The listed European property sector had a tough 2018. While the region's economies continued to grow, and the wider real estate sector enjoyed strong investment and occupancy performance, share prices in many of its leading listed real estate companies continued to slide.
The performance of European property stocks, particularly those of real estate investment trusts, stood in stark contrast to another metric by which these companies are valued. Net asset values, or NAVs — measured by the total value of a property company's assets minus its liabilities — remained buoyant as share prices slowly sank.
The median discount to NAV experienced by Europe's eight largest listed property companies, each with a market capitalization above €5 billion, rose from 0.9% at the end of 2017 to 30.0% by the end of 2018, according to S&P Global Market Intelligence data. Of the 25 largest listed European REITs by market capitalization, 19 were trading at a discount to NAV as of Jan. 11, with U.K.-based retail REIT Hammerson PLC trading at an uncomfortable 57.0% discount, the data showed.
The growing disconnect between share price and NAV has exasperated some analysts. As 2018 progressed, Mike Prew, managing director and senior analyst for real estate at global investment bank Jefferies, increasingly questioned the use of NAV as a metric. Prew revealed in one of many critical notes that the lack of credibility around NAV had led Jefferies to consider removing it from its analyses of company performance. Prew highlighted support for his view among REIT managers by quoting the co-founder and executive chairman of U.K. self-storage company Big Yellow Group, Nick Vetch, who has described NAV as "drivel."
So, is NAV no longer of any value to the listed European property sector? Robert Duncan, director of real estate equity research at Numis Securities said in an interview that, despite its flaws, NAV still has its place. "The problem is, there is no better metric," he said. "We're using the least-bad metric."
The disconnect seen between share prices and NAV per share happens when the property "market goes into paralysis [and] assets stop trading," Duncan added, leaving valuers with limited transactional evidence on which to base their valuations. "When there are no transactions happening, the quality of the valuation reduces because it's backward looking," he said. "But the equity market is forward looking. The equity market doesn't want to know what the NAV has done — it can see that. It wants to know what the NAV is going to do."
The divergence is nothing new at this point in the real estate cycle, Duncan said, having appeared during the 2007/2008 property crash and other slumps previously. But a key difference in this cycle is making the valuing of property assets more difficult, thus exacerbating the discounts to NAV, he added.
"Typically at this point in the cycle you would see — having had a very strong rally in London offices — some of the [property] funds starting to rotate through into the retail space, yet nobody wants to do that [due to the extremely challenging operating conditions faced by retailers]," Duncan said, using London, which is Europe’s largest property market, as an example. A reluctance among investors to move out of the office market and into retail, combined with the inability of retail investors to sell their assets at their desired price, has caused "a weird stasis" in the property market that has deprived valuers of sufficient transactional evidence, he added.
Uncertainty around retail property values appears to be the prime source of the disconnect between NAVs and share prices. The median NAV discount among European retail REITS, which S&P Global Market Intelligence defines as REITs that derive at least 75% of their net operating income, EBITDA or operating income from retail assets, was 34.0% at the end of 2018, according to S&P Global Market Intelligence data. This compared to a 12.8% median NAV discount among all European REITs. Tom Leahy, senior director for Europe, Middle East and Africa analytics at Real Capital Analytics, said there has been a sustained drop in the number of traded retail properties in the U.K. and wider European markets in the last two to three years, with a fall of about 35% between the end of 2017 and the end of 2018.
|Equity investors have lost faith in valuations of retail property assets |
such as Intu Properties' Victoria Centre in Nottingham, U.K.
Source: Intu Properties
The turbulence in the retail property market has not been the only factor pushing NAVs and share prices further apart, said Duncan. The unprecedented influx of capital from international investors into European property in recent years has upset the market's longstanding assumptions and expectations around values, he said. Traditional metrics that have influenced property valuation, such as the U.K. 10-year gilt yield, have lost much of their relevance as investors from China and elsewhere have flooded the market seeking better returns relative to their local benchmarks. "All historic classical valuation metrics drop away [in that situation]," Duncan said.
Christian Luft, head of pan-EMEA valuations advisory at real estate services firm JLL, which undertakes valuations for a number of European REITs, said the deepening NAV discounts have put valuers under increasing pressure and scrutiny. But he rejected suggestions by some equity analysts that cozy long-term relationships between real estate services firms' valuation teams have fed inflated valuations, pointing to more regular rotation of valuers by REITs in recent years.
Still, Luft admitted that the valuation profession could always improve. There is debate in the industry about developing valuation methods that do not rely as heavily on transactional evidence as market values do, he said. Such methods would take into consideration market sentiment and where valuations are likely to go. "We as an industry want to be relevant and useful, not just necessarily hide behind one definition," said Luft. "Things like forecast values and not just the values at [a particular] date are useful. We can't do much about [companies' need to record a value at a fixed date in their accounts], but what we can do is perhaps bridge that gap with a view of where we see things being in 12 months."
Whatever new methods European valuers settle on, NAV should retain its value for the region's listed sector for a long time to come, according to David Harris, an alternative asset manager at Uniplan Investment Advisors and adjunct professor at New York University specializing in real estate securities. Harris, who has experience working in both the U.S. and European markets, believes the European listed-property sector should count its blessings when it comes to NAV. "The absence of the mark-to-market balance sheet puts [the U.S. property market] at a disadvantage compared to Europe," he said, noting that listed U.S. real estate vehicles account for assets using historic cost, minus depreciation.
"Wouldn't any investor wish to know what the net asset value of a company is?" Harris added in response to the suggestion that some analysts have considered removing NAVs from their data sheets. "Why would you [ignore] one of the metrics that most investors would be keen to have some knowledge of?" While the U.S. listed-property sector considers NAV a valuable metric and spends a lot of time trying to calculate it, Harris said, much greater weight is given to cash-flow metrics like funds from operations and adjusted funds from operations.
NAV's qualities as a metric probably balance out its drawbacks, said Numis Securities' Duncan. But the listed sector's obsession with NAV should be tempered where possible, he added, and a broader perspective adopted. "There are so many reasons why we use it and so many reasons why we shouldn't," said Duncan. "The valuation industry isn't broken, but people need to stop being myopic in NAV's use."