Value investing obviously works – Warren Buffett wouldn’t be as rich as he is if it didn’t. True, he’s exceptionally good at it and he’s leverage the float and cash flow of insurance companies to get there but the basic underlying idea of his is to buy into value which is greater than the price being asked for it.
Which is great, obviously. There’s just one little difficulty with that basic value investing idea. Which is the correct identification of value which the market as a whole hasn’t recognised. A useful example of this being the British commercial property market at present. It’s easy enough to find quoted property companies trading at significant discounts to net assets. Hammerson (LON:OTCPK:HMSO) and Land Securities (LON:LAND) being only two examples.
If we’re to value invest then great, they’re below asset valuations, buy in and watch as the two prices converge, right? Except, of course, it’s possible that it’s the valuations which will converge down to the market price, not the other way around.
This is something we had a look at back here when we talked about Tritax Big Box. A Reit aimed specifically at building the internet warehouses, not high street retail stores. The point being that we’ve significant change happening in the underlying market here. Actually, rough statistics say that some 18% or so of UK retail spend is online now and some 16 or 17% of retail floorspace is empty. There’s a connection between those two numbers, obviously enough.
We would therefore expect to see a certain decline in the value of commercial retail property and also in the companies that own much of it. Thus HMSO and LAND perhaps.
Except there’s the one little unique point about British commercial property leases. They’re on varied terms, 15 to 25 to longer years. There are rent reviews, obviously enough, no one caught by the inflation of the 1960s and 1970s is going to do without those. Such reviews might be at 3 or 5 or 7 years. None of that’s very much of a surprise.
The one thing that is perhaps a surprise is that such rent reviews are always upwards only. A general decline in market rents will *not* lead to a reduction in rent at that review time.
This has significant implications for the accounting treatment of the capital value of a commercial property. As the rent is never going to go down – it might go to zero through being empty, but it’ll not decline gently – we end up with those capital valuations rather being set in stone in the corporate accounts. And it is those valuations that are being used to give us the net asset value of these quoted companies.
Those net asset values are based upon the idea that rents never do go down. And on continuing leases they don’t. Yet if we do have this structural change away from bricks and mortar retailing to online then quite obviously the valuations of those retail properties is going to be falling. Yet the structure of the market doesn’t allow for gentle realisation of such falling valuations.
That is, those valuations are a lot weaker than we might like:
Landlords including the Crown Estate, Hammerson and Land Securities, are struggling to find tenants for former Toys R Us shops, one year on from the retailer’s collapse, figures obtained by The Daily Telegraph reveal.
Analysis by the Local Data Company has found that more than three quarters of Toys R Us stores are still standing empty.
Retailers including B&M Bargains, The Entertainer and Matalan have leased 23 sites, but 75 are unoccupied. Three have been demolished.
There’s a temptation for a landlord to hold out for a tenant. If one or two properties are rented a little more cheaply then there’s no need to revalue the entire estate. If some portion of properties are empty it’s easy to say that it’s only temporary, there’s no need to revalue the entire estate. But if significant portions of the estate are rented out at the new, lower, market rents then there should indeed be a full revaluation of the entire estate at the new and more realistic replacement rental numbers, not those actually being achieved on the historic leases.
Do you see the problem?
There are some unpalatable high street trends doing the rounds at the moment, from tie-dye to zebra print and white jeans, but for shop owners the hardest thing to wear this season is the fashion for rent cuts.
On Friday, the stricken department store chain Debenhams launched its long awaited company voluntary arrangement (CVA). It joins a list of retailers that already includes Mothercare, Carpetright and New Look going cap in hand to their landlords, asking them to take back the keys to their worst performing stores and, if they wouldn’t mind, slashing the rent on the ones they actually want to keep.
Debenhams wants to ditch 50 of its 166 stores, dumping a swath of retail space back on the hands of furious landlords – often the stock-market-listed shopping centre owners, such as Hammerson and Intu, who themselves have mouths to feed. They are already struggling to keep up with inboxes bulging with begging letters. Yet more forfeited stores threaten to worsen an already gloomy picture: a recent report looking at the health of Britain’s top 500 high streets showed a net 2,500 store closures in 2018, up 40% on 2017.
This is not to say that we should all go short on British commercial property, nor even just the retail flavour of that. Rather, it’s to warn against making the opposite mistake.
Value investing tells us that we should look for mismatches between the market price of a stock and the objective value of the underlying assets. When there’s a mismatch, the market price is below value, we buy and wait for the market price to rise in convergence. But there are times when the mismatch is actually in that supposedly objective asset valuation. The market price is at least closer to the right one. Which is where I argue we are with British commercial retail property. Currently reported net asset valuations are wrong, much too high. It is they that are going to fall, not the market price of the stocks to rise to create that convergence.
That is, don’t buy into UK commercial property based upon the asset value story. Other reasons might be valid, this one isn’t.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.