 43.6% from their peak in June 2007.

As can be seen from the above chart of the FTSE 100 it has been a relatively mixed week for the blue chip index, with a mild recovery off the recent lows followed by further profit taking.

Tuesday marked the end of the second quarter of 2009 during which the FTSE All-world stock index rose more than 22%, which marked its best quarterly performance since records began.

Encouragingly the second half of the trading year also started strongly, with an array of manufacturing data from the leading economies suggesting the severity of the recession could be now behind us. China’s purchasing managers index (PMI) rose to 53.2 last month from 53.1 in May and Japan’s Tankan survey of manufacturing sentiment rose for the first time in two years, which boosted commodity prices.

Manufacturing data in the UK also rose to 47 in June from 45.4 in May, which exceeded analyst’s forecasts of 46.5 and represented the highest reading since May 2008, although it still remained below the threshold needed for expansion.

A sharp drop in US employment in June set back hopes of a swift second half recovery. Non farm payrolls fell to 467,000 last month, which exceeded the forecast drop of 367,000 and the unemployment rate also fell to 9.5% from 9.4%, which sent markets back down towards last weeks lows.

Technical analysis of the above chart highlights the break of key support at 4300 and shows that this could now provide resistance to any further strength. Furthermore, the 50 day exponential moving average (EMA) has been breached, which is now another level for the index to contend with. Minor support is seen at 4200 and a break of this could trigger a further move down towards 4000.

However, the relative strength index (RSI) has tried to rally over the past week and is demonstrating some divergence, which suggests the momentum behind the recent weakness is falling and that any buying could drive us higher.

In summary, the recent global economic data has been encouraging on the whole and unemployment is a lagging indicator, so it was not entirely surprising to see continued weakness in the data. Technically a break of 4200 may initiate some further selling, however markets have been resilient and I am reluctant to enter outright shorts at these levels and would prefer to buy on weakness.

One sector that has grossly underperformed the wider market since the financial turmoil began is the real estate sector, with the sector average falling around 70% in the past two years.

Falling prices and stricter requirements to achieve credit have weighed heavily on the sector, with average house prices falling around 18% in the past twelve months. Sales have slowed dramatically and several construction companies have had to launch rights issues in order to obtain sufficient funding.

However, recent housing data suggests that the property market is stabilising. Nationwide claim that house prices rose for the second consecutive month in June, which brings the annual decline down to 9.3% and this represents the smallest fall since July 2008.

Lower interest rates have boosted affordability, with the proportion of disposable earnings devoted to mortgage payments falling significantly over the past 18 months. In the UK typical mortgage payments for new borrowers have declined from 48% of average disposable earnings in Q3 2007 to 31% in Q1 2009, which is a long way below the longer-term average of 37%.

As a result, consumers appear to be more confident about their future financial situation and this is confirmed by a survey by Gfk/NOP leading to predictions that Britain may be one of the first major economies to pull out of recession.

After being hit particularly hard, many housebuilders have rallied strongly on the back of the apparent stabilisation in the housing market and improvement in the general economy. The likes of Taylor Wimpey and Barratt Developments bouncing 700% and 250% respectively since the end of last year.

However, it is the commercial property companies that are of particular interest to me. They have underperformed the house builders during the recent rally, as although real estate values are stabilising commercial property companies continue to face a number of challenges, which include: facing declining rents, difficulties obtaining financing and the prospect of growing unemployment, which means many companies will keep struggling next year.

The global recession has hit commercial real estate companies hard, with capital values falling 43.6% from their peak in June 2007. However, recent data suggests that the decline is starting to slow, with capital values falling 8.7% in the first quarter compared with 14.3% in the previous quarter. Furthermore, rental income appears to be improving, with a 600,000 square foot letting in London achieving double the rental figure it achieved last quarter.

The top performing sector over the past year has been the general retailers, with the sector average gaining an unbelievable 24% during this time. More disposable income has helped the retailers and it indicates that rents achieved from shopping centers may be more than many analysts had feared.

The critics would argue that the rental outlook remains bleak, with increased unemployment leading to rising vacancy rates over the next few years. Many also believe that rights issues will continue to plague the sector, as companies struggle to cover their liabilities.

However, the stock market is a forward looking indicator and I believe that much of the negativity is factored in at these valuations. The likes of British Land (LSE: BLND) and Land Securities (LSE: LAND) have only rallied 29% and 25% respectively off their lows and historically commercial property companies tend to be the last to recover, but things appear to be improving and recent global economic data has confirmed this.

A number of commercial property companies are still trading at a significant discount to their net asset values, which suggests that the market believes their assets have considerably further to fall, but in light of recent events this may be overly bearish.

Many related companies are trading on forward earnings of around 12.5x and offer a healthy dividend yield of circa 6%. It could now be a good time to consider investing in these companies before they begin to catch up with the rest of the sector.

The likes of Big Yellow Group (LSE: BYG) look attractive, with a quality asset base and £60 million available for investment at these levels. However, in my opinion an interesting way of attaining an exposure to these companies might be to invest in the iShares UK property fund (Epic: IUKP). This fund offers a weighted exposure to leading property companies and real estate investment trusts (REIT’s) domiciled in the UK.

It is less risky than investing in individual companies, has good liquidity, does not incur stamp duty and pays an attractive dividend yield of around 6.5% per annum. It is a contrarian buy, but off a high of over £10 in the spring of 2007 the shares can now be bought for 284p, and with the technical picture also improving, it looks interesting at these levels.

Mark Allen is Head of derivatives at Simple Investments Stockbrokers. The writer does not hold a position in IUKP. The material in this report has come from Simply Charts and the iShares corporate website.