The UK real estate sector has lost 19% post-referendum, taking us close to trough multiples. However, this still fails to fully capture the downside to NAV in our revised forecasts. Neither do valuations compensate investors for a unique combination of cyclical and structural risks in the London office market. We downgrade five UK stocks and now have seven Underperform ratings.
* A domestic, cyclical sector facing structural risks
UK real estate is highly geared to the domestic GDP cycle leaving it vulnerable to Brexit related
uncertainty. An uber low-yield environment and functioning credit markets make a 2008/9 style
blowout in yields unlikely, but falling rental values will still trigger yield expansion. Thankfully,
defensively geared balance sheets stave off the risk of recapitalisations in the sector.
* We forecast a 20% decline in NAV by 2018e
An average 70bp rise in UK yields and varying declines in rental values result in 21% downgrades
to our 2018e NAV forecasts. We see greatest downside in the London office sector due to a
cyclical loss of employment and risk that London suffers disproportionately from Brexit. An average
c.15% correction in office rents for the REITs only unwinds the last two years’ growth.
* Too early to catch a falling knife
UK real estate now trades at 20% discount to spot GAV, comparable to the peak discount applied
to trough valuations in 2008/9. This suggests the worst of the de-rating has taken place, however
valuations still provide an insufficient cushion for the downside risk to values. In our view it is too
early to be buying UK real estate into accelerating NAV declines and we see only limited prospect
of buybacks or M&A coming to the rescue in the short-term.