MoneyWeek Interviews: Marcus Phayre-Mudge, fund manager at TR Property Investment Trust

Ahead of the MoneyWeek Summit on the 29th of September, we wanted to bring you a series of interviews with some of our favourite fund managers, both those who will be attending the summit and those who aren't. 

In this interview MoneyWeek’s Deputy Digital Editor Rupert Hargreaves sat down with Marcus Phayre-Mudge, fund manager at TR Property Investment Trust, to talk about the outlook for the global real estate market.

We hope you enjoy the interview and if you've not already you can buy tickets for The MoneyWeek Summit at https://www.moneyweeksummit.com/. 

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Transcript Extract

Anyone who has been exposed to REITs or the property sector over the past 18 months will know how much of a difficult time it's been for investors. 

We both own TR Property Trust and are both feeling the pain in our own portfolios. So what are your current views on how the market’s reacting, and has it overreacted? Is there more pain to come?

That's a fantastic question to start with. Essentially, the market is complicated. And it's complicated because it's actually got a lot of sectors that are performing very differently. So to answer the question, simply - some markets are clearly now oversold. Everybody has suffered from the rapid change in the cost of money and that's really what's driven the downturn. What's different compared to previous cycles is actually market fundamentals are not bad. We have many sectors where there's still an awful lot of strong demand. 

We'll talk about those sectors in more detail, I'm sure a bit later. The thing is that real estate markets are really killed by two sorts of separate illnesses. One is when the cost of money shoots up, and therefore leverage becomes more expensive. The other is an oversupply of physical real estate, or collapse in demand - we've had very little of that, you know, we hadn't had really had oversupplied markets, I know construction hasn’t been much greater than demand for many years. That's quite simply because after the GFC, the global financial crisis, banks in particular, really stopped lending speculatively. So developers were forced to go and find capital elsewhere. This was a real constraining factor. If you look at the central London office market, you know, we're on we're in a period of, you know, very, very low supply relative to history. Now, of course, demand itself as it has, has pulled back, particularly in offices, and we'll talk about that in more detail, I'm sure. But at the same time, in the West End, we have vacancy levels of sub 3%. Obviously, in the City, it's probably 7% or 8% and in Docklands it's 13% to 14%. Those particular markets where demand has reduced quite significantly. But when we look at, you know, broadly across all our Pan-European markets, we see, you know, remarkably little oversupply. So, for the last 18 months, it's really all been about the cost of debt. 

We've really focused on working out which of those companies have debt burdens that they are not they're not able to cope with. Simply you have two friends who both have bought flats recently, one of them bought two years ago, one of them stuck with a floating rate mortgage and the other was smart enough to go and buy a five-year fix. The one who bought the five-year fix doesn't care about what's happening to interest rates. And actually, you know, his or her cost of their mortgage each month has been static. Meanwhile, your friend on a floater has had a shocker because their cost of debt has gone up hugely. For us, we're just looking at companies you have that scenario but on a much, much bigger scale. 

The great news is - to give you one live example, this morning, a company called Eurocommercial which owns, shopping centres in France, in Sweden and Italy, produced its half-year numbers, which saw its top line rent received increase by 8.2%. And that's a combination of natural rental growth, plus also indexation, because what we're probably going to get into a bit later on, is the fact that matter is one of the great things about real estate, particularly in Europe is that rents are index-linked to a greater or lesser extent.

That's something I'd like to cover in a little bit. But first of all, TR Property has beaten its benchmark in 11 of the past 12 years. You yourself have been around in this industry for long enough: We're seeing as you've described, interest rates have gone up, it's a different capital cycle, different market cycle, how does this market cycle compare to previous cycles that you've seen or seen companies go through? How are they reacting differently? How should investors react differently to the current current environment?

Well, first of all, thank you for highlighting our relative outperformance because essentially, that's what you know, justifies what I do. Investors can quite easily go and buy an ETF, a tracker of my benchmark, but I'm really pleased to be able to say that, you know, we have been beaten that benchmark consistently over the years. And over the last decade, you would have made about 60%, more being with us rather than with it with a tracker. There are a number of reasons for that and some of them are about the structure of the trust, and we'll get what we're able to invest in. We'll get into that a bit later. But to answer your question, the really interesting thing, this time around, because obviously, as you say, I've been through many cycles, I started as a surveyor in 1999 and then got into real estate equities, around 1999 or 2000 and I’ve been working on the trust since then. It's really been about the speed of the change in the cost of money, which has been very, very dramatic and caught a lot of companies unaware. However, what we found is a big difference between the UK and Europe, and a lot of UK property companies, very encouragingly - and great credit to many of the boards of these companies - they really learned their lessons of the financial crisis, because a lot of UK companies basically went into a deeply discounted rights issue and that was very, very valued, destructive. And I think boards have been very determined not to do that. And it's really encouraging when we look across our UK companies, you know, we haven't an average, even after the correction we've seen in valuations, which may not be over but the ones we've had so far, we still have for the vast majority of our company's LTV are the in the 30s. That's really because, in the investor community, we're just not prepared to allow companies to push their gearing up. 

Now when you look at the private market and remember that way more real estate is owned privately than publicly. You know, every private equity firm out there would give their, you know, give their eyeteeth to have leverage as low as 35%. They're really hurting. And in fact, I think this is going to become and it's going to come to pass quite quickly now a real opportunity for a lot of our listed companies, they have firepower. They have the ability to to draw on revolving credit facilities and other forms of debt. They have deep relationships with these with their banks. 

In Europe, it's a bit more of a mixed bag. Our Swedish property companies, for example, always operated with much higher levels of leverage and also focused on short-term debt. Their argument is that if interest rates go up it's because economies are warm, their economy is warming up, and therefore they will capture that in rental growth and capital growth. Because what's happened this time is the economies are not growing but the price of money has moved dramatically. We've had to avoid a lot of Swedish property companies and our jokey strapline is “the nation that brought you the safest car brings you the scariest property market.”

An infamous one is called SBB. I won't pronounce the very, very long Swedish full name, it has about 30 letters in it, but that share price is down 85%. We don't own it, obviously, we haven't owned it. But just to reflect the what happens with these guys, if you get into too much, too much leverage. 

The other area, which is quite interesting is that when interest rates were basically zero or negative during that long phase of quantitative easing by central banks, you saw a lot of Euro bond issuance. So a lot of companies in Europe taking advantage of unsecured debt. And this has been a problem, we've identified this, we could see that pothole in the road down the line, so we were able to avoid some of some of those companies. 

A huge amount of this now is in the price. I mean, let's take a stock like the Vonovia, the largest residential business, listed business in Europe with 375,000 apartments, this is buy-to-let on an industrial scale. They have a lot of these, a lot of these bonds, that share price has gone from 60 euros to 19. And remember that, you know, this company has virtually no vacancy, there is a shortage of apartments in Germany, and every building has a waiting list. And rents are restricted. They're regulated, which so essentially, they're they're below, below open market value. 

We have another business called Phoenix Spree Deutschland where when tenants leave, they're able to refurbish these flats and sell them to owner-occupiers. And the amazing thing about residential markets compared to commercial is that actually a flat, particularly in a regulated market, like Germany, or Sweden is worth more empty than let, so you kind of got the best of both worlds. Whereas here, you're when you're thinking about commercial property, you know, industrial building, or an office building, clearly, if it's empty, it's, you know, it's a worry for the landlord. It's much worse news. 

So I think a lot of this is is investors, not really focusing on the, on the minutiae, and not realising, actually, there's a lot of embedded value in many of these stocks. 

There's an interesting argument there. Do you think in the UK, and especially in Europe, if you have this situation where you have a lot of, say, retail businesses collapse because of a bad economic environment - almost every single economy in Europe is struggling to build enough houses, rents are skyrocketing, especially places like Ireland, Portugal, Germany, rents are really going unless they're regulated in Germany -  do you think there's, there's a failsafe there for companies to say, “well, if we can't get the tenant for retail, we'll just turn it into a flat”? 

Absolutely, there will be I think, an increase, I wouldn't say huge, because it's going to take time, but there's a groundswell from, particularly from governments realising that it's just environmentally unfriendly to leave buildings empty. It's environmentally unfriendly to go and build a new build on a greenfield. And actually converting existing properties is something we should all be doing and give the UK government credit, they've been doing that through something called permitted development, where you, you know if you have particularly older office buildings, outside of a core area and certain cities, you have been free to make that conversion. You can't do it in central London, you're not allowed to, but in the investment trust, we have done it. We sold a building in Vauxhall to a residential developer to convert it, and we made about 40% on our money in a couple of years on the back of that, because it was worth much more with a residential consent than an older office building. 

I think that the other thing is that there's a real push to develop communities where I mean, one of the old problems is people don't want to commute an hour or an hour-and-a-half on public transport, often underground. So if you can kind of create the 15-minute city where you live work and play in relatively close proximity, that will require a much more mixed-use environment. So to your point, converting commercial, redundant commercial uses to residential and there's money to be made.

And you're making it in the trust?

Yes, absolutely. And we have we have a big holding in a business called Picton. Very well-run company and it is in the process with one of its large office assets going through that conversion process. And as a result, that asset that on the face of it, to many people looks like a liability, relatively short leases in the offices, they're going to, they'll be able to convert that to residential.

There are a couple of listed office, regional office players in the UK, that are really trading at 50% to 60% discounts to reported net asset value. So do you think over the next couple of years, there will be a serious adjustment there and there's more money to be made from investors and these companies?

I’d really like to say, yes, but sadly, the answer is no, because we've done a lot of work on this. The cost of conversion, particularly for older buildings, is high relative to new build, it can be up to about three times the cost. Once you get below about £300 to £350 per foot, it's unlikely to be economical. So for the London area, Reading Maidenhead around other cities, you know, the nice leafy suburbs of Manchester and Bristol and Birmingham, etc but if we're talking about, you know, regional towns, residential values, I'm afraid just aren't, aren't enough. So it's not a bailout. So an asset, which five years ago had a capital value per foot of £500 or £600 you may find, by the time the leases come to an end, the building is empty, you have to comply with the Energy Performance Certificate regime, you've got to be a Grade B by 2030, which means you can't let the building as a kind of lack of old building for a few pounds of foot, you've got to spend the money, that actually the clearing price will be, you know, a fraction of that value, maybe £100, I don't know, but we're already seeing examples of that. 

So the market will just find a clearing price and then either the building gets pulled down, something else is replacing it, or there'll be a conversion opportunity. But it will take time for the owner of the asset to realise that the game is up somewhat. 

Now, really, interestingly, listed property companies don't really play in that space. And when you look at staying with offices - and we'll move on to other asset classes in a minute - I'm sure that you know, actually, there are very few companies that specialise in. We're a very big owner of a business called Edison. Now, one of the reasons we got into that, and that that business now is 100%, retail warehousing, but they were five years ago, a very much a diversified play. And they had about a third of their portfolio in offices. And they sold all of those offices about 18 months ago. And it was on the back of that sale that we really became very interested and bought a lot more shares. And they've been in the news recently after the board carried out a strategic review. 

Whilst we have all these issues in office markets, and by the way, if you want 5000 square feet in the West End, today, brand new best-in-class office space, you will pay a record rent, rents are rising, they're not falling. Meanwhile, we can go to Barnsley or Blackpool or Brighton with a secondhand space where you can rent a property 25% below where they were they were.

If you look at the listed UK-listed REITs, they're trading at 50% discounts to report in NAV. Do you think there's going be more acquisition activity with these companies?

The answer is, unfortunately, yes. And this comes back to the fact that real estate can be owned privately or publicly. There was a huge wave when money was very cheap, a huge wave of private equity capital coming in and buying listed property companies. There is a slide on the TR property presentation, which is on our website for anybody who wants to have a look, which identifies all the companies in the last three years who've been taken private and whether we own the shares or not. I'm pleased to say we most cases we have. If equity markets continue to leave these stocks trading so cheaply, will it happen in the next three to six months. Already this year, we've had Blackstone buy Industrial REITs, where we owned 12% of the company, we've had CPT merge with with with London Metric, 

This is a real underpin for owning listed REITs. You and I own TR property and anyone else listening who also owns REITs will actually appreciate the pain they've had. Now we have seen some recovery and it is worth noting that between October last year and the end of February, which is when broad global markets started to feel about the likelihood of peak interest rates, we saw a 30% rally in REITs. The market then sold off again on the back of the US regional banking situation and sticky inflation in the UK. But what's very clear when you look at the inflation numbers now the PMI data, etc. Is that inflation is coming down, it’s still elevated, but coming down. And I think, you know, the longer rates rise, the closer we are to peak rates, as it were. 

Do you think I mean, from a purely income perspective, is this still an attractive sector? And then if you could explain a bit about the European sector, because in the European sense, or most, it's more widespread to have leases linked to inflation and how is that in the current environment good for investors?

Yeah, it's an absolutely crucial point. I'm really glad we've moved on to this because essentially, the total return from real estate over multiple decades - the vast majority of that return is actually income. The capital account ebbs and flows in a cycle as you would expect, but the income is always there. And so you know, over a multi-decade period, you would say about 85% of your return actually comes from from from the income, but we're at the point where we've had a big negative capital return so we could be in shock.

Coming around to the point where we're going to have the double whammy, we're gonna have the income and the capital return. We're coming back to the income to the point I made right at the beginning. We've seen very little corporate distress, we are seeing businesses quite capable of absorbing the increases in rents that they're being asked to pay. And across Europe - and I highlighted the numbers from Eurocommercial this morning - rents are up 8% in the half year, that's a lot. They are able to capture inflation, it's not the same everywhere. So you have to be quite careful, you can't just look at European CPI and say right, everyone's gonna get that. There's quite a broad spectrum. But essentially, all European leases are index-linked to a greater or lesser extent, it's only in the UK that we have this rather quaint structure with only five yearly rent reviews. But of course, that's really going by the wayside, because leases are shortening all the time. The consequence of this is we come back to your dream property company, where the debt, they've got their debt fixed for five years, I would use a UK example, Picton Property have been very smart and fixed their debt out to 2031. If they can grow the top line, all of that is going to fall straight through to earnings and to dividends to you and me. Now, this is substantial. And the key for markets is to avoid for us is to avoid any sub-market where there is overdevelopment or collapse in demand. And where earnings are not going to be sustained. So offices are clearly an area of concern. But pretty well, every other market. You know, things are looking reasonably set fair.

That's interesting. So you're saying basically everything apart from offices has a brighter outlook?

Yes, I mean, obviously, the one that's been heavily damaged over the last 10 years has been retail. I mean, we all of us have walked around and shopping centres and there's been you know, boarded up units. It's been a particular problem in the UK because essentially the department store format has failed so you generally have these shopping centres with big department stores at either end as you know, they were used to attract people in and of course, we're left now with just just John Lewis. 

So you know, the woes that we've experienced here in the UK, we do genuinely have too much retail. That is we're seeing that evolve very quickly with a change of use, etc. But values have been hit. And more importantly, rents have essentially halved. So you've now got it because it's all about finding that balance and retailers today, most big retailers can afford to operate from the store.