With interest rates looking like they've peaked and real estate investment trusts (Reits) looking to return to growth, this is the time many investors like to 'buy the dip'. Use this window to buy Reits trading at a discount to net asset value (NAV), so the thinking goes.
We have questioned the wisdom behind this idea before. NAV is a helpful metric for telling investors what a valuer has decided a Reit's buildings are worth minus its debt, but it does not tell you how well a Reit has managed those buildings.
There are other approaches. US Reit investors focus much more on earnings than NAV, and countless non-Reit investors use price/earnings (PE) ratios to find value. And while earnings are in some ways less relevant to Reits in that they have their own flaws from a valuation perspective, investors should not ignore them completely. Earnings analysis can unearth some hidden bargains.
EPRA vs IFRS
The main drawback of using IFRS earnings to measure a Reit's performance is that it includes valuation swings. Since interest rates started rising in 2022, Reits' IFRS earnings per share (EPS) have plummeted due to sinking valuations.
Some investors might view all this as a fair representation of performance. After all, assets with high tenant demand hold more value than vacant assets. For example, Regional Reit's (RGL) portfolio of regional offices has lost much more value than Unite's (UTG) portfolio of student accommodation buildings. As such, Unite is one of the few Reits not to have posted an IFRS loss per share during this downturn, although it did do so during the Covid-19 pandemic when lockdowns emptied its buildings.
However, while IFRS earnings can reveal which Reits have the best tenant demand, the simplest way to analyse this metric is to look at EPRA earnings, which strip out valuation changes and calculate net rental income (rental revenue minus the costs of running the portfolio) on a per-share basis.
By doing this, Reits often reveal their true colours. Unsurprisingly, Unite's EPRA EPS is many times higher than Regional Reit's. However, what is somewhat startling is the extent to which the market has factored this into Regional Reit's share price. It trades at just two times its EPRA EPS, making it the cheapest UK Reit by this metric by far.
The obvious caveat to this is how badly Regional Reit has performed, having admitted last week it was mulling tapping shareholders for equity at a "material discount" to NAV to keep the wolves from the door. Other Reits are cheap by this metric for a reason, including the troubled retail landlord Hammerson (HMSO).
However, some PE valuations do look out of kilter with fundamentals. Assura (AGR) is priced the same as Hammerson by this metric, which we believe undervalues the hospital landlord. Assura has high leverage, but its portfolio is fully let to the NHS, so the visibility and near guarantee of its future earnings justifies the debt.
This price mismatch is not unusual. Many other UK Reits have an EPRA PE ratio similar to Hammerson and Assura's despite varying in terms of their sector and their performance. Indeed, most UK Reits' prices hover between 10 and 20 times EPRA EPS, with only a handful outside that window. As such, many other cheap-looking opportunities appear.
For example, Assura's main rival, Primary Health Properties (PHP), has been paying growing dividends for 28 consecutive years because its long leases to the NHS give it visibility. Sirius Real Estate (SRE) has also been raising its dividend for almost a decade, thanks to a model of consistently growing its rent roll by actively managing short leases to SME businesses. However, despite their successes, their PE ratios are only marginally above that of Triple Point Social Housing (SOHO), whose business model faces vocal criticism from charities, regulators and investors.
Priced for growth?
The data also helps to identify some expensive-looking businesses. For some, these heightened prices look justified, but for others, there are questions about the wisdom of such lofty valuations. Grainger (GRI) and Unite are examples of where quality comes at a price, with both having posted surging net rental income over the past few years due to booming residential and student accommodation demand.
And despite ranking as one of the most expensive Reits by EPRA earnings, the data also shows how it is cheaper than its closest peer, Empiric Student Property (ESP), which is sometimes considered the lower-priced alternative to Unite because of its discount to NAV. This data flips that assumption on its head.
Then there is Life Science Reit's (LABS) eyebrow-raising valuation. The Reit is cheap on a discount to NAV basis, but since listing in late 2021, the life science landlord has struggled to fill its office and lab space buildings with enough tenants to generate a decent rent roll. That means EPRA earnings are much lower than it is for more mature Reits. The rent roll may grow in time, but the PE valuation shows how far the company is from where its value implies it should be.
The final thing to consider is Great Portland Estates (GPE). We have long been bearish on this stock because of its overdependence on long leases in the central London office market. Since Covid, it has struggled to grow its rent roll while rising interest rates have hammered its valuation. Some might consider it cheap on a discount to NAV basis, but EPRA PE presents an alternative view. By this metric, GPE looks expensive, giving more grist to our bearish rating.
EPRA PE analysis is far from perfect. As well as ignoring property valuation, it overlooks debt, dividend yield, covenant strength, property devaluations and the potential for further rental increases. Still, if you want to find a Reit with hidden earnings potential, using this metric can unearth some surprises.
