Who really pays for property trusts' high yields?

Take those dividend yields, which range from 5 to over 11 per cent. The problem here is that they are uncovered by earnings: all the UK property trusts, bar two (see chart), pay out more to investors than they receive in rents. The shortfall comes from cash balances, which the trusts maintain by selling buildings or, if they are sufficiently popular, by issuing equity. Either way, NAV per share is reduced. The result is a financial circuit - the trusts are taking from Peter in the future to pay Peter now.

A historic problem

The practice of paying uncovered dividends emerged largely for historical reasons. These trusts were launched in the boom years to provide a secure, asset-backed income to risk-averse investors. Companies were consequently loath to cut dividends when vacancies appeared in their portfolios during the 2009 recession, and at first they had a good excuse to keep them up - property values were bouncing. The narrative became that they were merely distributing capital gains as income, because income is what their shareholders want.

But now that the post-crash bounce has fizzled out, dividend payments are simply exacerbating the impact on NAV of falling property values. As this problem has dragged on over the past year, managers have started to murmur about 'rebasing' dividends - in many cases for a second time, as the less resilient trusts already made cuts in 2009-10. Nobody likes to be first, but Picton Property Income finally announced a 25 per cent reduction last week, after dropping heavy hints in its July annual results. "In the current environment, we believe the balance should be more weighted to strengthening the balance sheet rather than over-distribution," wrote chairman Nicholas Thompson.

The question now is whether Picton's move will be copied by its peers. James Brown, an analyst at Winterflood Securities, thinks ISIS and IRP investment trusts may seize the chance to cut their dividends, which are "unsustainable at the current level". But Richard Kirby, manager of F&C Commercial Property, has always argued that cover will improve as his company buys or develops buildings over time, and that "uncovered dividends in the investment trust sector are understood".

Investors Chronicle supports cuts in this case because they would bring greater clarity to the earnings and balance sheets - at the moment, these trusts are taking on the financial characteristics of annuities without admitting it. But the wider point is that shareholders need to look at the dividend yield as part of a 'total return' that also includes the movement in NAV.

Falling values

That brings us to the second point - those big discounts to NAV may not be as attractive as they appear. Outside of London, property values are falling, so the NAV estimates, which are based on surveyors' quarterly property revaluations, may be too high.

All the main UK investment trusts have now issued their September NAV updates. In what has become a recurring pattern, the only trust not to clock a fall was F&C Commercial Property, which has by far the most substantial London weighting of all the vehicles, principally at St Christopher's Place off Oxford Street. Its NAV will be protected again in the current quarter by an exceptionally profitable disposal announced last week. It sold a shop on Oxford Street let to Boots for £28.1m - a rental yield of just 3.6 per cent and an 18 per cent premium to its book value.

Outside the West End, however, neither investors nor lenders have much appetite for assets. One major concern is that the banks own great swathes of distressed property that they are gradually leaking into the market. Meanwhile, economic growth is weak, so businesses are not, in aggregate, expanding into new office, industrial or retail space. The result is flat or (in the case of retail) falling rents and declining valuation multiples. That is a toxic combination that is weighing directly on investment trust NAVs.

Consensus forecasts for commercial property values have steadily deteriorated over the past year, in line with economic growth forecasts. Brokers now expect no rental growth and a 1.1 per cent erosion of capital values next year, following a 4.7 per cent fall this year. The recovery will finally come in 2014, they hope.

Bargains for the brave?

Yet there is a positive message to salvage here, which is that these projected falls are reasonably modest compared with the discounts at which some of the trusts trade. With rental yields on property already very high relative to 'risk-free' gilts, nobody expects a rerun of the 2008 crash. In theory, the discounts at which these trusts trade already over-compensate for the impending falls in NAV. Those who buy at current levels could do well when sentiment towards the sector improves - even if that's not for another five years. Just don't watch the share price in the meantime.

Of course, the biggest discounts reflect other risks, too - above all the risk of refinancing. Many trusts, particularly those oriented towards Europe, geared up heavily in 2005-07 and have looming refinancing deadlines, even as banks' appetites towards commercial property lending goes from bad to worse. The most obvious example is Alpha Pyrenees, which has a loan-to-value ratio of 75 per cent; it will almost certainly have to raise equity or sell assets when its boom-era debt package expires in 2015.

Among UK trusts, the most highly geared are Redefine (which reversed into Wichford) and Picton. We tipped both last year in the expectation that the huge discounts to NAV at which they traded would normalise once they renegotiated their debt packages. Frustratingly, that strategy has not worked. Even though both have announced momentous improvements in balance sheet health this year, their shares prices have failed to react in a market that has favoured track record over speculative opportunity. They remain buys, with staggering value on offer - but strictly for contrarians, who are not the kind of investors these property funds were ever aimed at.

IC VIEW:

Only two trusts in the core peer group - F&C Commercial Property and UK Commercial Property - can claim to have lived up to their original promise as low-risk sources of income, and these may be worth buying (see below). The others have all been in various stages of distress. That has given them room for improvement, and occasionally those improvements have translated into sharp re-ratings. Shares in the Standard Life vehicle snapped back to par after it announced a debt refinancing in December, for example. But these re-ratings have been erratic, with improvements often overshadowed by the weak market backdrop. On the whole, it's a sector worth avoiding unless you're a daring contrarian.