Is Civitas top of the REITs?

What makes a real estate investment trust (REITs) worth holding? Beyond the obvious – that it is easier to buy a real estate portfolio with lots of fellow shareholders than become a property tycoon overnight – there are several important boxes to tick.

The first is that a trust’s underlying assets are in a stable part of the property market. Because a REIT’s chief attraction is usually its streams of rental income, which in turn fund dividend payments, there needs to be a strong prospect that there will be tenants to pay the rent in perpetuity. Call this the future-proof test.

There also needs to be some sort of growth story, so that returns and dividends stay ahead of long-term inflationary pressures and interest payments. This can be achieved by a mixture of portfolio management and rent uplifts, balanced against the cost of funding from debt and equity markets. This we might term the opportunity test.

Growth also means overheads are more easily covered, or third-party contracting can be brought in-house. These are classic economies of scale.

Civitas Social Housing (CSH) – which rents out care homes to housing associations on long-term leases – appears to meet each of these criteria. Prior to the pandemic, there had been some concern about the stability of its tenants, most notably after the collapse of Civitas customer First Priority. But results for the 12 months to March highlighted the virtues of a rent roll ultimately backed by the government, as collections remained high and rental income pushed up 4.4 per cent to £47.9m.

The only blot on this ledger was a provision of £256,400 to reflect efforts to collect aged arrears. Compare that to fellow REIT Land Securities (LAND), which only managed to collect two-thirds of the rent owed by tenants in its latest March quarter, for a reminder of how much worse this could be.

As commercial property landlords work out a future for their sites and business models, Civitas can rely on two pillars of indirect support. One is a government whose flagship capital support policy for housing is a 95 per cent mortgage guarantee scheme for first time buyers. A second, to quote non-executive chairman Michael Wrobel, is “a substantial and structural mismatch between the need for social housing and its availability, especially bespoke specialist care based social housing”.

This set-up all but assures growth opportunities for private sector players like Civitas and Triple Point Social (SOHO). A plan to “expand into advanced homelessness provision”, as well as deploying a woefully under-workshopped piece of corporatese, sees the trust branch into another under-supplied sub-sector while piggybacking the strong market reception of fellow socially-minded REIT, Home (HOME).

Despite these tailwinds, Civitas made just six property acquisitions in the period. These explain the 5 per cent uplift in the annualised rent roll to £50.8m and 4.2 per cent growth in investment property pile, respectively. One senses, however, that activity will soon start to pick up following February’s drawdown on an £84.5m facility with M&G. Indeed, £19.5m of this was used to acquire 25 supported living and care facilities across Wales and England after the period end, and there remains a “substantial pipeline of over £200m” of opportunities. Alas, no comment was made on the pace of near-term purchases.

Still, this backdrop will provide some comfort to anyone querying the group’s dividend cover, which despite improving still came in at 91.6 per cent for the year. Stronger sentiment toward the shares suggests investors recognise it is a matter of time before debt facilities are used to bolster statutory income. In turn, portfolio growth should help bring down gearing.

To these assets, Civitas would like investors to add a fourth criteria: the trust's ability to add value beyond the bottom line. Management points to an independent study which found the trust created “a social value of £127m…including £79.5m of savings to the public purse” in the 12 months to March.

The ultimate civic benefit of the tax treatment of REITs – which are exempt from corporation tax on income profits and capital gains, passing on tax liabilities to an investor base that often hold shares in levy-proof wrappers – was presumably beyond the scope of the study. But a freshly-inked tie-up with E.ON to reduce carbon emissions across the portfolio will cheer both ESG-minded allocators and cost-conscious investors.

Such pledges are of a piece with corporate pledges to improve society, even if they only happen to coincide with profit-seeking activity. But that isn’t stopping landlords from trumpeting their contribution to the greater good.

Enter stage right, UK Residential REIT (URES), which is set to begin trading on 16 July after announcing plans to raise £150m in an initial public offering. The vehicle’s investment manager L1 Capital, which plans to buy a seed portfolio that includes 1,214 residential units in cities including Bristol, Liverpool, Manchester and Birmingham, highlighted affordability concerns in the housing market as a linchpin of its growth strategy.

In practice, this means targeting the middle market of the private rental sector, which held up more strongly than both the top and bottom ends last year. “Our average rent is £825 a month,” L1 Capital chief investment officer Kee Gan told us. “That’s the median point outside of London, and it’s a much more affordable product where the mass market is.”

L1, which already manages a residential property portfolio worth around £50m, cites affordability as the key ingredient of “a defensive and stable tenant base” in its prospectus. “In the event that a tenant leaves, the company’s buildings are able to appeal to the mass market,” it adds, pointing to high costs of home purchases, fiscal headwinds around buy-to-let and lifestyle flexibility as drivers of demand in the private rented sector.

Gan also highlighted the structure of the residential market in the UK, which is dominated by owner-occupiers and private landlords. By his firm’s estimates, just 3 per cent of the country’s private rented sector is in public hands, compared to around 40 per cent in the US and 60 per cent in Germany.

The opportunity hasn’t gone unnoticed by foreign capital. This week, Australian bank Macquarie announced plans to raise £1bn from debt and equity markets to invest in the purpose-built rental housing sector, following in the footsteps of PRS REIT (PRS).

By contrast, URES’ focus is on acquiring existing apartment blocks at a 20 per cent discount to market value. This also sets it apart from Civitas, whose assets are valued as a function of its net initial yield and the reliability of an average unexpired lease term of 22.6 years.

One point of interest over the coming year will be the effect of rising inflation on rental incomes. Civitas benefits from annual inflation-linked uplifts based on the consumer price index and capped at 4 per cent. Gan says he expects rents in URES’ portfolio to increase in line with wage growth.

Right now, the former sounds more dependable, and the shares remain a buy. But both models looks solid prospects for capital growth.

Last IC View: Buy, 103p, 30 Nov 2020