Why banks should be building a different viewpoint of property companies into their strategy

Citation

Robinson, B. (2000), "Why banks should be building a different viewpoint of property companies into their strategy", Balance Sheet, Vol. 8 No. 6. https://doi.org/10.1108/bs.2000.26508faf.001

Why banks should be building a different viewpoint of property companies into their strategy

Bill Robinson

"What America does today the UK will do tomorrow" has always been a useful rule for analysts. One thing that America does today is finance companies with more debt than equity. The difference between the UK and the USA in this respect is very striking. Broadly speaking the amount of debt in UK companies averages less than one-third of their value. In the USA, the average is more than two-thirds.

We should expect the UK to become more like the USA, with increasing use of debt finance. One reason for this is the change in the UK macro economic environment. We now have an independent central bank, and there is a widespread belief that low inflation is here to stay. Those conditions have long underpinned the use of bond finance in the USA. Now they prevail on this side of the Atlantic we can expect bond finance to increase here too ­ helped by UK corporation tax changes that have increased the attractiveness of debt relative to equity.

A particularly interesting opportunity has arisen in the UK at the long end of the market. The fall in government borrowing has reduced the supply of gilts. Yet the growing number of longer-lived pensioners means that the pension funds still have a healthy appetite for long dated securities delivering a safe income stream. This gap between supply and demand at the long end has been widened by the Minimum Funding Requirement (the regulations governing pension funds' gilt holdings put in place following the recommendations of the Goode committee). The resulting demand for long-dated government bonds has driven up their price and driven down their yield. So the yield curve on government bonds is currently steeply downward sloping. Companies looking to borrow long can do so on very attractive terms, as Figure 1 shows.

The property sector is particularly well placed to exploit the inverted yield curve. Properties let on long leases to blue chip companies or government departments can deliver an income stream that is a very good substitute for a government bond. However most property companies, as they are presently constituted, cannot profit from this opportunity. This is because the activity of property companies is a mixture of a very safe activity, and a rather risky one. The safe activity is managing existing properties, typically let on long leases to companies with good covenants.

Government gilt yield curve Figure 1

The risky activity is the development of new properties. This involves buying up parcels of land, which may show no return over many years, while a suitable site is created and planning permission sought. When the land is finally assembled, huge costs are incurred in putting up the buildings. There are risks of overrun, and risks that the property may not prove as attractive to tenants as was anticipated when the building was specified. But when the development is complete, and the property let, the management of that portfolio of property becomes a very non-risky activity.

The way forward for property companies is thus clear. They need to hive off the relatively risky development activity from the relatively safe management activity, and then borrow up to the hilt against the management activity, by issuing long dated (15 years or more) bonds.

A further twist in the story is the use of securitisation (another common US practice destined to become more widespread in the UK). When a typical property, which mixes property management with development, issues a normal bond, the credit rating depends on both activities and the cost of debt will reflect the risky nature of property development. The debt is thus more expensive than it need be.

Securitisation is the ugly name given to the process of creating a ring-fenced income stream based on a set of assets that can then be given their own credit rating. A bond is then issued which is backed by the income from those assets. The essence of securitisation is that the credit rating, and hence the rate of interest charged, depends on the risks inherent in a tightly defined activity rather than on the reputation of a company.

Securitisation can enable companies to borrow at a lower rate of interest, which may in turn enable them to increase their gearing and capture more tax savings. It is an interesting option for a company whose activities are a mix of the safe and the risky. By hiving off the safe activities into a separate vehicle, it can borrow more against those activities, at a more attractive rate of interest, than would be possible with a conventional corporate bond. Securitisation is an obvious way forward for property companies. It enables them to create value both by reducing interest costs and by taking on more debt.

There are two further reasons why we might expect to see a surge in bond finance for property companies. The first is that the fall in long term interest rates has made debt an increasingly attractive form of finance. As Figure 2 shows, the 10 year bond yield has recently fallen below the initial property yield. This crossover point, which has not yet been reached with equities (the bond yield is still higher than the average dividend yield), is the result of falling inflation. It means that the risk premium inherent in investing in property is now lower than the inflation risk premium demanded by bondholders.

Gilts yields fall below property yields Figure 2

The practical consequence of this crossover is that it offers an average property company the opportunity to borrow at a rate of interest below the yield on the property they might buy with the borrowed money. It is not quite an arbitrage opportunity, because in theory the return on property is riskier than on the bond. But it does offer property companies the chance to do financing deals which are cash positive from year one.

Such deals, aimed at getting more debt into property companies, are an attractive way of dealing with the fundamental problem of the sector, which is that property companies traditionally trade at a discount to net asset value. The discount reflects the tax penalties on holding properties in a company rather than directly. However the tax disadvantage is balanced by the potential for capital gain offered by a good property development company. The size of the discount thus reflects the balance of opinion about development prospects.

Figure 3 shows the history of the property sector discount. There was a period of optimism about the property sector in the mid-1990s when the discount disappeared. However the corporation tax changes in 1997 made it less attractive for pension funds to own property companies and the discount re-emerged. Today it stands at around 10 per cent, sending a clear signal that the prospects for development gains do not outweigh the tax penalty of holding property in a company and subjecting the yields to corporation tax.

The property sector discount to net asset value Figure 3

One way of dealing with the tax problem, and hence eliminating this discount to net asset values, is to ensure that the activity of managing existing properties is carried out in a ring-fenced, highly leveraged vehicle. This could be done, for example, by hiving off the property development activity into a separate company. The assets remain in the original company (to avoid triggering any liability to Capital Gains tax), which then eliminates (or greatly reduces) its corporation tax liability by borrowing up to the hilt.

This is where securitisation comes in. By constructing a portfolio of suitable properties, let on long leases to tenants with impeccable covenants, it is possible to generate an income stream that can be securitised on a high credit rating. The company owning that portfolio then becomes a highly tax efficient entity. A stream of income comes in from the buildings. A matching stream of income passes out to the bondholders. The bondholders enjoy a safe and tax-efficient income stream, underwritten by the rents from the buildings, without the hassle of direct property ownership. The company profits from the difference between the low cost of borrowing and the yield on buildings, and its capital value rises to reflect the net present value of the (large) tax savings.

This leaves the activity of property development in a separate company, perhaps with a small rump of buildings producing just enough rent to pay the salaries of the property developers. That company generates little or no income, and also pays little or no corporation tax. It becomes a pure growth play. The shareholders reap their reward when the property development comes to fruition.

Dividing companies to create focus is usually a good recipe for the creation of shareholder value. Gearing up to increase the value of the tax shield is another good recipe. Securitising is a third potential source of value and borrowing at the very long end is a fourth. Property companies currently have a remarkable opportunity to create value in all four ways at once. Expect some action in this long-undervalued sector.

Bill Robinson is head UK Business Economist in Financial Advisory Services at Pricewaterhouse-Coopers.