Weekly Bulletin #33
UK Office REITs Priced For Valution Collapse?
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UK Office REITs Priced For Valuation Collapse?
I highlighted Derwent London Plc (DLN) recently as a potential valuation situation over the medium term, noting how it trades at very depressed levels on a P/NAV basis, below its COVID pandemic low, and far below its historic average multiple.
Indeed all three of the London prime office REITs - DLN, Great Portland Estates Plc (GPE) and British Land Plc (BLND) - trade close to their historic valuation troughs:
There are three macro/market drivers behind current valuations:
Uncertainty and risk aversion towards UK assets following the UK’s mini-budget and gilts crisis
Rising rates making REIT yields less attractive and leading to a re-pricing of the underlying real estate
Post-COVID work practices with a view still prevailing that corporates won’t need as much office space going forward, reducing the value of the underlying real estate assets
While these are all legitimate considerations, an interesting thought struck me this week pertaining to #3 above amid the wave of corporate lay-offs occurring across the tech sector, including Twitter laying off ~3,700 staff (~50% of its workforce) and Meta letting go ~11,000 staff.
These lay-offs are occurring at the same time as large corporates are looking to reverse remote-working practices that became accepted in the wake of COVID. Until recently, if a firm didn’t offer remote working it was regarded as uncompetitive and would experience staff retention issues - essentially, if Company A doesn’t offer remote working, then staff will quit and join Company B which does. The power resided with the worker in this post-pandemic shift known as the Great Resignation.
However, there is a sense this is now turning - Elon Musk announced that remote working is now banned at Twitter, with staff required to be in-office for a minimum of 40 hours per week. Beyond tech, Pfizer employees will now be required to return to the office for 2-3 days a week. This follows moves already made by the banking sector since September to bring staff back into the office full time (or close to it). Even the recent UK gilt market volatility has been cited as a reason for increasing office attendances in London again.
So here’s my thought on this - employers expectations (demands?) for workers to return to the office will increase globally, with a slowing economy, high inflation and increasing lay-offs likely to kill off the Great Resignation. In an effort to avoid being laid off, staff will feel the need to be seen back in the office as “productive” on-site / in-sight workers (out of sight means out-of-mind, and therefore more likely to be let go).
In this scenario, I’d expect power to shift back to employers. Despite their “flexibility” lip-service, employers prefer workers being office-based for training, culture, productivity and staff-monitoring reasons, all the more so if a recession materialises and tighter management of staff is required. Indeed some would argue we’re already in a recession, hence the lay-offs and growing return-to-office calls.
I see the implications of a wider shift back to the office for these UK REITs as follows:
Office attendance will improve, supporting office space requirements;
In this post-COVID era, employers will need to provide high quality, amenity-rich office accommodation, i.e. the type of offices being developed and operated by the likes of DLN, GPE and BLND;
London office rents are currently holding, and I think are likely rise over time with inflation to compensate for the higher cost of developing and fit-out, and in return for the higher-specification space being provided.
These factors should ultimately support office real estate values in the medium term, in combination with the fact that physical replacement cost is now rising with inflation (materials, energy, labour etc). Additionally, in the context of London prime office REITs, London remains a global city with one of the most liquid markets in the world, and continues to attract strong capital inflows, which is further supportive of value.
In the shorter-term its possible these REIT valuations remain depressed due to investor sentiment amid recessionary concerns, plus the fact that rising interest rates tends to mean assets get re-priced downwards (growth tech stocks being the exemplar this year in this regard).
But given the above factors, do these REITs get permanently repriced downwards by 40% - 50% as current valuations seem to imply? Will we see prime London office blocks trading in the private market for 40%+ less than current market values? This seems very unlikely, but even if they did trade at such depressed levels for a sustained period they would surely be taken private by PE-RE, becoming potential special situations opportunities for equity investors.
To conclude, the market’s current take that “rising rates due to inflation means real estate must decline in value” strikes me as first order thinking. This view ignores the fact that over time rents and replacement values should rise with inflation. On this basis, the current discounts on offer for these REITs may in time prove to be deeper than what current valuations imply. This isn’t necessarily meant as a prediction, just a non-consensus/contrarian view on some out-of-favour assets that I think is worth considering.
Any Other Business
For these week’s AOB I’m sharing this recent interview with market strategist and historian Russell Napier, which makes for very interesting reading.
In this interview, Napier outlines how he sees a stagflationary future ahead, with a new capex boom and reindustrialisation of Western economies which may provide opportunities for investors.
Napier was proved correct when he foresaw a return of inflation two years, and I think this interview is well worth reading given the current market environment.
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