All aboard the consolidation train

This year has started with a bang for UK REITs, with LondonMetric’s recommended offer for LXi REIT (LXI) and Custodian Property Income REIT (CREI) and abrdn Property Income Trust (API) agreeing to a merger…  all before January is even out! As we have signalled for some time, investors’ growing frustration with the deeply-discounted stock market valuations of many externally-managed REITs has begun to force a much-needed consolidation in the sector. We expect 2024 to see the emergence of a stronger REIT sector comprising fewer but bigger constituent companies.

Last year finished with a growing sense of optimism in capital markets that the woes of the previous 18 months were behind it, and the expectation of a progressive easing of interest rates in 2024. With a dramatic fall in swap rates and gilt yields towards the end pf 2023, REITs enjoyed the benefit of a late ‘Santa Rally’ seeing an appreciation in share prices of up to 30% from the October lows. While some of those gains have since been surrendered as 2024 got underway, our view for the sector coming into 2024 remains one of cautious optimism. We believe that investors, having benefited from superior performances in alternative asset classes including bonds in 2023, will recognise the value in REITs, with the expected compression of income yields and financing costs of new debt expected to reduce.

However, there are likely to be bumps in the road in this journey. The latest CPI inflation data serves as a timely reminder that the sector is by no means out of the woods yet. The uptick in CPI from 3.9% to 4.0%, against the grain of an expected fall to 3.8%, illustrates once again the stickiness with inflation – before the possible effects of higher prices for goods and energy from the re-routing of shipping from the Red Sea are taken into consideration. We continue to believe that the MPC, scarred by its recent track record, will make one cut to base rates in H1 CY24 and maybe two to three in H2, so bringing UK base rates within the 4.25% to 4.75% range by the end of 2024.

We have believed for some time that 2024 would see further sector consolidation, particularly as frustrated investors in underperforming, largely externally-managed REITs push for action. Step forward LondonMetric, the sector’s super consolidator in-chief, and with the year barely two weeks old, announcing the biggest deal for many years with a recommended all-share offer for LXi. The deal will create the UK’s first ‘triple-net’ REIT of scale with circa £6.2bn of assets and a market capitalisation close to £4bn – unlocking further new opportunities as it gets to sit at the industry top-table for deals. The merger looks to create significant value, with LXi shares converting to LondonMetric shares on an implied 4% to implied net tangible assets (NTA) and with the potential to enhance earnings by 9% in FY25F on our estimates.

This has been followed by the announcement of another all-share merger, between CREI and API in a similar move to drive operational cost synergies and narrow the discount between share price and NTA. Furthermore, with around £50bn of commercial UK real estate due to be refinanced in 2024, and a sizeable proportion of it likely distressed, we believe the best capitalised players in the wider sector are likely to benefit from plentiful deal opportunities.

In summary, we continue to uphold our cautiously optimistic view of UK REITs for 2024 in what looks set to be a year of further consolidation. Our highest conviction sector call remains industrial and logistics, which remains a structurally supported sector with a fundamental imbalance between occupier demand and available supply. This should be further enhanced by development, benefiting from yield compression and reducing finance costs. Our key recommendations here include SEGRO, Tritax Big Box and LondonMetric. We also believe NewRiver REIT looks well placed given improving rents and stabilising asset valuations in retail parks and shopping centres, a strong balance sheet and the potential to do opportunistic deals.