Something to build on
Faith Glasgow surveys prospects for property
The past 18 months have been dire for the UK listed property sector. REITs continue to be faced with a challenging array of macro issues, including rising interest rates, tightening credit conditions, uncertainty around the future for office versus home working as work patterns shift, and increasingly tough environmental standards to meet.
Those headwinds were reflected in dramatic share price falls averaging 34% over 2022. Some recovery was seen in the first quarter of this year as hopes of falling inflation mounted and the prospect of recession receded; but banking crisis jitters in early spring put a stop to that, erasing the gains of the previous couple of months.
As Justin Bell, a director at broker Numis, observes: “The past few weeks of June have been particularly painful and led to more underperformance from the REIT sector versus the FTSE All-Share”, in the face of stubborn UK inflation and a 0.5% base rate rise.
“The past few weeks of June have been particularly painful and led to more underperformance from the REIT sector versus the FTSE All-Share."
But the derating of the past year is unsurprising, observes Alan Ray, investment trust analyst at Kepler Trust Intelligence. “Commercial property is a classic interest rate sensitive asset class, and there’s quite a well-established rule of thumb that investors want a spread of about 2-3% between the yield on commercial property and that on the ten-year gilt. The ten-year gilt yield has moved from almost zero to over 4%, so it’s no surprise at all that there’s been a repricing of commercial property.”
There are other factors at play in the current difficult scenario as well, says Bell. “Higher rates impact tenant margins, reducing their capacity to pay higher rents and leading to a likely increase in defaults.” They also make it difficult for private equity buyers – recently big players in the market – to keep investing.
Rate rises are the prime culprits, but not the only ones. Inflationary pressures are also undermining the strength of the sector – increasing asset build costs, further squeezing tenants’ ability to absorb rent rises, and pushing up REIT operating costs.
Moreover, as Mick Gilligan, head of investment trust research at Killik & Co, comments, some subsectors have been particularly hard hit. “There has been a correction in certain subsectors (for instance logistics) that were still quite highly rated as recently as last summer.”
"Many listed trusts have repositioned themselves away from the traditional office and retail assets and have much greater exposure to assets that are in parts of the economy that continue to do well.”
Against that, however, Bell argues that “all is not lost for a sector trading cheaply, with growing revenues and conservative balance sheets”. Current discounts are already pricing in further valuation weakness, so investors have some headroom for further challenges in the short term, while the median yield is 6.6%, up from around 4.5% a year ago. Meanwhile, portfolio debt is relatively low at an average loan to value of around 32%.
Bell also points to “significant rental growth as a result of strong supply/demand dynamics in many subsectors”. These include student accommodation, retail warehouses, industrial and logistics warehouses and care homes, among others.
In contrast, many offices are struggling, as hybrid working evolves and energy efficiency rules come into force that will make upgrades and refurbishments more costly.
Fortunately, says Ray, many of the listed trusts have anticipated these trends. “They’ve repositioned themselves away from the traditional office and retail assets and have much greater exposure to assets that are in parts of the economy that continue to do well.”
So is this a good opportunity to increase exposure to the sector? Gilligan believes so. “Inflation spikes tend to get reflected in real estate values immediately, but the benefits of inflation-linked rents tend to get overlooked, so we think that the correction is overdone for certain assets,” he says.
“We are cautiously optimistic on REITs with low levels of debt that doesn’t need to be refinanced for a few years, and good-quality tenants.”
Areas of particular interest for Killik include logistics, which was previously most highly rated and has therefore been particularly hard hit, and also high-quality offices with good environmental ratings, where tenant demand remains strong.
Both Ray and Gilligan pick out UK Commercial Property REIT (UKCM), currently trading at a 37% discount and yielding 6.6%, as a good choice. “It looks the most attractive option when you take into account diversity of portfolio, leverage, discount, yield and portfolio quality,” says Gilligan.
The portfolio has a bias to logistics and industrial holdings, where valuations have been decimated but which “still look very attractive in terms of supply/demand”, and boasts a range of high-end tenants including the UK government and Amazon.
For Andrew Rees, an analyst at Numis, the current uncertain environment means that income will be a critical underpinning to returns from property funds. He therefore suggests investors should seek out funds that can deliver “consistency of earnings to support attractive and growing dividends for shareholders”.
“To this end I think Schroder Real Estate (SREI) on an 8.3% yield and Custodian Property Income REIT (CREI) on 6.5% both look interesting,” he adds.
Andrew McHattie, publisher of the Investment Trust Newsletter, highlights abrdn Property Income Trust (API) on a near-40% discount that he believes “is at odds with its solid long-term track record under the experienced management of Jason Baggaley”. The trust has big chunks of assets in UK industrial property and retail warehousing, and offers a chunky yield of 8.0%.
"abrdn Property Income Trust (API) is at odds with its solid long-term track record under the experienced management of Jason Baggaley”.
However, in his view the real outlier in terms of valuations and yield is the office property specialist Regional REIT (RGL), currently paying a massive yield of 13.9% that reflects scepticism about the future for UK offices.
“There is a severe disconnect here between the prevailing sentiment and media view, centred on the death of traditional office working, and the much more positive narrative from the trust, which reports good levels of demand, occupancy, and rent collection,” comments McHattie.
There is also an argument for looking beyond the UK market, especially given that UK interest rate sensitivity and the potential for a domestic recession are by no means behind us.
Ray makes the observation that Europe is undergoing many of the same changes and challenges to the property sector as the UK; he picks the pan-European specialist TR Property Investment Trust, which invests in a portfolio of listed property companies across Europe. “The trust is able to navigate the various regional trends and opportunities by using its deep knowledge of the European listed property companies,” he explains.
Meanwhile, McHattie suggests that abrdn European Logistics Income offers some value on a discount of more than 30% and with a yield of 7.1%. “The portfolio is well diversified across five countries and, crucially, has two-thirds of leases with uncapped inflation linkage.”
Overall, there are clearly opportunities to take advantage of in the REIT sector. But the fact remains it’s all about interest rates: for as long as they keep rising, discounts are likely to persist and values could fall further.
