Graingers - how much life is there in the old dog?

Grainger (GRI) has had a good year. The shares are up from 70p to 253p, and the Investors Chronicle has it down as a buy.

It fits with a couple of major themes this year. First, it's one of the 'performing dogs' - like Enterprise Inns, £PUBS , and a lot of the smaller property stocks, it had uncomfortably high debt (partly as a result of downwards asset revaluations which destroyed its collateral). Having managed to refinance, has become much more attractive than it was earlier this year. Secondly, it's a residential property stock, and as recent months have shown the housing market perhaps not hotting up exactly, but certainly thawing, it's benefited just as much as housebuilders like Taylor Wimpey Plc

Grainger is a rather unusual beast as its basic business is renting residential property. And it's not just any old buy-to-let investor; it specialises in regulated tenancies and home reversions. These are naturally longer term lets, more akin to commercial tenancies than to the usual assured shorthold tenancy with its six-month break point. Grainger claims to be the UK's largest specialist residential property owner, and it is also involved in the German market. It's certainlya major player in the home reversions market with a 34% share [ref] Interim report 2009, p23; [/ref] .

Within the UK, it is geographically diverse; 54% of the portfolio is in London and the South East. The core traditional business, regulated tenancies, accounts for almost half the total market value. Retirement solutions - that is, reversion plans (home equity) account for a further 22%, and the German business is at about the same level. The remainder is split between property fund management and development; that's really quite a low exposure to development

These are all rather specialised markets and that may mean the assets aren't as liquid as more conventional residential properties. For instance, the home reversion plans are regulated, so while the tenants are still living in the properties, they can only be sold to a limited number of buyers [ref] Rights issue prospectus, p12 [/ref] . Regulated tenancies are more sought after; since no new ones have been created since the law on tenancies changed in 1989, the asset class is getting smaller every year. (Of course, that means Grainger is having to change its business model to survive - otherwise it would just have to become a run-off investment, and that would mean amortising its head office costs against ever fewer properties every year.)

Grainger has been looking at possible diversifications and could move into student housing, retirement villages, and a number of other areas. In addition, it already works with one Housing Association, and could expand that area.

Grainger's properties tend to be quite old, and unmodernised; it's not in city centre flats, for instance, where a lot of property market flak has been focused. Its properties also tend to have a relatively low average value; the average vacant possession value in its portfolio is £189,000, not all that much higher than the  Halifax average of £155k despite the high London and South-East representation [ref] Annual report, p 9: http://www.graingerplc.co.uk/article.asp?nid=76 [/ref] . The fact that the properties are unmodernised gives them a high reversionary potential -  £570m of it according to the company [ref] Preliminary statement, p7 [/ref] .

So far, so good. But of course residential property has been an awkward place to be this past couple of years, with prices down 13% or 18% from the peak depending on whom you ask - Nationwide or Halifax (respectively). Germany has suffered less - with stable values in 2009 calendar year so far, according to figures prepared by real estate research firm BulwienGesa [ref] Rights issue Prospectus, p10 [/ref] .

Downwards revaluation of Grainger's assets led to anxiety about its ability to meet its banking covenants. At the interims, it passed the interim dividend, and has just refinanced; it's paying out again now, with a yield around 1.5%, having maintained the final dividend at last year's 3.91p level.

The rights issue is intended to help the company buy up portfolios of regulated tenancies. Management says that with currently low values, these are attractive. The usual discount to vacant possession value is 20% - regulated tenances are currently selling at a 30% discount [ref] Investors Chronicle, 9 November 2009: http://www.investorschronicle.co.uk/Companies/ByEvent/Fundraisings/Analysis/article/20091109/d2a3aaa6-cd21-11de-9040-00144f2af8e8/Grainger-to-raise-250m-for-expansion.jsp [/ref] .

However, I can see two things wrong with this. First of all, timing. It's not exactly countercyclical to spend loads of money buying property all the way up to the market peak, but then stop buying as prices fall. In 2007, at the peak of the market, Grainger bought £403m of property; last year, £123m; and in 2009, with the market on its backside, it spent only £12m [ref] Year end results, p3 [/ref] . And it has been selling all the way down, while drawing in its horns in terms of development - the development portfolio's expected value has fallen from £142m to £71m (though I'm unsure how much of that is valuation related), and committed cash expenditure from £30m to £10m [ref] Annual Report, p 13 [/ref] . Countercyclical, no; I don't trust management's timing.

Now the second objection is that these regulated tenancies are typically acquired at low yields - say 3% [ref] Investors Chronicle, 9 November 2009: http://www.investorschronicle.co.uk/Companies/ByEvent/Fundraisings/Analysis/article/20091109/d2a3aaa6-cd21-11de-9040-00144f2af8e8/Grainger-to-raise-250m-for-expansion.jsp [/ref] - so even with relatively cheap debt, the rent roll will be below the weighted average cost of capital. Contrast this with commercial property, where companies like Hansteen have been saying they can acquire properties at yields of 8-9% or even more. Right now, I'm much more interested in the income than I am in capital growth - if we get a double dip, it doesn't make sense to be paying out good money in order to hold the asset, but a positive yield is still worth something.

In fact over the past couple of years the portfolio appears to have been hard put to it to earn enough in rents to pay the interest bill - and that's before taking account of valuation write-offs.

Obviously as a property company, Grainger is best valued on the asset value, though, so let's ignore the rather horrible looking P&L. Here, it does look rather a steal, because it's trading at a 25% discount to net asset value.

Er. Which asset value? Because we get three. We get gross net assets per share of 411p - that's before deferred tax or adjustments for derivatives; we get 'triple-net' assets per share of 251p, adjusted for deferred and contingent tax, and for mark-to-market; and we get the triple net asset value adjusted for the reversionary surplus of 360p [ref] Preliminiary statement, p14 [/ref] . So the company is trading at exactly net asset value, at a 25% discount, or discount of nearly 50%, depending on which figure you take. 

But in fact, with many of the commercial property stocks trading at a slight premium to net assets, and few deep discounts, that doesn't look too bad.

It's the income that really disappoints. Sorry to keep banging on about getting a decent return, but a yield of 1.3% is not worth getting excited about. Compare the commercial stocks and you see you could get nearly 4% with Hansteen Hldgs, and more with players like /Hammerson Plc or British Land Co Plc, and in many cases not only nicely covered, but also required (because REITs have to distribute a certain percentage of their rental income, or they lose their tax status). So you get a decent divi that pays your holding cost if the sector doesn't perform - and capital growth if it does.

There's not really much of a comparison in the residential sector. There's Sovereign Reversions, but that's only home reversion - it doesn't have the regulated tenancy portfolio. (Intriguingly, Sovereign Reversions has had negative cash flow every year since 2004 [ref] Investors Chronicle,  12 August 2009: http://www.investorschronicle.co.uk/Companies/ByEvent/TechnicalAnalysis/Analysis/article/20090812/6c3570ae-872d-11de-80de-0015171400aa/Sovereign-Reversions-faces-calls-for-a-runoff.jsp [/ref] - I have a suspicion that shows the overvaluation of residential property over that period, rather than being a clear sign of management incompetence.) There are a lot of residential funds that have been set up as 'vultures' fairly recently, but most of them are unlisted, professional-investor-only funds, with limited life and rather recondite structures.

If you're looking at Grainger now, my feeling is you've missed the boat. The rights issue has taken the risk out of the stock - but you have to really be a bull of the UK residential property market to want to buy it.