David Stevenson: Reits need a revival campaign

Pondering the trials and tribulations of many Reits, or real estate investment trusts, is a valuable way of thinking about the broader world of alternative investment trusts and what may happen to them in the next few years.

Reits may or may not represent good value, but they are the longest-established real asset-backed asset class that appeals to income-oriented investors.

Many alternative fund investors fret about issues such as the reliability of net asset values (NAVs), yields, dividend cover and liquidity, but all of these are issues that have long challenged the Reit sector, which to remind readers has dramatically declined in sheer quantity over the last few years due to takeover activity. Where Reits go first, other real asset classes go next!

The last few months have been brutal for most (though not all) Reits. I may think they represent good value – we’ll come to that later – but spiking gilt yields have hammered share prices.

According to the widely respected Reits research team at Deutsche Numis, gilt yields have risen more than 70 basis points since mid-September, with the Real Estate Investment Trust index down around 15% over the same period.

Many Reit investors scratch their heads because, on key metrics, Reits are showing evident signs of improvement: property valuations have stabilised, occupancy is picking up in many cases, and there has been positive rental growth.

It is also worth pointing out that, as Deutsche Numis analysts note, ‘balance sheets are generally conservatively positioned, and therefore many funds appear well-placed to deliver sustainable earnings growth’.

There’s also the not-unimportant fact that average dividend yields are running at more than 7% with takeover activity picking up: only this weekend brought news that Assura was another target.

Deutsche Numis notes that the best share price returns in 2024 almost exclusively came from funds that were swept up by the ongoing wave of M&A activity.

But there’s a catch, and I think it’s an important one. It’s called macro. Deutsche Numis analysts concede that ‘ultimately allocating to listed real estate will require investors to take a view on the macro environment’.

And therein, I think, is challenge number one for all alternatives funds, Reits included. Because they operate as bond proxies, asset allocators have to think long and hard about where they believe the macroeconomic fundamentals are going, which of course requires discretionary management.

That’s not how the world is going, especially regarding wealth and wholesale. We’re seeing the long-term impact of what Cross Border Capital’s Michael Howell has nicknamed the ‘giant global passive accumulation machine’.

More and more money managers are facing ever more intense pressure on the fees they charge. Thus, they find themselves shifting to a form of strategic asset allocation with fewer and fewer active macro calls.

This passive accumulation machine is drive by broad liquidity flows into liquid passive funds, many of which are built around risk grades (target date funds, for instance) and well-known benchmarks, implying maximum diversification.

In this framework, the fund selector starts from a top-down asset class perspective and may or may not generally find their way down to Reits or alternatives.

Strategic asset allocation involves tweaking broad benchmarks a bit but not by much, all while favouring those investment opportunities with the deepest liquidity which tends to preclude listed trusts.

At this point, another problem rears its ugly head. Being honest, Reits as an asset class haven’t been a fantastic investment in the recent past if you look at them from this strategic asset allocation perspective.

Nicholas Rabener is a quant-driven analyst who spends a lot of time pondering these strategic asset allocation debates for this research business, Finominal, which I highly recommend signing up for.

He put out a note looking at Reits, asking whether they served their purpose as a useful diversifier.

Rabener didn’t analyse the hundreds of Reits out there in the US and UK market but instead chose a helpful proxy, in his case a huge (Vanguard managed) US-listed ETF that invests in the biggest (US) Reits. As an aside, US Reits are much more popular, arguably much more successful in return terms and certainly more liquid than European ones.

His conclusions were stark: Reits weren’t very attractive. 

Using a returns-based factor exposure analysis, Rabener confirmed that Reits were, fundamentally, a form of exposure to bonds although the beta to bonds has not been consistently positive.

Here’s his slightly damning summary: ‘REITs had consistently positive exposure to size and low volatility, neutral exposure to momentum, and negative exposure to value and quality factors. Fundamentally, Reits are typically small, low-risk, expensive, leveraged, and low-profitability stocks... they do not offer diversification benefits due to a high correlation to stocks. Worse, they have consistently performed worse during market downturns.’

I have to say, I’ve heard roughly the same analysis from many other strategic asset allocators, virtually all of whom are sceptical, if not downright bearish, about Reits as an asset class.

Given this kind of analysis, one can see the makings of a real problem for Reits and, I think, alternative assets more broadly.

The data on long-term returns from investing broadly in Reits isn’t that compelling, and if we’re honest, isn’t persuasive for listed alternative infrastructure funds either. They are bond proxies but more volatile, and liable to sharp losses in economic downturns. The structure of the listed entities has a host of issues, not least cavernous discounts.

What makes it all much worse is that even if you overlook these headwinds you’re also faced with the macro judgment call – as a fund selector, you have to make a call about macro economics, which, as we all know, is a tough ask in a world where the passive accumulation machine is pushing down the rewards from discretionary management.

So, add it all up, and you have a harsh environment for Reits, and I would suggest alternative funds more generally. And, of course, those more general alternative funds also suffer from much broader debates around NAVs and discount models.

But I want to end on an upbeat note. Even if the financial world is being eaten alive by the giant global passive accumulation machine, it opens up more and more niches and spaces for valuation mispricings that can be captured by active discretionary managers.

There does come a point at which even if the past historical dataset is a tad unappealing, the forward-looking one starts to look compelling.

According to that analysis by Deutsche Numis analysts, occupancy is strong, rental growth is strong, work from home is beginning to unwind, and the UK economy is slowly picking up speed.

The fundamentals look more appealing, and if you’re willing to take that macro judgment call that rates are only heading in one direction, then the ‘bet’ looks especially appealing.  In the new world of commodified wealth management, making the right discretionary macro calls will be rewarded, eventually.

I’ll finish with one final aside. I noted above that Reits have been very successful in the US amongst the wider investing population. Talk to US investors, and they all seem to know about Reits because there’s been a consistent public education programme by REIT  trade organisations.

Any investment publication about income investing inevitably talks about Reits (and master limited partnerships) partly because of that huge drive to push Reits as a viable, liquid asset class.

That’s precisely what’s needed in the UK for Reits specifically but also alternative, infrastructure-based assets more generally.

They need a campaigning body (not the Association of Investment Companies) dedicated to real assets and Reits, which is out there selling the upside for alternative assets in a volatile world, which I think is considerable and getting more appealing by the day. That will help to secure the secondary market for these securities and help the sector to prosper.

Crucially, as I look down the buy lists for many retail brokers, for instance, I already see a heavy smattering of alternative funds, infra and Reits, so the market is out there and willing to listen, but it needs more evangelical messengers.

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