A Pickup At This Property Play

Published in Company Comment on 2 March 2011

But Segro has a long way to go yet.

Like many investors, I remain wary of UK commercial property. With over £50bn of distressed property loans sitting in the work out units of Lloyds Banking Group (LSE: LLOY) and Royal Bank of Scotland (LSE: RBS) alone, there is a massive overhang of property that would come on to the market in normal circumstances.

It doesn't because the scale of such forced selling would depress valuations across the board, the last thing the banks want, so they continue to support existing owners and "extend and pretend". It is a logical strategy, but makes property valuations fragile if not unrealistic.

That is a problem in the investment market. Property companies also have to grapple with issues in the occupier market, the real world of tenants, rents, leases, costs -- and vacancies.

Vacancies

Vacancies are the fly in the ointment for industrial REIT Segro (LSE: SGRO) which reported full-year results last week. Though the overall vacancy rate fell during 2010 from 13.5% to 12% (calculated as a percentage of the full rental value), it still represents a large amount of property not generating any rent.

And the impact is not just on rent foregone. Tenants pay service charges covering utilities, staffing, repairs, insurance etc. Not all of these costs go away if a property is empty. Of Segro's £63m of property operating costs, over a third, £23m, were costs relating to vacant properties.

But problems are opportunities, as the management consultants would have it. Add the £40m or so additional rent if the properties were fully let to the £23m, and Segro's recurring rental profits of £127m would be half as big again. 

More accurately, the company calculates that each 1% drop in the vacancy rate would add £6m to earnings. In a sense, the vacancy rate adds a level of operational leverage.

Portfolio

Segro describes itself as Europe's largest provider of flexible business space. It owns some of the largest industrial estates in the UK, especially concentrated around Heathrow and the M4 corridor, including the Slough Trading Estate, the largest estate of its kind in Europe, upon which the company was originally founded in the 1920s as Slough Estates.

In 2009 it acquired its distressed rival Brixton Estates for a bargain £190m, although the vacancy rate on former Brixton properties is 18.6%.

In 2010 it acquired BAA's 50% interest in the Airport Property Partnership, a joint venture with Aviva Investors containing airport-related industrial assets mainly at Heathrow, injecting £237m of its own assets into it. The company aims to grow and improve its portfolio by clustering assets in core markets, and it now has over £1bn of assets under management at Heathrow, both land-side and air-side.

By value, 72% of the portfolio is in the UK, 80% of which is located in the South East. The remainder is in Continental Europe, where the company is now focussing on Germany, France, Poland and Benelux.

In addition it is pursuing limited new development activity, with £68m of capital expenditure committed on pre-let projects which should yield £9m of rentals. A limited program of speculative development has started on the land bank in Europe.

Results

Segro reports both statutory IFRS accounts, which reflect changes in property values whether realised or not, and industry-standard EPRA results.

On an IFRS basis the company swung from a pre-tax loss of £248m in 2009 to a profit of £197m. That was mainly due to a £55m actual loss on sale of properties in 2009 and a £271m write-down, against a net property gain of £26m in 2010. This was mirrored by EPS which rose to 28.5p from a negative 41.3p.

EPRA profit before tax -- essentially recurring rental profits -- increased 22% from £104m to £127m. Though EPRA earnings also rose, EPRA EPS was down from 18.3p to 17.1p, due to the dilution of a deeply discounted rights issue in 2009.

The capital value of the investment portfolio rose 1.9%, combining a 4% rise in the UK clouded by a 4% decline in Europe. Germany was particularly hard hit with a 10% decline following the insolvency of a major tenant, Karstadt-Quelle, and unexpected refurbishment costs. The former is a fact of life for property companies, the latter looks careless to say the least.

Net borrowings reduced, with gearing dropping from 91% to 80%. This is comfortably within the company's tightest banking covenant of 160%. Property values would have to drop 28% to breach this limit. Interest cover was 2.2 times against a covenant of 1.25 times.

Net asset value per share rose from 354p to 366p.

Valuation

At 317p the shares are lower rated than the sector as a whole.

 Discount
to NAV
P/EDiv yield
Segro13%18.74.5%
REIT Sector6%22.94.0%

New management -- the FD takes over from the CEO in April and the UK property head has departed -- will no doubt work to narrow the gap, but fundamentally Segro's fortunes lie in a resurgent occupier market.

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