Fool's Eye View

[ June 1, 2000 ]

Ripping up the property book

By Christopher Spink (TMFEagle)

Great Titchfield Street, London -- One of the most thought-provoking Fool's Eye Views of recent weeks declared that "Price to Book is Dead". TMF Mayn, who wrote this piece, concluded that the ratio of market capitalisation to net asset value (assets minus liabilities) "warrants very little investment attention". Maynard was particularly withering about the optimistic valuations accountants often attribute to a company's fixed assets. These are buildings and heavy pieces of equipment you can't easily move.

He wrote: "Fixed assets are perhaps more susceptible to a book-keeper's optimism than most. Using subjective depreciation policies from the historical cost of the asset understandably leaves a lot of leeway. The true value of what any asset is worth is what a buyer is prepared to pay for it. Anyone who has tried to sell a second-hand car should know this basic fact of investment."

Mayn was focusing on the follies of valuing retailers, engineers, mining enterprises and leisure companies according to this redundant tool. However, one sector still heavily relies on valuing fixed assets -- property companies. These are sometimes called real estate companies. Essentially these companies' property portfolios have a fixed value on the balance sheet, attributed by a surveyor.

Analysts often claim one company is "cheaper" than another because it has a deeper discount to its book value (the predicted price one could get for selling off the properties in the portfolio and paying off any outstanding debts). Such companies have very little business apart from accumulating fixed assets, redeveloping them and selling them on at a profit.

Many also receive rents, of course, but these rise or fall in accordance with the underlying value of a property. This is called the rental yield. It is competitive and thus roughly the same for most buildings in a specific category, whether high street, commercial, industrial or residential properties. So day-to-day earnings from a particular building will proportionately be the same whether it is located in central London or deepest Devon. But the underlying "book" value of the building will be much higher in London than on Dartmoor.

Because of this, property companies concentrate on creating value by selecting "undervalued" properties in areas that might become more valuable, or else by developing redundant buildings, adapting their use to something more lucrative and increasing their value that way. That is why they are often valued relative to their fixed assets.

Bargain basement

TMF Essex wrote a round-up of the property sector a couple of months ago, pointing out the discounts at which many of the companies' share prices traded to their book value. Most real estate companies have underperformed the stock market over the long run. This is because they generally reflect the historical rise in property prices (8% per annum) rather than that of stock prices (12%).

13 out of 14 of the property companies in the FTSE 350 currently trade below book value.

                        Discount to NAV
Land Securities         -18%
Canary Wharf           +106%
British Land            -30%
MEPC                    -14%
Slough Estates          -15%
Liberty International   -34%
Hammerson               -27%
Great Portland Estates  -18%
Chelsfield               -6%
Capital Shopping Cents  -34%
Brixton Estates         -21%
Pillar Property           0%
London Merchant Secs     -4%
Minerva                 -13%

Of course to dispose of each company's whole property portfolio would cost vast amounts of money in fees, so price to book is a ridiculous measure. Also, each company has a different financial year-end. Given that a book value figure is only given to shareholders twice a year at best when results are released, book value only represents a snapshot at a specific time, which differs for each company.

Nevertheless, though, a 19% average discount to book value (leaving out the extraordinary value of Canary Wharf (LSE: CWG)) seems overly pessimistic and cannot easily be ignored. Perhaps one reason investors have neglected this area is because each company has a different and equally obscure way of valuing its property portfolio and its debt liabilities. This makes it hard to work out exactly which company represents "better" value than any of the others.

However, today two pension funds have decided that MEPC (LSE: MEPC) represents a bargain. GE Capital and BT's (LSE: BT.A) Hermes fund have made a £1.92b bid for the commercial property company. The 550p a share bid is 3% below MEPC's 569p adjusted net asset value per share as calculated at the end of March.

What prompted this move? Just as many private investors saving for retirement like to diversify their holdings by owning their own house, so pension funds like to have some their funds invested in property as well. With property companies at such a discount to net asset value it seems reasonable to buy such companies outright at a relative bargain to satisfy this desire for diversification. Expect further movement in this area before completely ripping up the property book.

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Related Links

• Fool's Eye View -- Price to Book is Dead
• Sector Dissector -- Property at a Discount