The best investment trusts for growth and income

Real estate investment trusts (Reits) make up a sizable part of the London investment market, frequently present valuation gaps and can offer attractive income. Recent times have been turbulent for Reits, though, thanks to a trifecta of falling demand, pressure on rents and, most significantly, the interest rate environment, which has impacted the ‘cap’ or ‘capitalisation’ yields used to establish asset values. Lower rental growth means higher yields, but for real estate the market also considers the ‘yield gap’ between the cap yields used for sector valuations and risk-free returns (RFRs – typically gilts) – typically property yields more than gilts so cap yields have had to increase.

However, despite economic headwinds, rents in general are not falling, only rising more slowly. Demand has skewed much more towards prime assets, with many occupiers looking for smaller (due to home working) but better premises. Some poorer quality space is proving unlettable and will have to be repurposed. A more material risk for this sector than tenant-related issues is concern about contagion from banking failures or banks otherwise becoming less keen to refinance Reits. This concern has caused many institutions to lose interest in the sector, triggering something of a sell-off, leaving many stocks on substantial discounts to their net asset value (NAV).

NAVs have been dropping as higher cap rates erode book values, with NAVs peaking last summer and showing declines since November. This has meant a double hit to Reits’ share prices, but is the market pricing in the right level of decline (the discount is, in effect, a prediction of how far portfolio valuations will drop) to book value? Analysts reckon that, at worst, NAVs could drop another 20 per cent. But many stocks are trading at higher discounts than this: typically around 25 per cent, although some are much worse. This could mean that there is value to be tapped in the Reit sector. 

The recently merged Shaftesbury Capital (SHC), owner of Covent Garden and Carnaby Street in London, stands on a near-40 per cent discount while shopping centre owner Hammerson (HMSO) stands on 55 per cent. Both are unloved. The best pick here, however, looks to be Helical (HLCL) with a strong existing portfolio of prime, in-demand office space and an attractive new pipeline; this stands on a 36 per cent discount which is too close to that of these unloved businesses.

One sector looking particularly healthy is student housing, where rents and demand for external, professional, multi-site landlords have a number of very positive, sector-specific, drivers. Private landlords and universities themselves are quitting the market in droves. This benefits Reits such as Unite (UTG) and Empiric (ESP), both trading at forward book value. There are similar positive trends in self-storage: Big Yellow (BYG) could be oversold, trading at close to its lowest rating in 10 years. 

Another interesting sign of value is that private equity (PE) has come calling. Since 2020, US PE giant Blackstone has absorbed Hansteen and St Modwen, and is now making moves on Industrials Reit (MLI) which has raced from a 15 per cent discount to an 18 per cent premium accordingly. This is likely to bleed across to the rest of the sector and discounts across the piece may begin to narrow. 

Many Reits also pay healthy dividends, although those invested in non-prime assets or shopping centres are at risk of cutting their payout, and investors should always check how well covered the dividends are by cash flow and profits: avoid trusts paying dividends out of their asset base. Student housing again looks good here, with Empiric offering in excess of 4.5 per cent. The extremely diverse LXI Reit (LXI) is interesting on a 6 per cent yield, while Supermarket Income Reit (SUPR), which has a solid tenant backdrop plus a lot of indexed rents, returns almost 7 per cent. The healthcare property sector is also robust, comfortably supporting Assura’s (AGR) 6 per cent income.

If one fancies a little more risk, Capital and Regional (CAL) has been a shocking long-term performer (99 per cent negative total return since 2007) but the ship has been righted and the near-9 per cent yield on this now microcap looks fairly healthy. 

General investment trusts for income

There are a number of different strategies adopted by investment trusts (ITs) to deliver, and ideally defend, their dividend streams. Here we will be looking at both equities-skewed and alternative asset class trusts, those with very long records (the ‘dividend heroes’) and those looking to keep pace with inflation.

This is a great place for income with many of listed investment trusts (ITs) paying an annual running yield above that of the market, with the mean average yield across all funds at 3.8 per cent (excluding the higher risk VCTs); this is fractionally higher than the FTSE 350’s yield of 3.45 per cent. The easiest, and likely more dependable way to look for income here is to go with the so-called dividend heroes, the small number of trusts that have increased their payout for more than 20 years unbroken. Top is City of London, with 56 years of consecutive payout increases, and those in bold in the table have all managed at least 50 years. However, these while reliable, may not deliver the best yield. While Bankers (BNKR) and Claverhouse (JCH) pay around 5 per cent, the average for the 50+ club is only 2.6 per cent, or 1.9 per cent excluding the two aforementioned. Better income, albeit often with more risk, can be had elsewhere but either of these would be a pretty decent place to invest.

Equity income stock bias

Playing safe with trusts investing in UK-listed equity income equities, a good pick might be Lowland (LWI) offering 4.8 per cent income and almost 5 per cent annual dividend growth or the £1bn Law Debenture Corp (LWDB) only paying 3.6 per cent but averaging 12 per cent income growth and delivering a 145 per cent total return (TR) over the past 10 years (9 per cent CAGR). For global income, perhaps JP Morgan Global Growth and Income (JGGI): only a 3.75 per cent yield, but 20 per cent annual income growth and a double-digit annual TR over the past decade. All of the above have good scale and liquidity but do trade on less of a discount than the sector average. 

Alternative assets 

Higher and often faster-growing income can be had in the alternative assets sector where over 70 per cent of trusts offer a yield greater than 5 per cent. Here, investors can pick from a range of investment profiles or strategies: private equity, renewables, infrastructure or fixed income (debt instruments).

Private equity: this is the high-risk end of the sector and generally investment is for growth. However, some decent yields can be had, but usually there is limited income growth, sizable discounts to NAV and volatile share prices often leading to negative total returns. 

Renewables: this sector has strong environmental, social and governance (ESG) credentials, solid growth potential due to the global energy transition, generally safer levels of income because customers are typically governments or large utilities and many have pricing arrangements that provide cover against inflation (indexation). The only real downside is that this is still a fairly new sector and the likes of long-term repair and replacement costs are not yet fully understood. A well-established play is the largest player, Greencoat UK Wind (UKW). This has around a 5 per cent yield, has concentration risk (it is only UK-focused), but it aims to increase its dividend in line with inflation and has a healthy dividend cover of almost 4 times. Octopus Renewables Infrastructure (ORIT) is very similar to Greencoat but has recently started to shift away from UK wind into overseas markets and solar. A better yield (5.75 per cent) here but less inflation protection. An interesting but still pretty new fund is Gresham House Energy Storage (GRID), which invests in network battery assets, a vital element for smoothing out the erratic energy delivery from wind and solar. The yield is 4.5 per cent but the share price is above NAV whereas the other two both stand on a small discount. 

Infrastructure: in this segment, one can gain far greater diversity by asset type and geography, many of the investments are very well established and all of the trusts are larger/more liquid. A good choice here is BBGI Global Infrastructure (BBGI), which offers a diverse portfolio with much of its income coming from government bodies, where many contracts to operate the likes of roads and bridges are often index-linked. The yield is close to 5 per cent, but the shares are unique in this sub-sector in standing on a small premium (around 4 per cent). 

Fixed income: while most funds make direct investments in assets, a different approach is to invest in either direct or syndicated loans made to projects such as wind farms or transport systems. Investing in debt is seen as riskier than direct investments but, especially for infrastructure projects, defaults have been historically very low. Despite this, interest rates payable to, and thus yields from, debt investing trusts can be high. A good example is Sequoia Economic Infrastructure (SEQI), a fund about as diverse as BBGI  but a debt investor, typically targeting floating-rate loans (a good place right now) and short-maturity debt. The average loan interest rate is 11 per cent (individual infrastructure schemes tend to have low credit ratings), allowing the fund to yield over 8 per cent and, more recently, the rise in market interest rates has worked well against inflation. This is higher risk but a 12 per cent NAV discount does add a little more comfort. 

Another interesting trust is Biopharma Credit (BPCR) – this can sound risky, being tied to the smaller end of the pharma sector, but loans are only made against approved therapies and equipment, often with equity kickers and usually with helpfully high repayment or early redemption charges. The latter means that if the biotech borrower repays early through strong product cash flows or issues bonds/equities in a refinancing, extra charges become payable. These add a more strategic dimension to the loan book and have allowed it to make returns comfortably higher than just interest charges. The yield here is around 7.25 per cent and dividend growth since 2014 has averaged almost 10 per cent, suggesting that the risk premium here is too high. 

In our next article in this IT-focused series we explore where the best opportunities for capital growth can be found, again in both the more vanilla funds and the more esoteric. The sector has experienced a fairly undiscerning sell-off and there are bargains to be had.