Property investment trusts and the case for value

Janus Henderson risked a gross understatement when it cited “ongoing uncertainty” as a reason for attempting to call time on its UK Property PAIF (GB00BP46GG64) this month. The open-ended property funds sector has endured two industry-wide series of trading suspensions in recent years, as well as hefty investor withdrawals in the meantime. Morningstar Direct data shows investors pulled a net £1.7bn from the Investment Association UK Direct Property sector in 2021 alone, it having previously seen £1.4bn exit in 2020 and nearly £2.5bn go in 2019.

We have previously made the case for looking beyond open-ended funds for exposure to physical property. As that implies, the wider world of real estate investing should not be off investors' agenda entirely, particularly as a fresh assessment of the closed-ended property funds suggests there is value to be found.

Rollercoaster ride for the generalists

As we approach the two-year anniversary of the UK’s first pandemic lockdown, it’s worth noting that life since then has been pretty volatile for the diversified, 'generalist' commercial property trusts. Companies such as BMO Commercial Property Trust (BCPT) sold off heavily in 2020 on the back of concerns about the durability of retail and office assets, and then enjoyed a fierce rally when investors turned to reopening trades. Now, the trusts continues to languish on enormous share price discounts to net asset value (NAV). 

There are many possible explanations. For a start, investors have favoured trusts with a focus on promising sub-sectors, from logistics offerings such as Tritax Big Box REIT (BBOX) to residential property specialists including Home REIT (HOME) and healthcare property plays such as Impact Healthcare REIT (IHR). Other examples include Urban Logistics REIT (SHED) and the fairly recently launched Life Science REIT (LABS).

Liberum analysis from late last year found that UK real estate investment trusts (Reits) with a focus on logistics raised £3.8bn between 2018 and 2021, with long-lease vehicles raising £1.8bn and healthcare Reits taking on £1.6bn. The diversified Reits, however, raised just £158m. This is also reflected in valuations, with some of the trusts mentioned above, including Tritax, tending to trade on premiums to NAV and offering lower dividend yields.

Part of the problem for the generalist names is they are perceived as being too exposed to unfashionable parts of the market such as retail and office space. High street retail still faces a structural decline, while demand for offices remains difficult to estimate. Other challenges also remain: as Alex Newman noted in his property outlook for 2022, office developers and landlords must raise the minimum energy performance certificate rating on all non-domestic rented buildings to at least a ‘B’ by 2030. Savills data suggests that 87 per cent of UK office stock falls short of this standard.

As Dan Cartridge, assistant fund manager at Hawksmoor Fund Managers, notes: “There’s a benefit in backing newer launches in areas like industrials where it’s easy to improve the environmental rating, or funds like LXI REIT (LXI) where properties are on very long contracts and the trust is building out new properties that will hit high ratings straight away.”

With this and the threat of a UK recession now possible in the months ahead, investors steering clear of diversified property trusts have a strong enough rationale for doing so. But many of these trusts are not so exposed to old fashioned sectors as valuations might suggest.

What do the generalists actually hold?

Our second chart shows how funds categorised by Winterflood as UK commercial property plays invest their money. Most of these disclosures date to either the end of 2021 or late in that year.

Many have decent exposure to industrials, an area tipped for further growth on the back of strong demand. The industrials category can encompass various assets, from industrial estates to logistics units benefiting from the shift to ecommerce. These sectors, and out-of-town retail parks (retail warehouses) are widely seen as growth sectors.

From BMO Commercial Property to Schroder Real Estate (SREI) and AEW UK (AEWU), some trusts still have a reasonable measure of exposure to offices and standard retail properties. But it’s worth noting that investors may have priced in too much uncertainty, and that such funds may well shift further away from vulnerable sectors in the future.

As Conor Finn, investment fund analyst at Liberum, noted in December: “The diversified Reits have generally been more active than the specialist Reits in divesting assets and recycling capital into new assets. We have seen very few examples of consistent disposal activity from specialist Reits investing in asset classes such as logistics, healthcare, residential and so on. Many of these portfolios have risen significantly in value, but disposals create the potential issue of being forced to reinvest capital at lower yields.”

As Cartridge warns, rotating a portfolio of illiquid assets can be a lengthy process, meaning investors could miss out on exposure to popular sectors while they wait for the generalist funds to recalibrate.

But there is an argument that trusts such as BMO Real Estate Investments (BREI) can be a cheaper play on areas such as industrials. Winterflood analyst Emma Bird recently pointed to BMO Commercial Property and Standard Life Investments Property Income (SLI) as offering value on recent discounts, with the former working well as a source of core exposure to UK property and the latter standing out as an actively managed portfolio with good environmental, social and governance credentials.

Finally, Winterflood argues their shares could actually re-rate due to their dividends. AEW UK REIT was the only diversified name to maintain its dividend level throughout the pandemic, Schroder Real Estate recently announced an increase which reinstated its pre-pandemic level of payouts, while LXI initially cut its payout in the pandemic but later increased this above pre-Covid levels. Other trust have continued to pay, albeit at reduced levels, since the start of the pandemic, and any improvement in these payouts could result in a share price boost.

More generally, property still appeals as both an inflation hedge and a possible diversifier. On the first point, Bird notes that the specialist trusts are more likely to have inflation-linked income than the generalists, but adds: “A number of fund managers highlight that lower inflation-linkage could actually be positive within the industrial sector, where open-market rental growth is forecast to exceed capped inflation-linked rental growth over the next few years.”