This year has been unforgiving for UK real estate investment trusts (Reits) and rising interest rates will make it even worse for indebted funds, with Warehouse Reit (WHR ) being the most exposed.

UK property funds were winners last year as they benefited from low inflation, historically low interest rates, and what appeared to be a recovery in the economy. However, just over six months later and they are feeling a multitude of pressures, including a rise in borrowing costs as 10-year gilt yields hit 2.5% from 1% last month and borrowing spreads expanded.

Numis analyst Justin Bell used the iShares UK Property ETF as a proxy for tracking the sector, and said it is down 21.5% this year versus a 5.6% fall in the FTSE All Share.

Bell said the issue of interest rates is looming large for many of indebted Reits. The Bank of England has already made five consecutive swift hikes that have left the base rate at 1.25% and it is set to rise to almost 3% by the end of the year – a point it hasn’t reached since 2008.

This is putting balance sheets in the spotlight and Bell said ‘poorly structured debt can rapidly undo years of positive returns’.

‘The key question now is whether balance sheets can withstand rising rates,’ he said.

‘Companies with a high proportion of floating rate debt may have to deal with an unforeseen rise in finance costs, while near-term debt maturities also pose a risk if lending conditions become unfavourable.’

Bell said Warehouse Reit, the portfolio of logistics assets nearly doubled in size during the pandemic but has slid back to a market value of £623m, is under most threat from rising rates as all of the fund’s debt is floating rate and ‘only a small proportion is hedged via interest rate caps’.

It has a £182m term loan and a £163m revolving credit facility, which are both due to expire in January 2025, although the lenders can extend the duration of the loans by two years.

The interest paid on the loans is Sonia – the inter-bank lending rate that replaced Libor – plus a margin of 2-2.5%.

‘Two interest rate caps of £30m each limit Sonia to 1.5% and 1.7%, but these only run until November 2022 and November 2023, respectively,’ said Bell.

Paying to fix the rate level on their debt would ‘be similar to their current portfolio valuation yield’ and Bell said ‘it would probably be better off selling assets if it can, to reduce leverage’.

Warehouse Reit is not the only fund feeling the heat from the rising cost of debt. Bell said Abrdn Property Income (API ) and Balanced Commercial Property Trust (BCPT ), formerly BMO Commercial Property, both have debt facilities that will need refinancing in the next 12 and 18 months, respectively.

He said this refinancing ‘may coincide with a period of significantly higher interest rate’.

Higher interest rates will have a ‘pronounced effect’ on dividend cover, which gives an idea of how easily a trust can pay its dividend and a dividend. Cover of 1 means a trust can pay its dividend from earnings, but below 1 and the trust will have to use reserves to pay it.

‘Dividend cover is generally strong across the peer group, but the nuances of each company’s reporting distort the picture,’ said Bell.

Analysis by Bell shows that Urban Logistics (SHED ) has the lowest dividend cover ‘due to cash drag from raising equity twice in July 2021 and December 2021’.

Industrial Reit (MLI ), which was known as Stenprop before overhauling its strategy into multi-let industrials, is close behind but Bell said if the one-off costs associated with moving the premium segment of the main market and the implementation of its technology platform were stripped out, its dividend was fully covered.

Despite Bell sounding the warning on Industrial’s dividend cover, he sticks by his decision to add the trust to his recommend list at the beginning of the year, and said it is still one of his top picks.

The shares have tumbled by a quarter since the end of April when Amazon warned that it had spare warehouse space in the US, creating an industry sell-off. However, Bell said Industrials has no exposure to Amazon or even the types of buildings it occupies.

He noted that the resilience of Industrial’s small and mid-sized tenants will be tested over coming months ‘but given that rents in Industrial represent 1-3% of average turnover and typically they are the only place of work for tenants, it is likely to be a last resort to vacate’.

‘On a 15% discount to March EPRA net tangible assets and 4.5% dividend yield, I think this is a good entry point to a sector with exceptional long-term supply-demand dynamics,’ said Bell.

UK Commercial Property (UKCM ) is another stock that could find rate rises present a battle but Bell is still tipping it. It was one of the best performing Reits in the first half of this year, with its shares flat in a falling market.

However, Bell said this masked the ‘rollercoaster ride’ with the shares up 24% in April and then giving back all the gains.

The generalist trust is trading at a ‘monster’ discount of 33% which Bell said is ‘very harsh’ given it has a low loan-to-value but 64% exposure to industrials.

‘It is worth noting that its portfolio net initial yield is low compared with the peer group at 4%, reflecting its high weighting to industrial and London and South-East geographies,’ said Bell.

‘This could make the net asset value more sensitive to rising rates.’

HE said the low LTV that the trust will be able to ‘take advantage of any dislocation in the market if there is a direct-market sell-off and pick up some cheap assets’.