Four ways to build returns in real estate

Investors wrote off property during the Covid-19 pandemic, often in the mistaken belief that UK commercial property trusts are chock-full of high street retail and office assets.

But as the cloud of lockdown has lifted, valuations have rebounded sharply. Diversified real estate investment trusts (REITs) have seen double-digit uplifts in portfolio values over the past year, in many cases eclipsing the falls witnessed in 2020.

Share prices have also rebounded, albeit to varying extents. “The winners have clearly been the logistics-focused plays – Tritax Big Box and Warehouse REIT, for example – as well as LXi REIT, the long-lease trust that is one of our core selections for property exposure,” says Charles Stanley analyst Ben Johnson.

“Some other sector-specific plays have worked well too, but interestingly the diversified property trusts have generally been left behind, recovering strongly off their lows but still languishing at wide discounts.”

Underlining investor hesitancy, the diversified property sector was trading on an average discount of more than 25% on 27 May, according to Numis.

There are, however, compelling reasons in the current environment to allocate to the property investment trust sector as part of a wider portfolio – one of them being discounts. Let’s take a closer look:

1. Inflation linkage

With the consumer prices index (CPI) rising at 9%, its fastest rate for 40 years, and set to go higher, protection against inflation is a priority for investors.

“Property has traditionally been a good hedge against inflation; although rental growth won’t be anywhere near the current levels of CPI, some inflation protection is embedded in the leases of certain REITs,” says Richard Williams, a property analyst at QuotedData.

“Although mostly capped around 4% per annum, index-linked rent reviews do benefit long income specialist LXi REIT and social housing companies Civitas Social Housing and Home REIT.”

In an inflationary environment, Peel Hunt real estate research analyst Matthew Saperia likes “beds, sheds and meds” – companies like Warehouse REIT and Primary Health Properties – “where landlords retain a degree of pricing power, often underpinned by robust levels of occupier demand”.

2. Cushion against recession

Trusts have been buying back stock to try to narrow their discounts, but many still remain wide.

That may be no bad thing amid the Bank of England warning that rocketing energy prices and the cost of living crisis will push the UK economy into decline this year. Johnson points out that the starting valuations at which new investors can initiate positions amount to a “reasonable cushion” against recession.

“A looming recession is not good news for landlords, but value can still be found in diversified REITs, which are trading on significant discounts to NAV despite recent valuation uplifts,” says Williams.

3. Structural advantage

Investment trusts are ideally suited to illiquid investments like property, as underscored by the tsunami of redemptions suffered by open-ended property funds since they reopened.

“We strongly believe that the structural advantages of investment companies should underpin superior returns and relatively attractive income characteristics,” analysts at Investec said in a research note.

“For more illiquid asset classes such as commercial real estate, the long-term differential may be meaningful. Meanwhile, given the acute liquidity mismatch, the open-ended structure is simply not suited for illiquid investments.”

They point to far superior returns, significantly higher dividend yields and strong fundamentals underpinning the UK commercial property trust sector.

4. ESG angle

As public companies with large portfolios, Peel Hunt believes REITs are leading the real estate sector on the adoption of ESG best practice and commitment to net zero carbon. “This will undoubtedly provide another source of competitive advantage in the years to come,” says Saperia.

By 2030 all buildings will need to adhere to energy performance certificate ratings of B or higher, up from 20% to 25% at present. “There will be a crunch point within the next few years,” says Alex Moore, head of collectives research at Rathbones. “Landlords will need to invest more, or the building will be deemed a stranded asset.”

In this regard, Williams at QuotedData rates Standard Life Investments Property Income Trust and its “forward-thinking” manager, Jason Baggaley. “This was highlighted in the fund’s acquisition last year of open moorland in Scotland as a carbon offsetting play,” he explains.

“With property being one of the biggest carbon emitters and as the drive to net zero intensifies, landlords are going to have to take difficult and potentially costly decisions. By getting in early at a relatively cheap fixed price, it looks a shrewd move by the manager that could pay off handsomely in the future.”