Is it the right time to buy capital and counties?

23 September 2016

South African investors have always had the option of investing directly in UK real estate without having to utilise offshore allowance through Intu, a leading shopping centre owner and operator, as well as Capital and Counties, a property developer.

Since the Brexit referendum vote, Intu has declined by about 11% to the end of August whilst Capital and Counties has dropped an even sharper decline of 26% in rand terms. A large proportion of the share price declines can be attributed to the devaluation of the British pound relative to the rand of about 10% over the same period.

Given this decline, the question often asked is…“is it the right time to buy Capital and Counties?”

Central to answering the question is understanding the entity and drivers, as well as inherent risk scenarios and of course opportunities.

Capital and Counties offers investors exposure to UK prime retail assets such as Covent Garden, which accounts for about 58% of the value of the assets on the balance sheet. This unique retail asset has been repositioned and redeveloped to drive up rentals by attracting various premium and unique retail, including food offerings. Management has successfully executed on this strategy and are on track to achieve £100m rental income on the property by the end of December 2017. By June 2016, 50 new leases and renewals were signed at 7% above the December 2015 estimated rental levels.

The company has committed €72m on redevelopment projects in the precinct to further enhance value. Although the bulk of redevelopments to enhance rentals has been done, average rentals at Covent Garden are still lower than Central Prime London rentals. This leaves more room for rental increases although the current economic conditions are likely to pose challenges. These income generating retail assets should be able to withstand the current environment given their unique quality.

Investors in Capital and Counties also gain exposure to the so called Earls’ Court masterplan which is a residential development opportunity comprising of about 70 acres of land located in Central London with good access to transport. This portion of the fund will be the largest driver of growth in net asset value in the medium to long-term due an overall shortage of housing in London.

Investors in Capital and Counties also gain exposure to the so called Earls’ Court masterplan which is a residential development opportunity comprising of about 70 acres of land located in Central London with good access to transport.

The development aims to provide about 10,000 residential units, but the challenge is absorption by the market of the units to be supplied. London house prices have increased by about 49% since the first quarter of 2013 to the last quarter of 2015, as the market attracted a lot of foreign buyers especially at the high-end, with a large proportion of the purchases increasingly being made for investment or rental purposes.

The recent transfer duty increases as well as uncertainties surrounding the Brexit vote have however led to a slowdown in the number of sales transactions and previously achieved selling prices for the residential units are coming under the spotlight as they are likely to come under pressure. In the recently reported results, the value of Earl’s Court has in fact been reduced by 14% with the overall property values declining by 3.8% on a like-for-like basis reflecting the uncertainty.

Gearing levels within the Capital & Counties remain conservatively low at around 20%. Further write downs in asset values are therefore unlikely to lead to a breach in debt covenants. Low funding costs as well as potential fiscal stimulus are likely to be supportive of asset values.

The weak British Pound is also likely to invigorate some buying interest amongst offshore investors looking to offshore diversification. The risk however lies in the uncertainty of the eventual outcome relating to the finer details of Brexit and its impact on the economy as it will affect development margins, the pace of net asset value growth and sentiment around the stock.

With details around Brexit only to be finalised some time next year, investors are likely sit on their hands with the share price likely to remain depressed until there is greater visibility of earnings or net asset value growth. This investment is more likely to only generate good returns in the long-term and there will be no instant gratification if you are a short term punter.

We therefore believe the long-term investment case for Capital and Counties remains intact and hinges around its unique quality retail portfolio which should prove defensive & continue to achieve good rental growth.

The shortage of housing in London, the city likely remaining a global financial centre and the UK retaining its appeal as a safe-haven among developed markets should be supportive of prices in the long term.