Property sector must work to stave off lull

If development was the main story for investors in the UK listed property sector in 2010, then next year will be about how companies take advantage of returning problems among the more heavily overleveraged in the market.

The hard graft of working through the remaining problems caused by the crash will begin in earnest in 2011 after the unexpectedly sharp recovery over the past 18 months delayed the worst of the fall-out. Larger companies in the sector need to begin using their financial strength having returned balance sheets to good health; otherwise a dull year awaits, even if positive on a total returns outlook.

Support will come from their mostly good quality income streams, with some rental growth in better-placed parts of portfolios – most obviously in London offices where developers will begin to find pre-lets for new schemes. Investors can also expect modest dividend growth, but yields remain unexciting at an average of about 4.5 per cent across the majors.

But it is far from being all positive. Regional economic weakness and government cutbacks will remain negative for overall rental growth, while over-renting is still a factor in most portfolios. Meanwhile, following the rally in prime property, capital growth will be modest at best, and provide little support for shares.

As such, there is a need for canny deal-making to make the difference, even if this can be difficult for the larger portfolios. Hammerson has scarcely been rewarded over peers for its astute activities this year, for example.

However, if large generalist Reits are to outperform with above-average returns, they need to use their weight for large deals and corporate activity led by active managements looking for off-market deals. The £1.6bn Trafford Centre offer by Capital Shopping Centres showed admirable intent, even if pricing was perhaps full. There has otherwise been too much bidding against like-minded rivals at public auctions. Using the same spread sheets leads to the same conclusions, which does not make dynamic deal flow.

Companies that have built empires tend to appear benevolent dictatorships, particularly in London, where a handful of investors making property calls have carved out success at Shaftesbury, Great Portland Estates and Derwent London. These nimble companies will remain in vogue next year, partly because London’s market emerges first from recession but also for their developments and nose for a bargain around the West End.

There are also smaller stocks that are likely to show some excitement. In particular, there are those that will want to bolster financial positions with new investors as well as those able to benefit from the forced sale of property to solve debt calls from impatient banks. The companies positioned to exploit such opportunities – such as London & Stamford, Max Property, Metric Property, LXB Retail and Conygar – can be expected to have a good year.

Aside from the conclusion of Simon Property’s 425p offer for CSC – a decision that remains finely poised given shareholder support for both sides – there is a good chance of further corporate and take-private transactions. Investors should look to where there are significant discounts, and at the smaller end this means the “zombie” investment companies that lack finance for future activity.

There may be interest in more notable specialist developers. It could be worth watching companies such as Unite and Grainger, while next year might finally see movement in the self-storage space. The emergence of Laxey as a shareholder of Quintain is hardly surprising given a share price that spent much of 2010 at about 40p against a basic NAV of 120p. Attention should also return to Minerva next year, given the stake of almost 30 per cent still held by Nathan Kirsh, the South African investor, who is unlikely to sit on his hands after this year’s high profile fight with management.

Forced sales

More broadly, next year is likely to be characterised by further debt problems across the sector, particularly if rising interest rates heap pressure on those pulled to safety by the plateauing bounce in values. New debt will remain constrained, while the weight of equity targeting property is still strong but has moderated. In fact, banks will probably step up attempts to recoup money from borrowers by forcing sales, with a wave of maturities of debts that were given extensions in 2008 and 2009.

Managements need to outperform on their own merits rather than relying on market movement, some for the first time in many years, by seeking out accretive deals. For where some will struggle next year, those that have waited with the cash will enjoy life in a more choppy market.

dan.thomas@ft.com