Commercial property valuations are now coming under pressure, but there are reasons to maintain exposure to selected listed REITs.
Firstly, the high dividend yields provide an attractive income stream, while rental growth through active property management initiatives and upside from rent reviews are supportive of payouts, too.
Secondly, the deep share price discounts to net asset value (NAV) already factor in the likelihood of weaker property valuations as investors seek higher net initial yields (NIY) to compensate for the upward shift in government bond yields in the past 12 months.
Thirdly, the peak Bank of England (BoE) Base Rate is unlikely to exceed consensus market expectations (4 per cent) on the basis that fiscal and monetary tightening, combined with below inflation pay reviews, will have an accentuated impact on consumer demand while a slowing global economy could yet act as a handbrake on the general inflationary backdrop.
Interestingly, two-year UK gilts are yielding 2.98 per cent, below BoE Base Rate of 3 per cent, while both five-year and 10-year gilts are yielding 3.2 per cent. All three maturities had yields of 3.5 per cent before the 'mini' Budget on 23 September. Share prices across the sector have rallied in the past month as UK gilt yields declined, highlighting their sensitivity to this key metric.
A high-yielding REIT play
- Half-year NAV edges up to £192mn (121.9p per share)
- Half-year pre-tax profit of £8.3mn and EPS of 5.25p
- Quarterly dividend maintained at 2p a share
- New £60mn five-year fixed loan priced at 2.96 per cent
AEW UK Reit (AEWU:94p) has produced a resilient half-year trading performance given the ongoing political and economic uncertainty.
The property portfolio declined 3.1 per cent on a like-for-like basis in the six-month period, but NAV edged up slightly as the £29mn disposal of Eastpoint Business Park, Oxford, last summer realised a 16 per cent premium to carrying value. Purchased for £8.2mn in 2015 on a NIY of 9.4 per cent, the asset delivered an eye-watering internal rate of return (IRR) of 22 per cent in the five-year holding period.
AEW’s investment manager also banked £9.3mn from the sale of a vacant office building in Glasgow to IQ Student Accommodation and completed the £1.7mn disposal of an industrial warehouse in Swinton on a NIY of 6.6 per cent. The capital is being shrewdly recycled into higher-yielding assets.
In June 2022, AEW acquired a fully let retail warehouse on the edge of Dewsbury town centre for £4.7mn on a NIY of 9.4 per cent. The park has a low passing rent of £8.28 per square foot (sq ft), so should offer scope for decent rental growth. In addition, AEW paid £2.6mn for a solus leisure and retail warehousing unit in Glasgow let to JD Sports Gym, a subsidiary of JD Sports Fashion (JD.). A vacant plot on the site offers potential for redevelopment, while a NIY of 7.4 per cent and low capital value of £99 per sq ft suggest potential for valuation upside.
Capital recycling aside, AEW’s investment manager notes strong occupational demand trends in both industrial and warehousing, sectors accounting for 71 per cent of the total portfolio. For example, a lease renewal with anchor tenant Charlie’s Stores at the Arrow Point retail warehouse in Shrewsbury achieved 46 per cent above estimated rental value (ERV), and the recent letting of a unit at an industrial asset in Rotherham locked in a rent 49 per cent ahead of the level paid by the previous tenant. Expect further acquisitions as AEW retains a £38.9mn cash balance, of which £30mn is available for new investments.
Importantly, AEW is well funded, having refinanced its fully drawn £60mn loan facility in May 2022 at a five-year fixed rate of 2.96 per cent, representing a comfortable 28 per cent loan-to-value ratio on the £214mn portfolio valuation. The £1.8mn interest cost is covered almost 10 times by gross passing rental income of £17mn, with the higher ERV of £19mn highlighting potential for rental growth when the group’s 35 commercial properties come up for rent review.
Admittedly, further declines in commercial property valuations can be expected in the near term, the key reason why AEW’s shares have succumbed to profit-taking in the past six months, having previously rallied from 110p to 135p after I first suggested buying (Alpha Research: ‘A high-yielding capital growth property play’, 19 November 2021). Indeed, based on historical averages, investors are likely to demand a yield of around 5.0 to 5.5 per cent from commercial real estate if 10-year gilts settle at 3.5 per cent. The implication being that average market values could fall by 15 per cent, or perhaps more.
Arguably, this is now factored into a 23 per cent discount to NAV, with the share price supported by an 8.5 per cent dividend yield. Importantly, AEW has strong reversionary value in its portfolio, so future rental uplifts will help offset the negative impact of downward valuations. It also has low balance sheet gearing and a cash balance equating to 20 per cent of NAV to take advantage of investment opportunities. The dividend stream looks safe – the board has paid out four quarterly dividends of 2p a share since I initiated coverage and have held the payout at this level for 28 consecutive quarters. The shares are worth holding onto. Hold.
Schroders REIT well positioned to weather the downturn
- Interim NAV falls slightly to £366mn (74.8p a share)
- EPRA earnings edges up to £8.6mn (1.7p a share)
- Dividend per share increased 20 per cent to 1.6p
- Comfortable loan-to-value ratio, net of cash, of 31.4 per cent
Schroder Real Estate Investment Trust (SREI:46p) looks well positioned to trade through a more challenging environment, having increased its portfolio exposure to sectors and locations enjoying high occupational demand from a granular and resilient tenant base. The portfolio also offers an above-average income yield and a near-term pipeline of asset management initiatives to support returns.
Around 46 per cent of the £532mn portfolio’s valuation is weighted to multi-let industrial estates, 11.8 per cent to retail warehousing, and 27.9 per cent to good-quality offices that are mainly located in higher-growth cities. In the six-month trading period, 33 new lettings, rent reviews and renewals generated £5.1mn of annualised rental income, or £1.9mn of additional rent above the previous level. Rent collection rates of 99 per cent across the 42 properties are at pre-pandemic levels, highlighting the resilience of the portfolio, too.
Moreover, ERV of £35.4mn reflects a reversionary yield of 6.6 per cent, well above the MSCI Benchmark of 4.8 per cent, and 15 per cent of the portfolio by contracted rents is inflation-linked, a tailwind for rental income in the current high inflationary environment. It’s worth noting that Schroder REIT benefits from relatively low leverage of 31.4 per cent, an average loan maturity of 11.2 per cent, low average total debt cost of 2.7 per cent and no near-term maturities. This is a competitive advantage relative to peers.
True, Schroder REIT's shares have slipped from around 52p to 46p since I initiated coverage (Alpha Research: ‘Targeting high-yield property to out-run inflation’, 4 March 2022), albeit the board has paid out 2.37p a share of dividends in the interim. The shares now trade 38.5 per cent below NAV and offer a 6.9 per cent annualised dividend yield, multiples that are clearly pricing in weaker property valuations in the future. Furthermore, the forthcoming correction could be relatively swift relative to past cycles given the lower levels of new developments in progress and a healthier banking system. Hold.
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