There is plenty of deep value on offer in the commercial property sector.
One of the most contrarian of sectors at the moment has to be commercial property. Like most other areas of the market, it was even more contrarian around early March since when there's been a slightly more positive shift in sentiment. But by historical standards, the prices are still nowhere.
On the whole, there's very good reason for this; many loans made by the banks on commercial property purchases over the last few years are now worth more than the properties they're secured on. And as most such commercial property loans include a loan-to-value (LTV) covenant that requires borrowers to top up their equity if valuations fall below agreed ratios, investors are understandably nervous of the likelihood of discounted rights issues to top up equity levels -- or worse, administration.
Wheat or chaff?
The opportunity in this kind of situation for private investors lies in sorting the wheat from the chaff as the market tars all companies in the sector with same brush.
McKay Securities (LSE: MCKS) looks to be a good case in point. McKay is a REIT (Real Estate Investment Trust) which means it is obliged to distribute 90% of its property income each year.
Like most other commercial property companies, McKay's value peaked around two and a half years ago when the shares went north of 480p. Today, they stand at 124.25p, valuing the group at £56.9m.
£1 coins for 56p
In exchange for this, investors will receive a net asset value (NAV) per share of 227p. So that's nice and easy – swap the c.127p buying price for 227p's worth of value, so you're effectively buying £1 coins for around 56p. Add to that an income stream of 14.2p a year at the last count -- representing a yield of over 11% -- and head for the sun.
If only life were that simple!
But that is the basic attraction of the shares – the overall NAV combined with the massive yield.
The drawbacks
The problem is that the NAV fell by almost half last year. If it falls a lot further again, McKay could be in danger of breaching its LTV borrowing covenants. However, the final results to the end of March show an LTV of 51.5% which though up from the 2008 level of 38.9%, still leaves McKay with "a comfortable amount of headroom" according to the company's Finance Director.
For McKay, the bigger potential problem on the horizon could be vacancies. If the recession continues, not only may values continue to fall, but commercial property companies could find themselves with lots of vacant lots on their hands and not much income to distribute. Most of McKay's properties are in the south east, and quite a few are centred around the M3/M4 corridor.
In fact, the south-east office market accounts for half the group's property portfolio. And demand is falling as one might expect. This means that vacancy levels in general will increase and rents fall given the laws of supply and demand. At the end of March, though, McKay's portfolio void by rental value had increased marginally to 10%. This is better than average and is helped by the fact that the group collects rents directly rather than through third party agents. But are we through the worst?
To buy or not to buy?
As with any other potential investment, it's all about balancing risk and reward. If you think commercial property and overall economic pessimism has more or less bottomed, then McKay might well be an excellent long-term investment with a huge yield to keep you going as you wait for a re-rating of the price. Such double-whammies are rare. And McKay does look much safer than many of its peers. But if you decide to buy, try and do so in a pension fund or ISA as a proportion of the dividend is treated as property income and is taxable.
On the other hand, if you think there's a lot worse yet to come and McKay will suffer much higher vacancy levels, then that yield might not look so great. But something's got to give; either the share price will recover or the yield decrease.
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