We all like to think – we who think markets work that is – that markets work. Bit tautologous but there we are. Prices in a market reflect the “true” value of whatever it is. As it happens, this isn’t true. What is true is that market prices reflect the aggregate and average price of what everyone involved in the market thinks the price should be. We can be tautologous again and say that the market price is that real price as the price of something is what you can sell it for. Or we can be a tad more subtle and insist that the considered view of everyone with skin in the game is the closest estimate we’re going to get to that real price.
This obviously conflicts with the idea of value investing, which is to insist that the market price diverges, at times, from that real value. Buy at the lower market price and watch prices climb, over time, to that objective value.
Well, yes, it works. Except identification of that objective value is difficult. And at times it can be the normal sort of numbers we look at as our guide which are wrong. Such is what I think is going on with the British commercial property market. Say, Hammerson, Land Securities. They trade at a substantial discount to valuation. But it’s the valuation which is wrong, not the market price:
We would therefore expect to see a certain decline in the value of commercial retail property and also in the companies that own much of it. Thus HMSO and LAND perhaps. Except there’s the one little unique point about British commercial property leases. They’re on varied terms, 15 to 25 to longer years. There are rent reviews, obviously enough, no one caught by the inflation of the 1960s and 1970s is going to do without those. Such reviews might be at 3 or 5 or 7 years. None of that’s very much of a surprise.
The one thing that is perhaps a surprise is that such rent reviews are always upwards only. A general decline in market rents will *not* lead to a reduction in rent at that review time. This has significant implications for the accounting treatment of the capital value of a commercial property. As the rent is never going to go down – it might go to zero through being empty, but it’ll not decline gently – we end up with those capital valuations rather being set in stone in the corporate accounts. And it is those valuations that are being used to give us the net asset value of these quoted companies.
Those net asset values are based upon the idea that rents never do go down. And on continuing leases they don’t. Yet if we do have this structural change away from bricks and mortar retailing to online then quite obviously the valuations of those retail properties is going to be falling. Yet the structure of the market doesn’t allow for gentle realisation of such falling valuations. That is, those valuations are a lot weaker than we might like.
Have a look there for the rest of the argument.