2023-11-27 21:44:13 ET
Summary
- British Land is trading at a material discount to NTA, but further valuation declines can be expected.
- The UK office sector is a key area of concern, and British Land has also flagged the potential disposal of non-core shopping centre assets.
- Considering the composition of British Land’s portfolio, and the sensitivity of NTA to downward property valuation movements, the stock looks to be fairly priced.
Introduction
UK-listed real estate investment trust (‘REIT’) British Land ( BTLCY ) reported 1H24 results on 13 November 2023 (from here on, I will refer to British Land as BLND, which is the company’s code on the London Stock Exchange). In this note, I’ll discuss interesting aspects of the BLND 1H24 materials that caught my eye and consider whether or not the negativity associated with the group’s heavy exposure to the UK office sector provides an opportunity for investors willing to take a contrarian view. For readers who are not fully familiar with some of the specific REIT terminology referenced in this note, BLND provides a glossary that includes helpful explanations.
Better Placed Than Most
Management is quick to highlight that BLND’s portfolio is in better shape than the market average. Whilst this is a fair point, it glosses over the fact that commercial property markets in the UK are still weak. High vacancy levels and depressed rental rates provide BLND’s current and prospective clients with alternative options and the ability to negotiate more attractive terms. When BLND refers to being in the right submarkets, they are talking about 89% of the portfolio. Presumably, the other 11% of the BLND book is exposed to the soggy market conditions that exist on the other side of the bifurcation line that management highlights in Exhibit 1 below.
Exhibit 1:
I have been following Hammerson Plc (HMSNF) - a UK-listed REIT that invests in shopping centres and retail outlets – quite closely for a few years. In my view, Hammerson isn’t a particularly well-managed company and I wouldn’t describe its assets as top-tier; yet Hammerson’s occupancy rate is high, at 95%. My impression is that the quality of the tenants that Hammerson has today is, on average, quite a lot lower than would have been the case five or six years ago. The downgrade in tenant quality has been a reasonably consistent theme across the UK retail space, driven in part by the demise of large department stores and the increased presence of non-retail tenants in shopping centres. A similar pattern appears to be playing out in the office sector (discussed further below). In that context, I’m not inclined to take much comfort from the seemingly impressive occupancy statistics published by the likes of BLND and Hammerson.
Retail – Bottoming Out?
The UK retail property market has been through a torrid time over the last 5-6 years. The chart below (Exhibit 2) is taken from Hammerson’s 1H23 slide pack and clearly illustrates the massive fall in capital values and rents for the group’s UK shopping centre assets. But perhaps we are now nearing the end of the correction period? With both ERV (estimated rental value) and NEY (net equivalent yield) flattening out, it is looking likely that the worst may be behind us.
Exhibit 2:
Both Hammerson and BLND have retail exposure spread across shopping centres and retail outlets (BLND refers to the latter as Retail Parks). It is interesting that Hammerson has declared that they see retail outlets as ‘non-core’, whereas BLND has opted to focus on Retail Parks and has designated shopping centres as ‘non-core’. I doubt that this juxtaposition of strategies is likely to result in the two groups swapping their non-core portfolios - mainly because I think both companies would prefer a straight sale in order to reduce debt.
While Shopping Centres are generating good returns for us, as we’ve said previously, we prefer the occupancy fundamentals of Retail Parks where we also have scale and a market-leading position. Therefore, we’ve identified Shopping Centres as non-core and intend to exit but at the right time and, obviously, at the right price.
Source: BLND 1H24 Transcript , page 11.
Meta Walks Away
News flow regarding the UK office market remains rather bleak. The fact that Meta was willing to pay BLND £149m to walk away from a contracted lease (which was worth around £22m pa to BLND) points to how weak demand for office space remains. BLND’s strategy to ‘reposition’ buildings that have housed (and have been built specifically for) traditional office tenants in order to appeal to the innovation and life sciences sectors reminds me of the change in direction that UK retail landlords were forced to take when department stores started to shrink and collapse. Repositioning office buildings for innovation and life sciences use will require additional capital expenditure that BLND may not be able to recover via higher rents – although management argues otherwise. In the 1H24 presentation speech, Darren Richards (Head of Real Estate) stated that repositioning “could” unlock rents in excess of 30% higher than Meta had been contracted to pay, and went on to describe how the Meta surrender premium would “super charge the economics” – this sounds like such good news that BLND must be hoping that other big tenants like Meta cancel their deals – imagine all the economic supercharging that would then flow!
In effect, by repurposing 1 Triton Square and other buildings in the Campuses portfolio, BLND is trying to push into a new market, a move that comes with additional risk as it does not play to the group’s past experience and skill-set. Even if Richards is correct in regard to his claim regarding much higher rental rates, then this must be balanced against the higher capital expenditure burden, the likely shorter-term tenancy agreements, and higher tenant credit risk.
Office Demand Profile Rather Unclear
Whilst WFH seems to have entered a period of moderate decline, a shift towards a hybrid (split between home and office) working model has gained momentum, implying that office attendance rates are unlikely to jump materially in the near term. It strikes me that, ‘on average’, employers are keen to get workers back to the office more, and so demand for office space could improve from current underlying demand levels. But unless employers take a hard line with staff and ‘force’ workers back to pre-covid levels of office attendance, demand for office space looks set to remain rather soft.
Whilst it is probably slightly too early to factor in a further drop-off in demand for office space associated with AI-driven worker headcount reductions, I certainly think that AI represents a medium-term downward risk factor for the office sector. Repositioning office space as data centres won’t be the answer to AI-driven demand fall either – routers, servers, and storage systems have very different needs in terms of building design than the human office workers that AI seems likely to replace.
Falling Knife Risk
As shown in Exhibit 3, BLND’s NTA (as measured by the industry standard EPRA NTA) declined by -3.9% over the six months to 1H24. Excluding the positive contribution from the Meta surrender payment, the NTA decline would have been almost -6%. An underlying NTA decline rate of around -12% pa is concerning, but it is at least an improvement on the -19.5% fall in NTA during FY23. BLND’s NTA per share has fallen from 730p to 565p over an eighteen-month period – this is a cumulative decline of -22.6% (which would have been -24.4% without the Meta surrender payment).
Promoters of REITs and similar investments often like to talk about the consistency and stability of returns from property portfolios; a value decline of over 20% in just eighteen months serves as a wake-up call for investors who may have previously been persuaded that REITs are low-risk investment propositions. The fact that BLND’s NTA can fall so rapidly implies that in the near term, investors considering buying BLND must be comfortable taking on the ‘catching a falling knife’ risk that such a trade carries.
Exhibit 3:
Valuations for retail (Retail Parks and Shopping Centres) were pretty much flat over the half-year. This outcome supports my comment above that the worst may be behind us in terms of retail valuation declines. The Shopping Centres' NEY of 8% strikes me as quite high, and in the absence of material rental declines, such an elevated yield ought to provide valuation support. Unfortunately for BLND, Retail Parks plus Shopping Centres combined make up only 32% of the group’s total asset value (refer Exhibit 4).
Exhibit 4:
Campuses (which is best thought of as office) make up the bulk of the group’s asset base – and this looks to be the part of the book that is under the most valuation pressure. London Urban Logistics has a rather low NEY of 4.7%, and I am concerned that valuations in the logistics sector may be somewhat overheated. It’s not all bad news though. LFL rental growth of 2.1% versus 1H23 is somewhat positive (refer Exhibit 5). That said, this growth rate is well below inflation, so it’s nothing to get over-enthusiastic about.
Exhibit 5:
EPC Upgrades – Early Days, But Going Well
The UK government has recently been winding back a number of ‘green’ policies, and the previously flagged Minimum Energy Efficiency Standard (‘MEES’) legislation requiring all commercial buildings to be EPC (Energy Performance Certificate, a measure of energy efficiency) A or B by 2030 could well be weakened in the coming months. However, until the government’s final position has been clarified, BLND and peers are sensibly making investments to meet the MEES targets as originally outlined in the government’s previous consultation process. BLND’s stated cost of EPC compliance is £100m, of which ~2/3 is expected to be recovered from tenants via service charges. BLND expects to spend £20m on EPC upgrades over FY24E, with a recovery rate of ~70%. The EPC upgrade program appears to be going well (Exhibit 6), but it is early in the process and I would assume that BLND will be tackling the simplest and lowest-cost projects first.
Exhibit 6:
Development Returns Disappoint
BLND is an active property developer, and the group says that developments “are a key driver of long-term value creation for British Land” (source: BLND 1H24 Release, page 16). The 1H24 presentation pack is light on detail regarding the expected IRRs on BLND’s current developments. Slide 27 of the 1H24 presentation (refer Exhibit 7) highlights attractive potential returns for two projects in the Urban Logistics segments – but investors should note that both of these projects fall into the ‘near-term pipeline’ and are not currently active project commitments. Further, on the two Urban Logistics projects that BLND highlights, there is a material difference between the prospective IRR (higher) and the IRR based on the initial purchase price for the projects (lower); I would definitely lean toward the purchase price IRR (lower) as being the relevant metric by which to assess BLND’s ability to create value, and I find the prospective IRR (higher) reference rather misleading.
Exhibit 7:
The reason that BLND’s 1H24 presentation didn’t provide IRRs for the ‘Committed’ developments becomes clear when we get to the page 17 of the 1H24 Release :
Reflecting the higher interest rate environment exit yields are c.100 bps higher than when we committed to Norton Folgate, 1 Broadgate, Aldgate, and Canada Water Phase 1, which has reduced their IRRs to c.3% (compared to a negative total return for MSCI over this period).
Only a couple of years ago, BLND was talking about the Canada Water development project delivering an IRR in the low teens % range. As shown in Exhibit 8, Norton Folgate, 1 Broadgate, and Canada Water combined make up ~76% of committed development estimated rental value (‘ERV’) - it is therefore pretty disappointing that the bulk of the committed development book is now expected to only generate an IRR of ~3%. BLND says that projects committed to after mid-2022 have expected IRRs of ~12%, but even if this ~12% forecast proves accurate, which is far from certain based on recent experience, the overall IRR will still be painfully low (due to the much smaller size of the post mid-2022 developments).
Exhibit 8:
Closing Comments & Rating
I would say that the consensus view amongst UK property investors is that it is still too early to call the bottom for the UK office sector; that’s certainly my opinion too. BLND’s heavy skew to office (Campuses) is therefore the most likely causal factor behind the stock’s wide discount to NTA (BLND is currently trading at ~£3.48, equivalent to ~62% of 1H24 NTA). The company has put the ‘for sale’ sign up over its shopping centre holdings, which represent ~9% of the group’s asset value; given current market conditions, I would not be at all surprised if BLND accepted an offer at ~10% below carrying value for this ‘non-core’ retail book. Add the ‘non-core’ 9% shopping centre exposure to the group’s 62% weighting to office, and I conclude that ~70% of BLND’s assets by value are due a material downward revision.
Exhibit 9:
Starting from BLND’s NTA per share analysis shown in Exhibit 9, a -15% downward adjustment to the value of the group’s property assets would feed through to a -24.8% fall in NTA per share. Given the composition of BLND’s portfolio, I would not regard a -15% property valuation decline as an extremely bearish assumption. If we limit the valuation decline to -10%, then the impact on NTA becomes -16.5% (I consider this a rather optimistic scenario). Taking a more bearish stance, a valuation decline of -20% would deliver an NTA fall of -33.0%.
Although the share market is anticipating further asset value declines for BLND, given that such a large proportion of the group’s property portfolio has a negative valuation outlook, I find it difficult to feel confident that too much pessimism is being priced in. At some point in the not-too-distant future, the UK office market is going to provide an attractive risk-reward opportunity, but in my view, we are not quite there yet. On balance, for me, BLND is definitely not a Buy, but I do not see sufficient valuation downside to support a Sell call. I therefore conclude this review of BLND with a Hold rating.
For further details see:
British Land: Justifiably Discounted