Following a poor couple of years, a spate of merger and acquisition activity has reignited interest in REITs, a convenient way for investors to own slices of the commercial property market.
What is a REIT?
A Real Estate Investment Trust or REIT is a property investment company traded on the stock market like any other share. Typically, they own and operate commercial property in various sectors such as offices, warehouses, industrial units and retail parks or malls. Some are broad, covering all or most of these areas, and some are more niche, specialising in a particular sector or sub-sector.
REITs are a convenient means for ordinary investors to invest in properties that would otherwise be inaccessible, plus it’s possible to buy and sell shares at any time – but, as with any investment, you could back less than you put in.
Are REITs a good investment?
Commercial property investments can provide a high and potentially rising rental income and some capital growth over the long term. REITs often have long-term lease agreements with tenants, which can help to make rental income and dividends paid relatively reliable. In addition, by index-linking rents or having upward-only rent reviews a growing income can be established.
However, they are also susceptible to the ups and downs of the economic cycle. Certain areas could face overcapacity, resulting in falling rents or empty properties that reduces investor income and hinders values.
In the short-term, REITs therefore tend to correlate (move up and down in price) somewhat with equities in relation to the economic cycle. They are also heavily influenced by the bond market as demand ebbs and flows for income-producing investments. Yet they do have their own drivers of performance and they can offer diversification benefits over the medium-to-long term.
REITs tend to offer a good yield over and above high-quality bonds and most equities, so they are of particular interest to income seekers, though the combination of income and rental growth can be attractive to all investors. Notably, REITs don’t pay corporation or capital gains tax on their property investments, but to qualify as a REIT 90% of their rental income has to be paid out.
How to research REITs
There are three important features of a REIT: The dividend income on offer (also known as the yield) the capital value of the portfolio (also known as Net Asset Value) and the amount of debt.
- Yield is a function of the price paid for shares and the level of income paid and is expressed as a percentage. For instance, a REIT providing 10p of income per share a year with a price of £2 will have a yield of 10/200 x 100 = 5%. All yields are variable and not guaranteed because they are calculated using these two moving parts, price and income paid. Although it might be tempting, investing only for the highest yields can be imprudent. A high yield could be a sign that the REIT, or the area it is operating in, is stressed. Perhaps growth in income is unlikely or, worse, there is likely to be a fall in rental return. Alternatively, there could be other risks such as high levels of expensive debt.
- Net asset value (NAV) is a measure of the value of the assets owned. For instance, if the properties owned by the REIT, less any debt, are worth £100m and there are 10 million shares, the NAV per share is £10. The NAV can fall or rise according to changing valuations in the property market or could potentially increase through successful development activity. Crucially, a REIT’s share price can trade at a premium or a discount to the stated NAV. This can vary according to investors having a more optimistic or pessimistic view of the prospects for underlying assets, the general economic environment or the quality and skill of the managers. As a general rule, REIT share prices tend to move in line with the NAV, but sentiment can be fickle. Buying a share at a premium can be risky as positive feelings could erode. Conversely, buying at a discount offers no guarantee of good value. Sentiment could be depressed for very good reason, for instance, there may be an expectation that NAV is likely to be revised downwards at the next valuation, or that there are underlying issues within the sector the REIT operates in.
- Debt is a further consideration for investors. REIT debt or ‘gearing’ is measured by the loan-to-value (LTV) ratio, which compares borrowings against NAV. The higher the ratio, the more debt, which generally equates to more risk. It works in a similar way to the LTV calculation for a mortgage. If the equity in your home is £100,000 and your mortgage is £300,000 the LTV is 75%.
Leveraging returns through debt is beneficial in a rising market, but it’s not a one-way street. Property prices fall as well as rise with broad economic trends and specific industry factors. As valuations change and debt is fixed, a REIT with a high level of debt might find its LTV go up if its portfolio loses value, and it could even find itself in financial trouble. Loss of rental income can also be harder to bear if there is significant debt to service. As such, REITs ought not have to have too much gearing. An LTV in excess of 40% could be uncomfortable and make for a particularly bumpy ride for investors.
How to choose REITs
There are dozens of REITs listed on the London Stock Exchange to choose from and they come in different shapes and sizes. Large ‘generalist’ REITs offer access to a broad range of property types, while more specialist ones focus on real estate in areas such as healthcare or warehouses.
A diversity of industry type and tenant base helps protect generalist REITs from a downturn in a particular area. However, a large, diversified portfolio can be harder to manage, requiring a wide skill set. Meanwhile, specialists are more exposed to market conditions in a niche industry, which can mean more risk. Although applying specialist expertise to a certain area can reap strong returns with a well-considered strategy.
Investors should therefore consider building a portfolio of REITs rather than having lots of money in a single one in order to spread the risk. That’s especially the case when looking among the more specialist, esoteric options. As with any investment in a single share, taking a long-term view is essential and investors should ensure they have the time and knowledge to carefully select and monitor them.
How have REITs performed recently?
For the past couple of years REITs have been at the intersection of two problematic trends. Firstly, as with equities and bonds, rising inflation and interest rate expectations very rapidly ‘reset’ the prices investors were willing to pay for all assets. REITs are particularly affected as they are constructed from ‘long duration’ assets that pay a steady return, so they are very sensitive to the prices of safer, so-called ‘long duration’ assets such as UK gilts.
Secondly, expectations grew that many REITs could suffer from the consequences of a recession, which grew more likely as the trajectory of inflation, and interest rates to quell rising prices, steepened. This brings increased risk of bankruptcies among underlying tenants and greater likelihood of ‘void’ periods without rent, potentially disrupting the flow of income.
To compound these issues, there has been the problem of rising debt costs for the REITs themselves, something that some were well insulated from as borrowing is mostly fixed for a long time, but an expensive headache for others, either because they are heavily weighted towards floating rate debt or because large refinancing requirements came at an unfortunate time. This has left the sector trading at inexpensive levels overall, albeit with a lot of variation according to asset mix and the impact of debt.
Is commercial property a good investment now?
Several REITs have been involved in merger and acquisition activity over the past year, a trend that appears to be accelerating. CT Property was bought by Londonmetric last August, with the latter now discussing a possible merger with LXi REIT. Meanwhile, Industrials REIT and Civitas Social Housing were taken over at handsome premiums to NAV by Blackstone and Hong Kong’s CK Asset Holdings respectively. Ediston Property was bought by Realty Income (a US-listed REIT) after it put itself up for sale with shareholders set to receive around 89% of the June NAV, again a good improvement on the prevailing share price. Finally, as recently as last week, Abrdn Property Income and Custodian Property Income REIT recommended a merger to shareholders to create a larger and more attractive combined entity.
What are we to take from this flurry of activity? We believe it highlights a couple of important trends. Clearly, prices became so low that valuations started to attract to a variety of buyers, while some REIT boards took action to generate shareholder value from depressed levels. These factors could also help underpin valuations going forward too. Additionally, size matters in the REIT world. Larger REITs not only enjoy greater economies of scale but shares tend to be easier to deal in quantity and thereby attract a wider variety of investors and more demand, so more mergers are likely to occur.
Despite these encouraging signs, the obstacles facing REITs more broadly haven’t gone away. The cost of borrowing remains an issue for some of the more leveraged ones, and the performance of the underlying assets in the face of building recessionary pressures is pause for thought.
With both landlords and tenants facing the constraints of higher interest rates, the outlook for inflation and the direction of rates are going to be pivotal.
Higher bond yields would further weigh on property valuations, although discounts to NAV do offer some buffer against this as the recent merger and acquisition activity has highlighted. In addition, there are areas where the outlook is particularly challenged such as retail and offices, though again greater discounts on REITs with significant exposure to these do typically stand to compensate investors. The low values and high near-term income on offer tend to reflect the uncertainty as to the trajectory of rents and the capital expenditure necessary to update or convert properties as necessary.
Overall, owning good quality assets is likely to be important. An economic downturn, even a shallow one, is likely to favour well-suited, ‘prime’ property, whether it is in offices, retail or industrial with more peripheral or marginal assets more likely to struggle with demand or poorer quality tenants. There may also be pockets of strength in areas exposed to more resilient online demand such as warehousing and digital infrastructure. up to standard, and this could eat into profits. Meanwhile, properties with strong ESG credentials are likely to be favoured by tenants.
How to invest in REITS in the UK
There are presently no REITs on our Preferred List of funds across the major sectors for new investment. However, our Collectives Research Team cover this sector in depth and the following ideas represent, in our view, good quality ways to access this area. You may find them useful as part of your own research. They are provided for your information but are not a guide to how you should invest. Before investing in any fund please read the relevant Key Investor Information Document or Key Information Document, and Prospectus to ensure they meet with your objectives and risk appetite.
Please note, the most important thing is to build more resilient exposure through balance and diversification. A basket of REITs spread across various areas and sectors should create a more reliable portfolio and overall income stream. All yields stated are variable and not guaranteed; The value of investments, and the income derived from them, can fall as well as rise. Investors may get back less than invested.
- TR Property holds a portfolio of real estate investment trusts and property companies across Europe. As such it is a ‘REIT of REITs’, though it does have a small level of direct UK property exposure through physical property rather than shares. Historically, the manager has been adept at avoiding the most troubled areas and it offers high quality, diverse exposure to the asset class with a bias towards logistics, healthcare and residential. Shares trade at a 6% discount to NAV, and with most of the underlying REITs on a significant discount to their own NAVs it produces a 5% yield presently.
- Tritax Big Box REIT is focused on larger scale logistics real estate, known as Big Boxes. Amazon is the Trust’s top tenant in terms of income, but there are dozens of renters across the portfolio of around 60 assets. The current evidence is that demand for these types of assets remains strong as they are mission critical for the large companies that use them. A deeper UK recession would likely hamper rental growth and capital values, but there is a near 20% discount to net asset value and an attractive 4.5% yield on offer currently.
- PGIM Global Select Real Estate Securities is an open-ended fund investing in a portfolio of REITs on a global basis, harnessing a large and well-resourced team with excellent coverage across various markets. We believe PGIM’s scale and experience in direct property offers them excellent first-hand insights into property trends that could enhance stock selection. With competitive charges and a broad, global portfolio it offers an option for those concerned about weighting their REIT exposure too much to the UK where there is only around 4% invested. Instead, the fund is overwhelmingly invested in the US and Asia. The yield as at the end of December 2023 was 3.3%, and fluctuating currency markets represent an additional factor as to how this changes over time.
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