Real estate investment trusts (Reits) had reason to celebrate last week. The potential end of the Bank of England's two-year rate-hiking cycle may mean commercial property valuations can begin to recover. The timing was particularly useful because Reits are also facing a new problem: weak economic growth threatening their rental income.
This presents a challenge for investors, too. Because, while comparing Reits by their asset values is simple enough, comparing them by their rent can be more challenging.
Rent: complex but vital
The problem with headline rent as a comparator is that it does not tell you how much money, time and effort a Reit has spent getting a tenant into its building. For example, an office Reit might increase the headline rent on a building by £100,000 a year, but it might then offer the tenants a rent-free period, more services and other benefits to convince them to sign for that increase. When you factor such goodies into the rent, it might only amount to a £50,000 net increase – or even a net decrease.
As such, net rental income is the industry standard go-to figure. It records the rental revenue less the cost of running the buildings, including any services or incentives it might have thrown in. In other words, the figure is a Reit’s profit before valuation changes are taken into account – as well as other costs such as tax and administration.
Yet, even though rental income is arguably the best number with which to measure a property company’s ongoing performance, there are things to watch for here, too. First, it does not tell you whether the dividend is covered: many Reits choose to pay uncovered dividends. Second, not all Reits or property companies record rent in the same way, and some don’t record it at all, making comparisons difficult.
Notwithstanding those caveats, Investors’ Chronicle analysed the net rental income or closest equivalent figure among a selection of prominent UK Reits. We then compared figures year on year to get a picture of recent growth trends. In cases where a net rent figure or similar was not available, operating or gross profit before changes in property value has been used instead (see table).
There are other reasons for caution when looking at such numbers. Two Reits, LXI Reit (LXI) and Shaftesbury Capital (SHC), have more than tripled and more than doubled, respectively, their net rental income in the past 12 months as a result of mergers. By becoming a bigger company, both benefited from a much larger rent roll overnight. As with some of the others mentioned below, we have excluded them from the table for ease of comparison. However, that doesn’t mean investors should ignore them or discount their performance. Growing rent roll by acquisition is still a means of growing rent roll.
Growth by acquisitions, albeit not mergers, explains many other net rental income leaps. Supermarket Income Reit (SUPR) hiked net rent by a third in its most recent results, largely because it bought nine more supermarkets over the year to 30 June. The strong growth seen in recent years at PRS Reit (PRSR), another name not included in the table, is a further example. The company grows by paying housebuilders to develop houses for its portfolio, which it then rents to families. The fact that Vistry (VTY) and Barratt Developments (BDEV) both said they would look to build more homes for pre-sales and bulk sales to organisations like PRS suggests the Reit will continue to be able to grow this way for some time to come.
However, growth via this strategy requires cash or debt. The former is something Reits rarely have – it is highly unusual for a Reit to be in a net cash position – and the latter has become much more expensive because of the jump in interest rates. Supermarket Income Reit funded its deal spree by selling 21 stores to Sainsbury’s, cashing out a clutch of properties with low property yields and using the money to buy ones with high property yields. The company has told the IC that it was unlikely to repeat that trick this year (see page 32).
On the other end of the debt spectrum, consider Great Portland Estates (GPE). It posted net rental income growth of 13.3 per cent for the year to 31 March. While this is much lower than Supermarket Income, its net debt to net equity ratio is also much lower: 21 per cent compared to 55 per cent. Investors should be wary about how much a company is fuelling rental growth via debt.
The other thing investors should be aware of when comparing net rental income is the scale. Were it included, top of the list for an increase without the help of mergers would have been Life Science Reit (LABS). It also grew by acquisition and development, being in the early stages of building a portfolio having only listed in late 2021. While its growth rate is commendable, £2.5mn in growth for a larger Reit would barely register.
The three FTSE 100 Reits Unite (UTG), Segro (SGRO) and Landsec (LAND) posted increases of 11.3 per cent, 10.3 per cent and 10 per cent. We are bullish on all three companies because, at their size, the rental upticks are strong enough to be evidence of attractive growth. However, this raises further questions for rent analysis as investors begin to factor in a Reit’s size relative to their rental income and their operating margin – an analysis that we have attempted before.
The final thing to be aware of when comparing net rental income is the pandemic. Though past performance is by no means an indicator of future performance, it is worth considering whether some Reits' large leaps in net rental income this year were the result of simply returning back to 2019 net rental income. Workspace (WKP), Empiric Student Property (ESP), Great Portland Estates and Landsec all posted a steep drop in net rental income in 2021 due to Covid strangling demand. Their performance since then has been mixed.
Complicated as it is to weigh up the various factors impacting growth in net rental income, the figure still offers insight. It can also be a way to understand how the company intends to grow and at what cost. As Reits move away from dealing with falling valuations and towards the possibility of a recession dragging down their rent, these considerations become particularly important.
