Copyright: David Lawson – appeared Property Week August 1998
Home pageREIT and revolution have become almost interchangeable terms. The impact of giant US real estate investment funds has been nervously anticipated ever since feelers came snaking across the Atlantic more than a year ago. Now they appear to be insinuating the distribution sector.
Ever since the news broke that Kingspark, a fast-expanding private Midlands developer, was talking to a REIT, it has been taken for granted that the market would be shaken to its core. REITs are not shy about boasting a different philosophy to UK investors. Valuations are geared to income rather than capital yields; leases are impossibly short; management is very hands-on, with more involvement by the landlord in the fabric and maintenance of buildings.
This all seems a timely solution for a problem which emerged from an earlier revolution. Outsourcing has become a driving force in major UK corporations and distribution is one of the prime services farmed out to specialists. But the downside for contractors is that these are usually short-term agreements - generally from five to seven years - a deeply unattractive prospect for institutional investors who generally demand a minimum of 15 years.
The logic goes that REITs will ally with this proliferation of contractors and force the rest of the market to follow down the road to shorter leases. Kingspark has been held up as the first shot in this revolution.
Chief executive John Cutts talks a good case for exploiting this special relationship and creating a 500m pound portfolio in three years. After all, in a mere five years since setting up the firm with David Kier, Andy Ruhan and Greg Court, the hyperactive team has created almost 6m sq ft of space. Now it has the added strength of Security Capital Industrial, which is ready to pour 1.5bn pounds into real estate outside the US.
Questions remain, however. Can one firm's efforts change the sector's ground rules? And perhaps more importantly, will other REITs come galloping in like the cavalry? 'There are certainly other REITs sniffing around,' says Alan Carswell, director of industrial for DTZ Debenham Thorpe. 'If they arrive, their combined muscle is bound to have an effect. There has been a mismatch in a substantial section of the market for many years, with distributors wanting shorter leases and investors seeking the stability of long ones.'
This friction has been hidden as the UK came out of recession, with second-hand property being let at more customer-friendly terms. Another influence has been distributors telling clients they would need to take over a building if a contract is not renewed. Fund managers have not stuck their heads in the sand, and some deals have been done on new developments on leases of between five and ten years. But they demand a price. 'Many are charging rent premiums of between five and ten per cent,' says Carswell. The inevitable question then arises whether occupiers stump up this extra tithe.
Obviously some will, and this gives clue as to the possible future shape of the market. A new sub-sector will emerge rather than some massive revolution, says Mark Perowne of King Sturge, who has had a closer view than most after valuing Kingspark's assets for Security Capital. 'The market has been dominated recently by owner-occupiers building for themselves. If REITs can offer an alternative, they could displace part of that trend,' he says.
Giles Scott at Chesterton sees different tiers emerging. One will cover the traditional institutional investment, let for 20 years or more to a major retailer or food processor. 'They can plan along that kind of timescale and will often do a lot of expensive fitting out with equipment for processes like cutting and packaging,' he says.
At the other extreme will be the five-year tenures of specialist distributors. Each will have its own investment profile, with valuations and yields to match the risk and reward. Carswell speculates that institutions might not be precluded because a mix of these assets could make an excellent foundation for the pooled funds now growing in sectors like leisure and retailing.
All this presupposes an invasion of REITs - which is by no means certain. Share values have tumbled in the US this year, so raising money for expansion is no longer easy. 'A big reorganisation is going on,' says Martin Barber, who not only heads Capital & Regional Properties in the UK but also the US industrial REIT CentrePoint. 'Those who expanded for the sake of size have been found out. Only the trusts which have added value are doing well.' He sees no threat of the UK being swamped by REITs desperate for growth.
In fact, there must be doubts about whether any trust will spend much time searching the UK for product. Why should a group like CentrePoint with 30m sq ft of space in Chicago alone bother to look here? 'We have talked to REITs but were not convinced of their intentions,' says John Duggan, managing director of Gazeley. He points out that the whole UK distribution market was 8m sq ft last year, and three-quarters involved owner-occupiers. That effectively leaves a small investment market which, at implied rents of around 5 pounds/sq ft, would yield 35m pounds/year in rents.
It seems that REITs will have to start building fast or Hoover up a lot of second-hand property. But even that may be difficult. 'There is very little good property available,' says Guy Frampton of CB Hillier Parker. 'I believe REITs will hit the market with a bang, but it will not be as easy as it sounds.'
The newcomers learned this to their cost in the summer when Security Capital was outbid on sites at Farnborough and Heathrow despite appearing to blow away the market with valuations based on cashflow. Kingspark can claim to be insulated by a massive landbank to work on but this could be tied to options and joint ventures with funders. It remains to be seen how they will view REIT-style leases.
In pure economic terms, an invasion of the UK would need to be set against 9% returns achieved across the board in the UK. But there may be an escape clause. Motivation for expansion lies as much in matching customer demand as maximizing profits. 'Major customers like Pepsi are demanding worldwide service, so REITS will seek to serve them in every country they can through global leasing services,' says Chesterton's Giles Scott. 'Brand loyalty cannot be over-emphasised as a crucial factor.'
Individual deals do not need to be spectacularly profitable because they merge in with provision of sites across the world. Europe, in particular, is seen as a new territory and the UK is a convenient springboard. This implies that the impact of REITs may be severely limited within the UK. It will be up to Kingspark and other pioneers to prove the doubters wrong.