Real Estate Investment Trusts and the Value Case

  • Almost two years after the first UK foreclosure, many diversified property trusts are enjoying deep discounts
  • We consider the case of GPs as a value game

Janus Henderson risked a crude understatement when he cited ‘continuing uncertainty’ as the reason for trying to call time on his British owned PAIF (GB00BP46GG64) this month. The open-ended real estate fund sector has suffered two rounds of industry-wide trading suspensions in recent years, along with significant investor withdrawals in the meantime. Morningstar Direct data shows investors pulled £1.7bn out of the UK’s direct property sector in 2021 alone, with it already seeing £1.4bn out sterling in 2020 and nearly £2.5 billion in 2019.

We have previously argued for exposure to physical property beyond open funds. As it implies, the broader world of real estate investing shouldn’t be entirely off investors’ agendas, especially as a new assessment of closed-end real estate funds suggests there is value to find.

Roller coaster for generalists

As we approach the second anniversary of the UK’s first pandemic lockdown, it’s worth noting that life since then has been quite volatile for diversified and ‘generalist’ commercial property trusts. Companies such as BMO Commercial Property Trust (BCPT) sold off heavily in 2020 on concerns over the sustainability of retail and office assets, then rallied fiercely as investors turned to reopening trading. Now, trusts continue to languish on huge stock price discounts to net asset value (NAV).

There are many possible explanations. Initially, investors favored trusts focusing on promising subsectors, ranging from logistics offerings such as Tritax Big Box REIT (BBOX) residential real estate specialists including House REITs (RESIDENCE) and health real estate games such as Health impact REITs (ROI). Other examples include Urban logistics REITs (HANGAR) and the fairly recent launch Life sciences REITs (LABS).

Liberum analysis from late last year found that logistics-focused UK Real Estate Investment Trusts (Reits) raised £3.8bn between 2018 and 2021, with long-term rental vehicles generating £1 £.8billion and Health Care Reits taking £1.6billion. Diversified Reits, however, only raised £158m. This is also reflected in valuations, with some of the trusts mentioned above, including Tritax, tending to trade at premiums to net asset value and offering lower dividend yields.

Part of the problem for generalist names is that they are perceived to be too exposed to old-fashioned parts of the market such as retail and offices. Convenience retail is still facing structural decline, while office demand remains difficult to estimate. Other challenges also remain: As Alex Newman noted in his 2022 property outlook, office developers and landlords must raise the minimum energy performance certificate score on all non-residential leased buildings to at least a “ B” by 2030. Data from Savills suggests that 87 per cent of office stock in the UK does not meet this standard.

As Dan Cartridge, assistant fund manager at Hawksmoor Fund Managers, notes: “There is an advantage to supporting new launches in areas like industrials where it is easy to improve the environmental rating, or funds like LXI REIT (LXI) where properties are on very long contracts and the trust is building new properties that will achieve high ratings immediately.

With that and the threat of a UK recession now possible in the coming months, investors avoiding diversified property trusts have a strong enough justification to do so. But many of these trusts are not as exposed to outdated sectors as valuations might suggest.

What do GPs really hold?

Our second chart shows how funds ranked by Winterflood as UK commercial property plays invest their money. Most of these disclosures are from late 2021 or later this year.

Many have decent exposure to industrials, an area that is expected to continue growing due to strong demand. The industrial category can encompass a variety of assets, from industrial estates to logistics units benefiting from the shift to e-commerce. These areas, along with outlying business parks (commercial warehouses) are widely considered growth areas.

From BMO Commercial Real Estate to Schroder Real Estate (SREI) and AEW United Kingdom (AEWU), some trusts still have a reasonable measure of exposure to office and standard commercial properties. But it should be noted that investors may have priced in too much uncertainty and these funds may well drift further away from vulnerable sectors in the future.

As Conor Finn, investment fund analyst at Liberum, noted in December: “Diversified REITs have generally been more active than specialized REITs in selling assets and recycling capital into new assets. We have seen very few examples of consistent exit activity from specialist REITs investing in asset classes such as logistics, healthcare, residential, etc. Many of these portfolios have increased significantly in value, but divestitures create the potential problem of being forced to reinvest capital at lower returns.

As Cartridge warns, rotating a portfolio of illiquid assets can be a lengthy process, meaning investors could miss exposure to popular sectors while they wait for generalist funds to recalibrate.

But there is an argument that trusts like BMO Real Estate Investments (BREI) can be a cheaper game on areas such as industrial. Winterflood analyst Emma Bird recently pointed to BMO Commercial Property and Property Income from Standard Life Investments (IRS) as offering value on recent discounts, with the former performing well as a source of core exposure to UK property and the latter standing out as an actively managed portfolio with good environmental, social and governance credentials.

Finally, Winterflood argues that their shares could actually be revalued due to their dividends. AEW UK REIT has been the only diversified name to maintain its dividend level throughout the pandemic, Schroder Real Estate recently announced a raise which restored its pre-pandemic payout level, while LXI initially cut its payout during the pandemic, but then increased it above pre-pandemic. Covid levels. Other trusts have continued to pay out, albeit at reduced levels, since the start of the pandemic, and any improvement in those payouts could drive the stock price higher.

More generally, real estate is still attractive both as a hedge against inflation and as a possible diversifier. On the first point, Bird notes that specialty trusts are more likely to have inflation-linked income than generalists, but adds: “A number of fund managers point out that a lower inflation link could actually be positive in the industrial sector, where – market rent growth is expected to outpace capped inflation-linked rent growth over the next few years.