Not many groups received exactly what they asked for from George Osborne’s Budget in March, but the real estate investment trust (Reit) sector was one exception. The chancellor promised to implement new rules allowing these property companies to invest in one another, just as they had hoped he would, as well as a consultation on whether they should be given institutional investor status, another long-held aspiration of the property industry.
The Budget announcements provided UK-listed Reits with a fillip: the British Property Federation said the changes would result in an inflow of funds into Reits, as well as greater deal activity and an increase in joint ventures.
Not that the boost was necessarily needed. Property companies have made significant gains in recent times – the average Reit was up 26 per cent during 2012 and has continued to post positive returns during 2013.
Moreover, Reits, which invest almost entirely in commercial property (in the UK but also internationally), continue to find favour with analysts. The sector is prized for its income-generating attributes, with many Reits routinely yielding well above 5 per cent. Real assets such as property – Reits’ investments range from warehouses to office blocks to shopping centres – are also traditionally seen as a good hedge against rising prices (though sceptics point out that rental income often struggles to keep pace).
HSBC, for example, has just added Reits to its portfolios as it seeks protection from inflation. ‘Reits outperform in several inflationary scenarios and never significantly underperform,’ the bank argues. Credit Suisse has also been advising clients to raise their exposure to Reits. JPMorgan Asset Management and Schroders have been bullish too.
One might argue that property companies – and Reits in particular – deserve a bit of good fortune, for they were dealt an especially poor hand by the financial crisis. Back in January 2007, when the UK government finally got round to following other countries in introducing a special tax regime for qualifying property companies, the outlook for Reits looked bright. Just a few months later, however, the financial crisis hit. The property market slipped into freefall and the attractions of Reits were forgotten as their holdings collapsed in value. Companies such as British Land were forced into fire sales of assets and painful rescue rights issues.
It wasn’t until the second half of 2011 that the sector began to show signs of sustainable recovery, as investors looked beyond the carnage caused by the credit crunch to the undoubted attractions of the Reit structure. The vehicles’ exemption from corporation tax, as long as they pay out 90 per cent of their income in dividends to shareholders, means investors do not face double taxation on these property vehicles. And analysts have always expected the development of Reits in the UK to follow the pattern established elsewhere, with more agile property companies able to raise finance from equity markets quickly in order to fund transactions.
Still, the question remains, will Reits’ comeback continue? Many property companies also saw strong gains in 2009, only for the recovery to slip into reverse with the eurozone crisis.
The key to answering that question lies in analysing the drivers for last year’s spectacular performance. One factor was certainly overseas interest in UK property, with international investors committing more than £20 billion to UK commercial real estate over the course of 2012, according to estimates from the accountancy firm Deloitte. Encouragingly, it expects international demand to be even higher over the course of 2013.
Deloitte’s analysis also suggests that key pricing points have now been reached in several areas of the commercial property sector. It thinks prime property such as London real estate has now become too expensive for many investors, which should broaden demand across the rest of the market. It also thinks falling prices in the secondary market have now largely run their course.
Overall, Deloitte’s analysts conclude: ‘It is likely that 2013 will be the year that the downward trend in commercial capital values is halted and we see a return to rising prices.’ The caveat to that is Deloitte concedes this is a ‘somewhat heroic prediction’.
Interestingly, there has been no shortage of property companies keen to cash in on investors’ new-found appetite for their stock, with a string of fund raisings this year. In March alone, British Land unveiled a £500 million placing, while Intu Properties (the former Capital Shopping Centres) sold stock worth £280 million and the developer St Modwen picked up £49 million of new funding from investors.
It’s not just equity that Reits have been raising. ‘The largest UK and northern European Reits are now taking advantage of the high-demand bond markets to issue bonds with, from the borrower’s perspective, highly attractive long-term fixed finance costs,’ says Alex Ross, senior investment manager at the Premier Pan European Share fund.
With the cost of capital so low, the hurdle rates that Reits must achieve in order to deliver to their own investors are lower than in the past. ‘This is why the Reit sector is well positioned to drive market-leading returns to investors in the coming years,’ Ross argues.
Still, there are plenty of risks facing the UK’s property market – even leaving aside the volatility that another escalation in the eurozone crisis would cause.
For one thing, the domestic economic outlook remains uncertain, which has clear implications for tenant demand and rental yield growth. The ongoing difficulties facing so many leading retailers are a high-profile example.
For another, while both the bond and the equity markets have been very welcoming to the largest Reits in recent months, large swathes of the commercial property sector continue to find access to credit very challenging.
Remember too, that Reit portfolios vary enormously, with some companies investing much more internationally than others. This brings the potential for greater risk and reward.
International diversification may reduce volatility and boost returns. And it’s a noticeable trend that the world’s sovereign wealth funds are committing more firepower to real estate.
On the other hand, exposure to the eurozone, or the developing markets of Asia, say, may be the last thing some investors want in the context of ongoing anxieties about sovereign debt defaults and the economic uncertainties in China.
Going down the collective route
For investors who feel uncomfortable with single-stock investments in Reits, one alternative is an investment trust specialising in property, of which there are more than 20. These trusts also hold diversified portfolios of property, as well as property company shares in certain cases, but have generally been run much less aggressively than Reits, with managers operating buy-and-hold strategies.
This approach protected investors during the credit crunch and the peak of the eurozone crisis, with property funds avoiding the extreme volatility seen in the Reit sector and, largely, maintaining their dividends throughout. On the other hand, the sector’s long-term performance record is hardly anything to write home about – the average trust lost 30 per cent over the seven years to the end of 2012.
Of the sector’s two largest trusts, F&C Commercial Property and UK Commercial Property, the former has the better track record, partly owing to the latter’s historical portfolio bias towards the retail sector, though both are in positive territory over the medium term. TR Property and high-yielding Standard Life Investments Property Income have also won plaudits from analysts.
Winners and losers in the Reit sector
The £550 million placing announced by British Land in March may act as a short-term drag on performance in the current low interest rate environment, but it is a signal of the company’s bold intentions. British Land has stuck with ambitious City of London developments such as the Leadenhall Building (the ‘Cheese Grater’) and has a number of strong prospects in development.
The Brent Cross Shopping Centre owner has been battling on the frontline of the retail sector’s travails, but an imaginative strategy – with investments in discount designer outlet parks such as Bicester Village, for example – gives it an edge over similar Reits. The latest evidence of this strategy is a new discount scheme for shopping centre customers based on technology that tracks their mobile phones.
Intu’s wider-than-average discount to net asset value suggests it might be of interest to bargain hunters, but the business, rebranded from Capital Shopping Centres in January, continues to worry investors. In March, Trafford Centre owner Intu announced its fourth fund raising in as many years to finance the purchase of a Milton Keynes mall for £250 million. Analysts fear it may be overpaying.
London specialist Shaftesbury has benefited from its exposure to the capital, which emerged from recession well before the rest of the country did, and also enjoyed the handsome rewards of the Olympics effect last year. However, prices in the capital are now looking stretched and better-value opportunities exist elsewhere.