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Vultures circle as distress sales begin

publication date: Oct 17, 2009
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SkyscraperWith the latest IPD figures showing the first positive total return figure for two years, it looks as if we may have seen the bottom of the commercial property market. Investors are looking greedily at commercial property yields well above what they can get on gilts – the usual comparison – and a number of asset managers, like LV=, are increasing their weighting in property.

In fact the market has been looking up for a while now. Rights issues earlier this year raised money on the stock market for British Land, Helical Bar, Hammerson and Land Securities – mainly intended to refinance balance sheets that were looking somewhat stretched. Investors eagerly backed most of these issues – since when, they’ve been rewarded by the sector rising markedly. For the companies’ directors, though, it must be a little galling to realise that they raised their money right at the bottom of the market.

Now we’re on a second round of rights issues, as Liberty International has just announced a new placing adding 10 per cent to its share capital. This comes less than six months after its earlier £600m capital raising. But while the first issue was intended to pay down debt, this one is intended to enable the company to invest in new property at rock bottom prices – to be a commercial property vulture.

Liberty is not the only one. A number of vulture funds – they prefer to be called opportunity funds – have been set up to take advantage of the sector’s weakness, and some of the listed real estate companies have also raised funds intended to take advantage of the substantial re-pricing of assets in the sector. While the earlier part of this year saw the established development and investment companies raising fresh funds, the vultures took over in mid-year as ‘rescue rights’ gave way to more aggressive issuers. Matt Churstain, real estate analyst at KBC Peel Hunt, says “Once the big players had raised money, they opened the door for everyone else.”

After all, existing companies like Hammerson have properties in their portfolios that were bought or developed at high valuations. Even worse, Minerva has a huge amount still in development, that may hit the market just when rentals are at their lowest. Investors in a new company or fund, on the other hand, don’t have any dilution from the legacy portfolio – if management manages to buy property at the bottom, investors will get the full benefit of any capital appreciation.

For instance in June Development Securities raised £94m new equity to finance expansion. The issue almost doubled the size of the firm – and the underwriters for the issue clearly thought it was a good opportunity, since the placing was priced at only a nine per cent discount to the previous closing share price.

London & Stamford was another company that raised £226m mid year and was heavily oversubscribed by institutions. Chairman Raymond Mould said the key reason for raising funds was to be able to invest at attractive yields.

He added, “These additional funds give us further firepower to take advantage of the exceptional buying opportunities available.”

From pessimistic to pro-active

In some cases managers who were pessimistic on prospects for the sector a couple of years ago have completely changed their stance. Hansteen’s management team had – with great prescience – sold out of UK property in 2005, with the disposal of the Ashtenne Industrial Fund. Now, on the other hand, joint chief executive Morgan Jones sees “unprecedented opportunities” for investing in the UK. He believes that prices reflect the illiquidity of the investment market, due to the difficulty of financing property purchases, rather than a decline in fundamental values.

Now it’s raised £200m in fresh equity to buy industrial property in the UK, in the largest fund-raising by an AIM listed company for two years. It won’t stay AIM listed, though – it’s already said it intends to convert to the more tax-efficient REIT status and transfer to the full list of the London Stock Exchange.

A tight 8.5 per cent discount to the market price before the offer is an indication of investors’ appetite for risk – or rather, their appreciation of the potential reward offered by the company’s investment programme.

Hansteen has already been active deploying its new funds, having taken an 18.5 per cent stake in Warner Estates. Hansteen should have an excellent feel for the assets in the Warner portfolio, since it knows most of them well. Ironically, it was to Warner that Hansteen sold the Ashtenne portfolio; now it’s buying it back.

The other darling of the vulture plcs is Max Property, Nick Leslau’s investment vehicle. Unlike Hansteen and L&S, this was a completely new company on the stock market; the May flotation valued the company at £200m and went well – the offer was oversubscribed, and the shares started trading at 124p against the offer price of 100p.

Its success is due to two major factors. First, management together with Och-Ziff fund managers backed the float, buying more than a quarter of the shares. That’s always something that fund managers like to see, since it gives management a stake in the success of the company. Secondly, the company’s management includes not only property magnate Nick Leslau, who runs the private property company Prestbury, but also Mike Brown, poached from Helical Bar. The property ‘dream team’ made the investment attractive for fund managers.

Like Hansteen, Max Property has already done its first deal, acquiring the Industrious portfolio out of receivership. The terms of the deal show just how property valuations have sunk – the assets (120 properties in all) were valued at £530m when put into receivership, but Hansteen got hold of them for £232m.

Ice rinkConservative about cash

However, though it’s said ‘a rising tide lifts all boats’, investors have been choosy. New River Retail aimed to raise £250m to invest in the retail property market earlier this year. Investors were not impressed, even though it was led by David Lockhart, a founder of Halladale Group, which made good returns for its shareholders when it was acquired by Stockland. It may have been the woes of the retail sector that put them off, as consumers conserved cash and cut their spending.

New River Retail is back now, but it is raising just a tenth of the funds – £25m. Compared to the sums raised by Max Property, Hansteen and L&S, it looks somewhat underpowered.

The type of deal these companies aim to execute can generate massive returns. For instance look at Conygar’s all-share bid for the debt-ridden Advantage Property Income Trust. Conygar is buying the trust at a 45 percent discount to its net asset value – so by the time Conygar has put the properties into its own balance sheet, it will have boosted its own net asset value from 161p to 193p a share.

Meanwhile, shareholders in Advantage get paid a premium of 17 per cent to the previous market value of the shares – so everyone’s happy. Of course the quoted property sector isn’t the only game in town. There have also been a number of funds coming to the market. Apache Capital Partners, led by Paul Orchard-Lisle, formerly chairman of Slough Estates, has been busy raising over £200m to share between three funds concentrating on infrastructure and commercial property in the UK, and London residential property. Apache, a specialist property fund manager, was founded in 2008 specifically to take advantage of the property market downturn.

HendersonIt’s interesting to see where Apache’s money is coming from – eschewing the UK market, it’s focused its fundraising activities on the Middle East, where investors are flush from years of high oil prices. May also saw Henderson launching its Central London Office Fund II, with £200m funds sought (£200m seems to be the standard size investment in the sector at the moment). Typically of the new generation funds, it’s a closed-end fund with a fixed period of seven years, and targets a 12 per cent annual rate of return. At the same time F&C REIT launched a £300m UK Opportunity Fund – another seven year fund, aggressively targeting a 20 per cent rate of return by seeking to buy distressed assets.

The big names of fund management have been slower off the blocks – and there’s been little to address the needs of the small retail investor, so far, with most funds targeted at high net worth individuals and institutional investors. That’s very different from the way things looked in 2007, when retail fund management companies such as New Star were launching new commercial property OEICs right at the top of the market.

These funds, of course, came to grief – trading in the New Star International Property Fund (now Henderson International) is still suspended. The difficulty for open-ended property funds is that if investors want to sell, they have to be able to raise the funds to redeem those units – that is, to buy them back – which could mean selling properties, never the most liquid of assets, into a buyer’s market. Fund managers appear to have learned by this mistake – almost all the funds now being raised are for closedended, limited period investment trusts, which don’t have this redemptions issue.

But what to spend it on?

There doesn’t seem to be much of a problem raising new funds right now. The real problem is seeing how all these new players are going to invest their funds. Most agents say there’s little stock available – particularly in primary properties. That could lead to too much money chasing too few deals – pretty much the same situation as in the residential market right now.

The problem for the vulture funds is that there is a lack of quality assets on the market. Now that the market has rebounded from its trough, the banks are hanging on to distressed assets rather than rushing to auction them off. Matt Churstein points out that the really troubled assets have been put into government protection programmes, and that banks are keen not to crystalize losses on those assets they retain. It seems more likely that larger property companies like Great Portland Estates will discuss some mechanism by which they can take some of the portfolio off the banks’ hands, while leaving the banks with an equity stake in the properties.

At the same time the property majors’ successful raising of funds earlier this year has taken the pressure off the quoted sector – Matt Churstein believes over two thirds of the companies in the sector have now been recapitalised. He says, “I don’t believe there’s going to be a massive amount of product coming on to the market – it will be a drip feed.”

However, fans of the vultures point to the fact that many property companies are close to breaching their banking covenants because of lower valuations on their assets. That’s likely to lead to distress sales. At the same time, some companies will see their cash flows dry up as high vacancy levels (12 per cent against a seven per cent norm) are also putting pressure on the less well funded property owner. Even companies with steady cash flow and adequate valuations could face difficulty if any of their loan facilities need renewing.

Some of the ‘vultures’ may also need to consider lower quality assets than they initially wanted – though that might mean taking on shorter lease lengths, for instance, rather than moving into secondary or tertiary properties.

While banks are reportedly more willing to grant credit for property deals, that doesn’t mean development is back on the agenda. That’s likely to exacerbate the competition for the few good deals that are available – but it does underpin the recovery of the market.

BarrattHousebuilders also raising cash

Meanwhile, the housebuilding sector seems to be picking up too. Barratt just announced a rights issue and placing of shares to raise £720m, and Redrow has come back for another £150m after a larger fundraising earlier this year, to enable it to buy and develop more sites. The City seems to be welcoming these issues, with a warm response to both, and tight pricing.

Jim Moore, the former head of Inside Track, has turned vulture, setting up a fund to buy properties at a discount from distressed buy-to-let landlords. He has one great asset – the database of Inside Track investors, many of whom are now significantly under water on their investments. The rich irony of the situation – as well as its moral ambiguity – has attracted a lot of media comment, but away from the headlines, there’s been a lot of quieter, but actually much more significant, investment going on.

A number of funds have been set up to invest in residential properties. The British Opportunities Fund was launched in February 2008 by Managing Partners Limited (MPL), an investment boutique – in retrospect, perhaps a year too early. Backed by HBOS, it takes a boutique approach to the market – cherrypicking distressed situations to make good returns.

Jeremy Leach, Managing Director of MPL, says, “On residential properties we’ve been able to buy at up to a 40 per cent discount, and get 9-10 per cent yield on a lot of properties. But the best opportunities we’re seeing right now are commercial – there are any number of small developers who have had their facilities closed off by the banks. They can’t even buy a pint of milk – they need to sell!”

VultureWalls & Futures is currently launching a London residential fund which is targeting 10 per cent yield, and expects to raise £10m of equity. Other firms to have launched commercial property funds recently include BDO Stoy Hayward Investment Management, with its Strategic Income Property fund and a minimum investment of £100,000; Seven Dials Fund Management, with the Lightstone Prime High Street fund; and Clavis Walden with its Property Authorised Investment fund, which will launch later this year.

Matt Churstain reckons the quoted commercial property sector alone has raised close to £6 billion in new equity funds this year. That excludes any money being raised by funds or for residential investment – and it also excludes debt finance. Add all of these into the pot and there must be £10 billion or more of new money headed for the property markets.

He has a buy recommendation on the commercial property sector right now – despite a 60 per cent rise in real estate shares since the trough in March. “There’s a lot of optimism out there,” he says, “and there’s still a lot of value in the sector.”

The vultures have landed.