Chief Executive's Statement

There continues a sense that the UK remains at the crossroads without any strong sense of clarity as to which direction the economy will eventually take. Probably in the main due to the swift application of the policy of quantitative easing, a complete economic collapse was avoided but there are undoubtedly pitfalls ahead wherever one looks. Unsurprisingly, after the traumatic experience of recent years, both business and consumer confidence is in relatively short supply and, as is often the case, it will need to be rebuilt slowly and carefully. It is of little comfort that the UK is not alone in these difficulties, especially since our major trading partner, the European Union, has its own problems on a perhaps more extensive scale.

This current uncertainty prescribes the behaviour of the consumer and consequently also of industry and business. Household savings ratios have now restored themselves to the reasonable level of five per cent as is the customary reaction following a period of financial stress. Given the challenges faced in the coming few years through increased direct and indirect taxation, as well as the likely rise in unemployment induced by government-led cut backs, the savings ratios may plateau rather than increase as these savings reserves are utilised to overcome the next few difficult years. It remains to be seen whether and how rapidly the private sector can take on the challenge of energising the spare capacity that now exists in the UK economy – for therein lies the solution.

Rental growth has now levelled out after a decline of several years and given current vacancy rates that exist within most sectors, is unlikely to increase at a significant rate until the medium-term. Prospective IPD Index performance will therefore depend more on interest rate levels and yields if further capital growth is to be achieved. We do not view this as likely for some time, but we need to remind ourselves that real estate is a long-term, cyclical business rather than a short-term sprint.

In such circumstances, it is reassuring to see that on an historic comparative yield basis, property still looks fairly priced in comparison both to the bond and equity markets. It would seem that the generous yield spread is justified by the uncertainty that lies ahead.

Apart from the level of interest rates, which are to some extent within the control of the UK monetary authorities, the two big UK banking groups are in control of a substantial overhang of real estate that represents the legacy of past lending to the real estate sector. In addition, there are, of course, the even more acute problems associated with the Irish banking system. To date, the banks generally have been cautious with regard to both the speed and quantum of the real estate they have released back to the market and have focused primarily on those prime assets which have found ready investors from within the substantial amount of money that is seeking to enter the market. Increasingly, having now harvested what might be termed the low hanging fruit, the UK banking groups may find it more challenging to dispose of those assets of a more secondary nature. But since their exposure to real estate loans is still at levels above those when the 1990 crash began, deal with these assets they must. Effectively, circa £100 billion needs to be found over the medium-term to reduce the banks’ inappropriate loan exposures to the real estate sector. Some of this amount will likely come from further loan loss provisions once the banks have internally replenished their capital through enhanced earnings, and some from redemption or refinancing. It is only once the banking sector has returned to health that the property business, amongst others, will have a chance to fire on all cylinders again.

The support of our shareholders in the last two years for fresh equity of £200 million has placed us in a strong position for the next few years. The large scale cash-rich real estate investors have traditionally and quite rightly been reluctant to invest outside the prime sector due to considerations of both risk and lot size. Development Securities represents one of the relatively few portals through which such much needed equity can flow in order to access the returns from this fertile area of the market, since we not only have the cash and the expertise necessary to deal with complex real estate issues, but have always remained diligently focused on commercial property in the UK. As such, our brand in the market has strengthened in those various areas of the sector where capital starvation is acute.

Development Securities, with its track record of partnership with both institutions and private investors, together with its transparency as a regulated, publicly listed entity, is increasingly seen as a desired partner for those in need of capital. Under such circumstances, we are tending to find that terms of trade are moving more in our favour.

It would seem that, for Development Securities, the next few years will be spent for the most part unlocking problem assets with pregnant value or carrying forward modest-sized development schemes which are unable to find sufficient available capital.

It is unsurprising that major development schemes in the next few years are likely to be restricted to Central London where special considerations have seemingly always applied. History would caution us that this market is the most volatile of all sectors in the UK, due to its heavy focus on the financial services sector and with an increasing representation by overseas investors who may often also be significantly represented in the occupational markets in Central London. It would appear that the likely reason why real rents have declined so significantly in the Square Mile since the early 1980s is that supply has continued on average to consistently outpace demand. Since the advent of Canary Wharf, this supply has also appeared outside the walls of the City of London but has nevertheless drawn off a considerable amount of demand, thus weakening rental growth within the core district. We do not believe that a new generation of very tall buildings in the Square Mile will alleviate this factor – rather, perhaps, compound it. Nevertheless, since there still appears to be value to be captured in the increasing agglomeration of skills in London, we continue to pursue Central London development schemes and search out those opportunities where creativity and added value justify risk and price. We are confident that we will eventually secure appropriate opportunities, but we proceed with caution.

Whilst property is not manifesting indications of a fresh price bubble, there is little doubt that quantitative easing encouraged the recent sharp upward re-pricing of the market as investors struggled to find assets that they could regard as generating significant steady cash flow and which offered the potential, at least, of an inflation hedge. The assets that we have been able to acquire over the last 18 months or so have come forward to the market by virtue of some degree of financial stress. Apart from the obvious instances of where we have been able to acquire property previously foreclosed by the banks because of loan defaults, there would appear to be increasing pressure from the banks onto their customers to resolve loans that are not fully performing and accelerate property disposals in order to avoid the need for loan foreclosure. Additionally, the absence of significant fresh capital to the property sector outside of the prime Central London market, has brought forward a number of situations where both fresh capital and expertise is required to unlock development potential. Finally, mainly in the area of strategic land improvement, there is a significant shortage of capital available to individuals who have expertise and are willing to partner with us in exchange for appropriate funding. Strategic land opportunities in which we have taken interest relate mainly to prospective residential land. Otherwise, our preferred asset class for development propositions emerging from the market still tends to be neighbourhood shopping centres anchored either by a major food store or by an equally strong major retail trading covenant. These schemes enable us to create value where demand is evident and also provide a defensive component due to the strength of the anchor itself.

More recently, we are evolving an increasing appetite in well established urban areas for mixed-use development projects that can embrace a not insignificant residential component. Of course, opportunistic transactions will always be of interest at the appropriate value.

Our current role, outside of possible large-scale commercial development in Central London, is focused on the transformation of assets, which presently languish for one reason or another within the secondary sector of the market, into higher quality real estate that will appeal to the ultimate cash investor. If interest rates remain low and inflation remains subdued, the cash investor will deploy his funds into these newly created or refreshed assets with or without a capital contribution from the banking sector. If inflation does begin to manifest itself, the cash investor will largely believe that his real estate portfolio will act in the medium-to longer-term as a partial inflation hedge.

Within the above strategic and tactical observations we will continue to run our business in accord with the same risk-averse policies which fashioned our track record over the last 15 years or so. Those strategies proved effective against the worst excesses of volatility that the UK market has ever seen and we believe will continue to do so.

Michael Marx
Chief Executive
1st March 2011

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