Is it time for investors to reconsider real estate investment trusts (Reits)? Peel Hunt seems to think so because of the income on offer, even though its analysis could be considered counterintuitive given the prevailing negative sentiment towards commercial property.
The reasons for this negative outlook have been covered ad nauseum, but in essence boil down to the rising cost of capital, and falling demand for office space amid changing work patterns. The latter factor may not prove as deleterious as initially feared, at least not as much as it did immediately after lockdowns. Recently published figures from the Office for National Statistics showed 44 per cent of the UK workforce is operating under hybrid arrangements, but this is an evolving trend and it differs markedly from industry to industry. In other words, the jury is out on this one, even though the risks to office valuations are likely to remain on the downside.
There are other factors at play, such as the obligations for commercial landlords to spend capital upgrading properties under the government’s Minimum Energy Efficiency Standard. But the fact that many real estate companies will see their borrowing costs rise dramatically when they refinance their debt is certainly the most sobering prospect. Little wonder, then, that billions have been wiped off valuations since midway through 2022.
Across the Atlantic, the property industry is in even more dire straits as sentiment is bound up with the ailing US regional banking sector, heightening fears over contagion. Moody's Analytics recently warned that commercial real estate prices in the US registered their first decline in 12 years during the first quarter of this year, while fund manager surveys confirm that capital has been flowing out of the sector.
So, it’s not difficult to appreciate why sentiment has soured, but is it time for a contrarian approach? The reality is you can't address that question unless you assess the prospects for income across the sector – and the Peel Hunt analysts have done just that. Their conclusions are more encouraging than you might imagine.
Understandably, they place great emphasis on debt servicing and dividend coverage rates, as distributions have been the principal driver of total returns within the sector. Over the next couple of years, the analysis points to a 20 per cent increase over the corporate interest rate floor at the end of 2021. Based on the swap forward curve, the effective interest rate could increase by 200 basis points between 2024 and 2029.
The upshot is that the rise in debt servicing and refinancing costs will be more than offset by the projected increase in gross rental income. And there is a timing element to take on board. The analysts make the point that the property sector was unable to take full advantage of the fall in rates through 2016-20 due to the “duration and largely fixed nature of [longer-term] borrowings”, but the opposite dynamic also applies, and this time to the benefit of shareholders.
Cash dividend coverage ratios differed significantly across the handful of companies covered within the analysis, ranging between five-year average multiples of 1.1 to 2.7, and there was also a marked disparity in payout ratios, so it may be unwise to draw too many general conclusions, especially given several Reits outside of the analysts’ coverage have recently cut their dividends. Yet prospects for dividend growth in the sector are broadly favourable due “in no small part to its conservatism regarding absolute debt levels”.
Regardless of the ability of Reits to offset increased financing costs, the reality is that persistent inflationary pressures will constrain real rates of return, but following the sector-wide markdown, most of the larger constituents within the sector are trading on forward dividend yields approaching 6 per cent or more, providing a potential bulwark against the ravages of inflation.
The FTSE Real Estate index has lost a third of its value since the beginning of 2022, so logic dictates that it will begin to retrace at some point, yet it’s conceivable that the shake-out in the sector has some way to run, evidenced by the continuing number of property sales that have been undertaken simply to generate liquidity to meet redemptions.
Many Reits are busy realigning their portfolios to reflect the new reality on the ground and we can’t be sure when the dust will eventually settle. That said, medium-term price moving averages have begun to coalesce with 50-day rates, suggesting that selling pressure may have peaked.
