Overview

• Strategic Delivery
  We sold £560m of secondary property in 2006 in anticipation that a downturn would impact most on non-prime assets. In the 19 months to the end of 2007 we made £345m of opportunist purchases in our core prime markets. Our development programme was timed to take advantage of the dearth of new construction and falling levels of new availability in West London – market characteristics which contrast with those of the rest of the UK. The building out of our development programme completed in April this year and at present we have no new construction work taking place or anticipated in the immediate future. We have made no new investment acquisitions in 2008.
• Financial Strength
  All of the Group’s on-balance sheet debt is unsecured and all of our wholly owned properties are unencumbered. At the half year end we had £415m of committed facilities of which £185m were undrawn. There is no requirement for any re-financing until December 2009 when £60m of these facilities expires. Our debt-equity gearing stands at 69% and our loan-to-value gearing at 42% with 87% of our debt fixed and the average cost of our debt being 4.8% (5.0% including our JVs). Our financial strength, cost of debt and flexibility make us potentially very competitive.
• Pricing Power
  Unique in a European context, Brixton continues to exhibit pricing power through the rental levels it achieves. This is due to focus, stock selection and a concentration on the more supply-constrained markets of West London. Following 5.1% transactional rental growth in 2007 we have shown 3.9% in H1 2008. (IPD’s industrials have respectively seen 1.6% and 0.5% over the two periods in their UK Annual and Quarterly Indices).
• Resilient Portfolio
  A diverse and robust customer base with insolvency rates remaining low.

In our 2007 Results we warned that “slowing growth rates combined with availability and pricing restrictions on finance could adversely affect occupational demand”. In our Interim Management Statement (“IMS”), at the end of April 2008, we added that we were “sceptical of some of the observations that the worst valuation reductions have been evidenced across the commercial property markets and that… prices would stabilise and perhaps even increase during the year”. What we also said at that time, still applies now: that there continues to be little transactional investment evidence in the general commercial and relevant to our specific industrial property markets.

Our half year results reflect the current uncertainties of the markets in which we operate and the valuation assumptions on which asset value is based. Our operational performance has been strong but our rental growth has been outweighed by upward yield shift. This has lead to a fall in net asset value but we are encouraged by our 13.5% increase in net rental income. Investment profit only reduced by £0.9m, adjusted earnings per share were down only 0.4p and both would have shown increases ignoring the effect of empty rates. Investment profit is the true measure of recurring profit for a UK REIT as profit before tax is distorted significantly by the downward valuation movement. The fundamentals of our business are secure and we have increased our interim dividend by 2.1%.

Outlook

Sentiment has now begun to reflect our views although many in the direct markets had been in denial over the likely impact of the financial turmoil being experienced in the developed world. There remains a state of considerable uncertainty, and this is evident in the apparent reluctance of the various property indices to react to the reality of much lower achievable values.

The apocalyptic opening lines of Bob Dylan’s “All Along the Watchtower” seem to capture the beleaguered mindset of the UK commercial real estate market:

There must be some way out of here
Said the joker to the thief
There’s too much confusion
I can’t get no relief
Businessmen they drink my wine
Ploughmen dig my earth
None of them along the line
Know what any of it is worth

Certainly, a fundamental current problem with direct property is indeed assessing value to “know what any of it is worth”.

The IPD UK Quarterly Index has shown relatively modest falls in capital values during H1 08: -8.3% throughout the commercial sector and -8.2% for industrials. But there have been few relevant comparable transactions. There is no real depth of evidence of willing buyers and sellers – the RICS Valuation Standards’ assumption. Financing remains difficult and sellers are reluctant to crystallise lower prices.

If the “thieves” are the funded or equity based opportunist buyers and the “jokers” are the owners who won’t sell, there is no “way out” of this impasse – yet.

Brixton’s portfolio fell in value by 6.2% in H2 07 and by 10.0% in H1 08 (-15.8% over the 12 months on IPD’s standing investment basis compares to -18.2% for all property and -17.4% for industrials in their UK Quarterly Index).

The issue now is how much further could property values fall. Overall, UK REITs tend to have better quality property, are more conservatively financed and have behaved in a way that demonstrated that they did not believe in a new paradigm of a non-cyclical economy. The same cannot be said for many of the operators of various funds – both institutions and corporates – and even allowing for the larger value falls they experienced in late 2007, there will be differential performance.

Turning to our specific markets, there have been two non-Brixton Heathrow industrial investment purchases this year at equivalent yields below 5.5% – and a third agreed – which are keener than the valuation of anything comparable in our portfolio at the end of H1 08. The valuers have a tricky task in a market where there is little relevant evidence, but in our view there is “too much confusion” over the interpretation of activity, real pricing and the benchmarking of prime and secondary values.

Additionally, there is “no relief” yet from the imposition of empty rates which has created more uncertainty and imposed a further financial burden on commercial property. However, there are now signs that the effect of the legislation is being seen as politically unacceptable.

So what is the “way out of here”? We believe that the sector could start to stabilise and recover if increased volumes of secondary and tertiary stock are traded in the next 6-12 months as distressed property starts to be made available. Initially, this should enable a return to more appropriate mark-to-market pricing.

While looking to the future, it is perhaps worthwhile also considering Brixton’s underlying position:

• The re-build insurance valuation on Brixton’s portfolio is circa £1.3bn to which can be added the market value of the land to give a total value of land and replacement buildings of around £2.7bn. Brixton’s market capitalisation is approximately £700m and with debt of just over £800m its enterprise value is approximately £1.5bn. The difference between this and the replacement cost (ignoring any income) seems, at the least, to be curious.
  
• An implied valuation of the portfolio at, say, £2 a share – around the low point of the share price this year – demonstrates that the June valuation would have to fall by a further 30% and the equivalent yield move out from 5.9% by another 260 basis points (“bp”) to 8.5%. At £3 a share the valuation would have to fall just under 20% and the equivalent yield move out 130bp to 7.2% from the June number.
• If it takes another two years to lease up what remains vacant from our development programme, investment yields would have to move out another 140bp to notionally erode the total profit on cost of approximately 25% that our development programme is calculated to have achieved. (And the profit expectation has already been reduced by just under £10m on account of the surprise imposition of empty rates).

Since our IMS, sentiment has worsened and there are more indicators of a downturn in activities but we have still not yet seen any major negative impact on our portfolio, and operationally we have been performing well.

With growth slowing, the interest rate/cost of money scenario unclear and inflationary concerns it will be surprising if this does not translate into lower activity across UK businesses and hence generally within our own portfolio. At this stage we are seeing:

• The best property, by location and physical quality, still showing good lettings although the leasing of second hand space appears to be slowing.
• Unlike our main development market at Park Royal, Heathrow having a new supply of recently completed buildings and demand being presently adversely affected by the global economic situation. Whilst the debate on the future of air traffic in the South East continues, Heathrow will remain an integral part of the UK economy and this temporary position should alleviate once the economic outlook improves.
• An increase in tenant defaults but these are still at modest levels.
• More tenants seeking assistance with the frequency of rent payments but we have few bad debts and recovery of rental income remains strong.

Going forward, we believe Brixton has a clear competitive advantage because of the positioning of its portfolio, its finances and its human resources – all of which also give the Company resilience.

Investment property is a long-term business and active managers such as Brixton should at least be able to derive support from their activities by obtaining income outperformance.

The core of our business remains the maintenance and improvement of income. We can see overall yields moving out further and asset values falling more. But with a strong track record of occupational transactional evidence we should continue to achieve growth from our present letting activities and also from the time-lagged effect of lease renewals and rent reviews. Indeed, we now only need modest rental growth, compared to our track record, of approximately 2% p.a. to exceed our WACC over a 5 year period and create shareholder value.

Ultimately, the real “way out of here” will be when the economy, the financial world and the markets stabilise. However, in the near term, distress should bring opportunities and we are well placed to look to capitalise on these.

Ultimately, the real “way out of here” will be when the economy, the financial world and the markets stabilise. However, in the near term, distress should bring opportunities and we are well placed to look to capitalise on these.