Buy London property at a discount

In my conversations with executives, analysts and fund managers over the past few months, one topic has come up again and again: Britain’s desperate lack of high-quality commercial property. The situation is particularly acute in certain niche markets, such as industrial property and central London and here’s one stock to buy to take advantage of this theme.

A undervalued share to buy

Buyers are starting to take note of the situation. Industrials Reit (which I highlighted in early February as “far too cheap”) is in the process of being acquired by US private-equity giant Blackstone for 168p a share, a slight premium to its underlying book value.

The stock was trading at a discount of 24% to its book value at the beginning of February, at a price of 124p. In London, the supply-demand balance is particularly acute. Supply is constrained by red tape and building costs while demand is booming.

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Businesses have not fled London in recent years. In some locations, demand is at a record high. But what firms want has changed. Retailers are no longer looking for whole buildings to display goods across five floors.

Instead, they will take one or two floors of a building with the rest of the asset going to other firms: a bar in the basement and a flexible office space on the top floor, for example. The pandemic led to major changes to the way we live and work, but the property market is adapting.

This isn’t true in all markets. It seems unlikely that out-of-town office parks will be able to diversify into retail and socialising to the same extent as centrally located city locations. Nonetheless, in markets such as London, the trend is clear.

The unique market opportunity

Great Portland Estates (LSE: GPE) is likely to be one of the biggest beneficiaries of the shift, and considering the stock’s current valuation, it could offer one of the sector’s best risk-return profiles. The group owns a portfolio of commercial property in central London, primarily the West End. GPE’s mentality has always been based on the principle that buying and holding property will never cover the cost of capital throughout the cycle, so an active asset management approach is required.

“That’s one of the ways we differentiate,” says Toby Courtauld, GPE’s CEO. “You see us typically rotating more than most, with lower levels of leverage,” he adds.

“Many people who’ve come into the market since the dotcom bubble burst have never lived through what we used to call the reverse-yield gap,” says Courtauld: where the cost of debt is higher than property yields.

One of the ways to make money when the cost of debt is higher than rental yields is to “get net new area on land you own”: to add floor space to an existing building (a new cellar or top floor, say) to bolster rents. It is also important to “own assets that have a structural demand for them, and... offer what the company wants”.

Most importantly, “using limited leverage” is vital for generating returns in a high-interest rate environment. GPE’s loan-to-value ratio (LTV), or debt-to-assets ratio, was just 19.8% at the end of March. The company had £457m of total liquidity at the end of the first quarter, before the acquisition of two new assets, both in central London, for an outlay of £53m.

Both of these assets will be developed to build out GPE’s flexible office-space offering, Flex space. These offices give customers a “hassle-free, high-quality, real estate experience”, and are far more profitable for GPE. For the “fully managed” offering, the rate GPE charges is more than double that of traditional leases.

GPE is looking to capitalise on this growth by more than doubling the size of its Flex space portfolio over the coming years. Demand is expected to remain robust.

The Bond Street area in general is seeing record rents as tenants fight over limited supply. “Buying the market is not a clever way to try and make money in central London,” says Courtauld. “You want to be buying the right assets in the right locations for the right people.”

The firm’s vacancy rate says all investors need to know about this approach. It was a mere 2.5% at the end of March. With a development pipeline of £830m, set to deliver 1.4 million square feet of new office space to central London over the next five years, GPE has the potential to deliver substantial asset growth.

And investors can buy this growth at a huge discount. The net tangible asset value per share is 757p based on the portfolio’s valuation at the end of March – excluding much of the development pipeline. With demand for space in central London at a high, it is unlikely the company will see the value of its assets fall significantly if rates continue to rise.

Rupert owns shares in GPE.