This week, the Halifax House Price Index said residential property prices in the UK recorded their first quarterly decline since 2012. The reasons given for this centred on affordability. House prices have apparently become too expensive given rising inflation and the squeeze on consumer spending which is beginning to be felt across the UK.
While the Halifax House Price Index is only focused on residential property, it could be a highly relevant guide for commercial property. Consumers may start to struggle to a greater extent now that inflation has surpassed wage growth. Spending on a wide range of items, including houses, may fall and leave the retail sector, and the shopping centres which house it, in a more difficult situation.
Therefore, buying a shopping centre operator such as Intu Properties (LON:INTU) could be seen as a contrarian investment. Its valuation may come under pressure in the short run if the outlook for consumers deteriorates further. But with a sound business model, appealing valuation and high income potential, it could be an appealing long-term investment.
Contrarian opportunity
By its very nature, being a contrarian investor means buying stocks when they are unpopular. At the moment, companies reliant upon consumers in the UK are not exactly ‘flavour of the month’. The rate of inflation has already reached 2.3% and Brexit talks have not made tangible progress. Inflation is now 10 basis points higher than the rate of wage growth, which means consumers will have lower real disposable incomes over the short run. This situation is forecast to worsen as inflation gathers steam, since uncertainty surrounding Brexit is likely to build as the deadline edges closer.
Therefore, for long-term, contrarian investors there could be an opportunity to buy stocks in the retail, property, and other consumer goods industries on the cheap. The financial performance of those sectors is likely to worsen in my view, since lower real incomes have historically meant spending on discretionary and staple items has fallen. This has been through a mixture of the postponing of non-necessities and trading down to cheaper, no-frills options which arguably provide better value for money.
Commercial property
The short-term prospects for commercial property and, more specifically, shopping centre operators such as Intu are therefore relatively poor. The problems which the owner of 10 of the UK’s biggest 25 shopping centres could have if consumer spending weakens may be made up of three main parts.
First, it may struggle to fill available space, thereby leading to a lower occupancy rate than the 96% recorded in 2016. It may take time for this impact to be felt due to an average lease length of 7.7 years, but new space coming up to let may not be filled as quickly as it has been in the past.
For long-term, contrarian investors there could be an opportunity to buy stocks in the retail, property, and other consumer goods industries on the cheap.
Second, the 3.6% rise in like-for-like net rental income from 2016 may fall or even turn negative. This clearly depends on demand. But if inflation rises to a sufficient level and the profitability of the retail sector declines, lower rents may be necessary to persuade incumbents to stay and tempt new customers to move in.
Third, the net asset value (NAV) of the company may fall. If, like residential property prices, commercial property prices experience a period of decline then Intu’s net asset value may fall. While in the long run this may not cause major issues for the business as long as recovery follows, in the short run it could mean a lower share price level as the market seeks a greater margin of safety.
Long-term buy
While the problems faced by Intu are not new or unusual, they have the potential to cause a decline in its share price in the short run. However, since Brexit really could go either way and is an unprecedented event, there could be a buying opportunity for an investor with a sufficiently high risk tolerance.
Although Intu is UK-focused, it has exposure to Spain. Around 4% of its £10 billion assets are based in Spain, and it is embarking on a major investment programme in an economy which is benefiting from the ECB’s loose monetary policy. Further uncertainty surrounding Brexit may lead to weaker sterling and the opportunity for a positive currency translation from the company’s Spanish operations.
While there is scope for a decline in Intu’s net asset value, it currently trades at a 25% discount to its NAV. This suggests the market may have already priced in a fall in commercial property prices. If Brexit talks and their outcome do not mean dire consequences for the UK economy and an even higher rate of inflation, there is scope for a significant uplift to the company’s valuation. Further evidence of its high potential return can be seen in its dividend yield of 5.1%. Dividends may represent over 90% of profit, but reinvestment requirements may not be substantial even over a long period of time.
Difficult outlook
While Intu and the wider UK economy face a difficult outlook, the company also offers high potential returns. As ever, being a contrarian investor can be a bruising and sometimes painful experience. In the case of Intu, there is a good chance its share price performance will disappoint in the short run – and possibly even over a sustained period. If inflation moves higher, consumer spending may decline and leave occupancy rates, asset values and rents down.
However, given its low valuation, high yield and degree of geographic diversity, Intu has investment appeal in my opinion. Although its future seems bleak in the short run at least, Brexit may not have a significantly negative impact on the UK economy. Instead, it could encourage consumer spending, rather than reduce it. The result of this may be improving profitability across the consumer goods sector and rising share prices. Therefore, for those investors who wish to go against the grain for the long term, Intu may be a sound investment.