Cause for cautious optimism as investor sentiment towards UK REITs finally starts to warm

After a largely loveless 18 months, we detect a warming in investor sentiment towards UK-listed REITS. In our view, this is due to a combination of factors.

Interest rates and real estate markets have always been intrinsically linked. Last week’s decision by the Bank of England to hold rates at 5.25%, following 14 back-to-back increases, has been seen by many market commentators as marking the likely peak of the current cycle, an unprecedented impact of which has been the rapid repricing of commercial real estate debt.

For real estate companies with a diversified debt stack this will result in the gradual increase in the average cost of debt over time. However, for listed REITs, equity markets have been quick to mark down valuations in response to the rebasing of property returns. REITs with a larger exposure to floating rates have seen the impact immediately with corresponding falls in earnings.

Many UK-listed REITs have responded accordingly over recent months by selling assets to reduce leverage (and expensive revolving credit facilities – RCFs) and purchasing hedging instruments to counter higher costs of debt. A stable and more predictable outlook for rates is therefore welcome news for REITs.

Property yields are also stabilising, albeit after sharp corrections related to bond market movements and investor requirements for higher returns. In part, this has been driven by a structural imbalance between supply and demand for real assets, particularly in industrial & logistics, residential and PBSA but also in sectors such as retail, which have already experienced a repricing of yields well before the uplift in base rates.

This is being reflected in an uptick in transaction volumes, with many recent deals being priced either at or above previous red book valuations. Such deals help to validate wider portfolio values and market forecasts for net tangible assets, which the stock market continues to regard as the holy grail.

REITs were originally founded as proxies for investment into direct real assets, with dividends equating to the distributable income. Historically, dividend distributions from REITs have been both highly visible and predictable. However, 2023 has seen more uncertainty begin to appear.

Several REITs sensitive to the real-time cost of debt through floating facilities either have reported or will report temporarily uncovered dividends as a consequence of higher costs (Supermarket Income REIT, Warehouse REIT and Urban Logistics REIT etc), while Regional REIT has signalled a significant cut (of circa 30%) to its dividend through higher unrecovered property operating costs. However, this now looks to have largely played out and the future growth outlook for dividends across the sector now appears to have been priced in by equity markets.

Equity valuations remain highly subdued across UK-listed REITs, albeit some more so than others. Those REITs with highly visible, secure income profiles and long WAULTs currently trade on the smallest discounts to forecast net tangible assets (of circa 20%). These include stocks such as LondonMetric Property, SEGRO, Assura and Tritax Big Box REIT, while those trading on the biggest discounts (of circa 40% to 45%) include London office specialists Derwent London, GPE and British Land. However, across the board, we now believe the current disconnect between validated transactional asset valuations and stock market-implied valuations looks overly anomalous.

In our mind, this presents an attractive value opportunity within the property cycle for UK-listed REITs. This is already being recognised by market consolidators such as LondonMetric Property, which continues to capitalise on the attractions of acquiring other deeply discounted UK-listed REITs using its own paper rather than expensive new debt. The UK-listed REITs sector now looks in better shape with an improved trading outlook as the sector moves on from debt financing turmoil. That said, it is also likely to be a sector of fewer but stronger and bigger players from consolidation and one where investors are also likely to be more scrupulous over the quality of future IPOs. A new dawn may now be upon us.