Property rises high but the markets look down: Tom Stevenson assesses the prospects for the industry following the sharp dip in share prices

THE FAILURE of the public offer element of Capital Shopping Centres' flotation last week has turned a spotlight on the valuation of property companies, whose shares are showing increasing signs of nervousness 18 months into the strongest bull run for years.

Until recently, many stocks in the sector were trading at premiums to their underlying net worth not seen since the heady days leading up to the 1987 stock market crash.

But the unwillingness of investors to pay 113p for 100p of underlying assets follows similar reductions in premiums at CSC's leading rivals. Since the new year, British Land's shares have fallen from 473p to 413p, Land Securities is down from 800p to 670p, and MEPC's shares are trading 100p lower than their peak at 463p.

The recent falls are understandable. At their peak, the top seven quoted property companies traded at premiums to net assets of between 10 and 20 per cent.

According to research from Credit Lyonnais Laing, the stockbroker, this was only the second time in the past 20 years that the property sector had been at such a premium. Ominously, in the previous instance, the premium was wiped out by a stock market crash.

Over the long run, property shares have traded at a 25 per cent discount to net assets and investors are justified in wondering how long the current enthusiasm can last.

To bulls of the sector, the current premiums are justified because they are expected to be wiped out by fast-rising net asset values.

But shareholders who have profited from the surge in property company values will be keeping a close eye on preliminary announcements because any disappointment in asset valuations could have a dramatic impact on share prices.

To outsiders, the valuation of properties is an arcane business whose credibility has been dented by recent differences of opinion between leading practitioners.

But the factors that determine the value of a property, and by extension the value of the company which owns it, are not difficult.

A building's worth is determined by two elements: the rents it can achieve and the value, measured by the yield, the market is prepared to put on that income stream.

Over the past 18 months, yields on property have fallen rapidly as declining interest rates have provoked a desperate flight from cash and a subsequent financial asset price bubble.

The fall in property yields has mirrored the collapse in gilt yields during one of the most prolonged bull markets in government securities for decades.

Interestingly, despite its sharp recent fall, the yield on property is currently higher than that on long gilts. This is unusual because the potential for income growth from property assets usually means the market is prepared to accept a lower return than on gilts, whose income is fixed for the life of the bond.

Property yields are high relative to other financial instruments such as gilts and equities, but they are also well above the long-term average in absolute terms. Ten years ago the income return on shares was the same as on property at about 6 per cent - now shares yield less than 4 per cent but property offers an 8 per cent return on capital.

That suggests there could be a further decline in property yields and a rise in capital values, even if gilt yields continue to edge up on fears of rising inflation or an upturn in equivalent yields in the US.

The second key factor in property valuation, underlying rents, presents a less rosy picture. Rents have fallen sharply since the peak of the market in the late 1980s and in most areas show no sign of picking up.

The main reason for that is chronic overcapacity caused by the coincidence of a massive building boom, creating hundreds of thousands of square feet of new space, just as economic recession was reducing the requirements of users of office, retail and industrial space.

The impact of that on rents has been dramatic and is well known. Office rents in the City of London and West End have fallen by as much as 50 per cent. And with plenty of empty space in central areas such as London's Docklands and peripheral areas like Hammersmith, the surplus is likely to take a long time to work out.

Less well-rehearsed are the structural changes in the workplace which could mean that a great deal less space is needed than the property industry is prepared to admit.

Christopher Jonas, former president of the Royal Institution of Chartered Surveyors, admitted in a recent speech that technological changes - mainly portable computing and telecommunications - could render the property industry's projections hopelessly optimistic.

Businesses such as BT and British Gas are only the most extreme examples of organisations whose workforces are undergoing a radical reduction in size. In the worst case, rents, which because of the British upward-only lease system are often stuck much higher than the market rate, might remain depressed for years to come.

That is an extreme view and one that is refuted by many in the industry. The opposing view is that, with the office vacancy rate in London below 12 per cent for the first time in four years and with only a handful of prime offices available in sizes of over 100,000 square feet, rents are bound to start rising.

Savills, the property agent, is most bullish on rents, forecasting a 12 per cent increase every year for the next five years in the City. Offices will cost pounds 49 a square foot compared with pounds 27.50 today, it says.

The stagnation in rents is important for two reasons. It puts the brakes on property valuations, one of the key determinants of a property company's valuation. But because rents provide the turnover from which earnings per share are generated, lack of growth puts a cap on dividend growth, which is the other main reason why investors buy property shares.

How the conflicting forces of falling yields and stagnant rents resolve themselves over the next few months remains to be seen. But according to Kleinwort Benson, three further factors are likely to maintain the market's momentum and push prices higher.

First, institutions are expected to turn a blind eye to the difficulties of managing real estate assets and the lack of rental growth prospects because of their demand for yield.

With equities offering only 3.5 per cent and cash 5 per cent, they simply have no alternative home for their money.

Second, property companies are not short of cash. Last year saw a dramatic turnaround in the finances of the sector with many of the leading players holding rights issues, and they all have money to spend.

Finally, because of the strong performance of the equity markets over the past year, the proportion of most funds' assets represented by property has fallen sharply.

It is thought that just to return to 1992's weighting, institutions would have to spend pounds 9bn on property.

If all those factors act in concert, the value of property company portfolios could rise by 20 per cent both this year and next. If it does, the small premiums that are left in share prices will disappear fast and the sector's recent weakness will be seen as a pause in the continuing bull run.

(Photograph omitted)