Property investors should retire the ‘mythical’ net asset value (NAV) when assessing the strength of real estate investment trusts (Reits) in favour of earnings which are more important in determining dividends.

That’s the view of Richard Shepherd-Cross, manager of the £420m Custodian Property Income (CREI ) trust, who at an Association of Investment Companies (AIC) event this week said last year’s severe property selloff demonstrated the limitations of using the NAV to determine the health of Reits.

The UK commercial property market has suffered a sharp derating in the past 18 months as rising interest rates and surging government bond yields have hiked borrowing costs and depressed valuations. Following the gilt meltdown caused by Liz Truss and Kwasi Kwarteng’s botched ‘mini’ budget in September last year, investors dumped Reit shares, causing their prices to fall faster than their assets. That has left many trading on wide double-digit discounts to NAV prompting takeover activity.   

Shepherd-Cross said 2022 was a year the Reit sector could have done without.

‘It would have been preferable to jump from fourth quarter 2021 to first quarter 2023 because all 2022 did was create a whole lot of noise and collapse of values that took us back to where we started [at the beginning of 2022] but created a bad memory for investors,’ he said.

Shepherd-Cross suggested ‘the [2022] third quarter values were mythical’ because, ‘the buildings didn’t change, the rents didn’t change, the tenants didn’t change, and the earnings didn’t change between the third and fourth quarter’.

The fact that NAVs have failed to recover has kept sentiment poor and Shepherd-Cross said it was ‘frustrating that there is undue focus on NAV’ because, due to the way valuations work, it represents ‘what a property could have sold for three months ago’.

‘As shareholders cannot access NAV returns, what becomes more important is earnings and the ability to cover the dividend,’ the manager of the 6%-yielding Custodian Reit said.

‘On the ground, the market for occupation is pretty strong, there is strong rental growth and falling vacancy rates. These should attract investors.’

US uses earnings

Shepherd-Cross said for investors to have a ‘happy experience of owning real estate’ they should buy trusts on an ‘earnings-denominated metric rather than NAV’, which would lead to ‘less volatility and more predictability in returns and a happier experience’.

This is a tried-and-tested method that already works, as it is used by Reits in the US, ‘where there is no mention of NAV at all, it is all earnings’, said Shepherd-Cross, whose Reit invests in small commercial properties in the regions outside London.

Focusing on earnings rather than NAV would also be beneficial to trusts that find themselves missing out in a market awash with good value properties as their discount prevents them from raising fresh capital to invest.

‘At the moment we cannot raise money, because we would be raising money at a discount to NAV,’ said Shepherd-Cross.

‘If we could raise money we could invest in earnings-accretive assets which is good for shareholders, but we can’t do it… We need to stop reporting NAV as if it’s important, because it’s not.’

Bjorn Hobart, manager of Tritax Big Box (BBOX ), the £2.7bn large warehouse investor, agreed that a shift away from NAV would be beneficial.

‘Taking on that US [approach] is something we would welcome,’ he said. ‘Focusing on earnings and stability of earnings, and progression of earnings growth.’

Earnings growth was ‘a fundamental principle that is driving value’, he added.

Mergers for capital

Consolidation of UK Reits has picked up pace this year with Civitas Social Housing (CSH), Industrial Reit (MLI), CT Property (CTPT ) and Ediston Property Income (EPIC ) becoming takeover and merger targets this year.

Shepherd-Cross, whose Custodian snapped up the small Drum Income Plus two years ago,  said the ‘driver for consolidation’ was coming from shareholders, largely the wealth managers that are themselves consolidating into larger businesses and are calling for trusts to scale up in size and liquidity.

‘When we launched [in 2014] we were told that £100m would be big enough but that figure is now £750m,’ he said.

‘There needs to be consolidation. There are funds at deep discounts that are too small and it is difficult to see how they will work unless they take the Ediston approach and offer themselves to market.’

He added that it was ‘disappointing’ that Ediston ‘went overseas and didn’t stay UK listed’, having sold to US-based Realty Income for £198m in September.

Hobart said there were ‘benefits of acquiring companies which are at deep discounts to NAV’ although he said the discounts ‘ultimately suggest that the shareholders do not have a strong belief in those companies’.

‘M&A can be very accretive… Raising capital would be a great opportunity. We are at a discount to NAV, although not as deep as some, and we are always running the rule over opportunity to see where we can enhance the portfolio,’ Hobart said.

Improve disclosure

Alan Brierley, an analyst at Investec, agreed with the need to improve ‘disclosure around cashflow and earnings’ but said it should go far wider than just Reits.

‘I think it goes beyond Reits and applies to much of the alternative sector,’ he said.

‘[Given] the holy grail of attracting new institutional investors, both domestically and internationally, we do wonder whether we need to move the debate on from the traditional focus on NAVs to earnings and cashflow metrics,’ he said.

‘This is still very much work in progress for us.’