Lock into a high yield before gilt yields fall

Schroder Real Estate Investment Trust’s (SREI:43.7p) portfolio continues to outperform its MSCI benchmark, delivering an above-average 3.1 per cent income return over the six months to 30 September 2023.

Exposure to the multi-let industrial sector, representing almost half the £466mn portfolio valuation, supported underlying rental growth of 2.4 per cent over the period, the outperformance being buoyed by new lettings and the reversionary potential of the group’s 40 properties. The industrial book reported a 5.3 per cent total return.

Exposure to retail warehousing is also supportive. Representing 19 per cent of the portfolio valuation and benefiting from anchor tenants such as Lidl and Sainsbury’s, the segment reported a 2.3 per cent six-month total return. Both industrial and retail warehousing outperformed the benchmark by two percentage points. This more than offset a 3.5 per cent negative total return on the office portfolio, which accounts for 25 per cent of the portfolio.

Reversionary portfolio offers defensive characteristics

Generating annual rental income of £28.8mn from 322 tenants, the portfolio is valued on a net initial yield (NIY) of 5.8 per cent and reversionary yield of 8.1 per cent, both of which compare favourably with MSCI benchmark NIY and reversionary yields of 4.9 and 5.8 per cent, respectively. That’s important because although MSCI benchmark NIY yields are 0.8 per cent above the 10-year UK government bond yield, the long-term premium is closer to 1.5 per cent.

This implies a potential future adjustment in real estate yields, or alternatively a fall in gilt yields, may be required before fair valuations are hit. My money is on the latter. However, even if valuations contract further, the portfolio's reversionary potential combined with the yield premiums offer strong defensive qualities. In the first half, the portfolio declined 1.2 per cent in value, far better than the 2.9 per cent fall in the MSCI benchmark. Also, it has some inflation protection as 11 per cent of contracted rents are inflation-linked, a proportion that is increasing with ongoing asset management initiatives, and a further 10 per cent of rents benefit from fixed uplifts. Voids are falling, too, down from 11.2 per cent at the half-year-end to 8.9 per cent after the completion of the group’s Stanley Green Trading Estate development, an 80,000 square feet operational net-zero warehouse scheme in Manchester.

Well-funded portfolio mitigates debt refinancing risk

Schroders Reit’s debt funding places it in good stead, too. That’s because the group’s £175.6mn borrowings have an average interest rate 3.5 per cent, average maturity of 10.2 years, and 91 per cent of debt is either fixed or hedged against movements in interest rates. A loan-to-value ratio of 36 per cent is comfortable, so much so that interest servicing costs are covered three times by operating profit. This enabled the board to raise the half-year dividend per share by 5 per cent to 1.67p.

The shares trade on a 28 per cent discount to NAV and offer a 7.6 per cent dividend yield, but the real discount to NAV is deeper. That’s because the £16.8mn (3.4p) fair value benefit of a £129.6mn loan fixed at 2.5 per cent with Canada Life until 2036 is not included in the group’s NAV of £296mn (60.5p). So, although the share price is little changed since I covered the annual results in June 2023, the high dividend and reversionary potential of the portfolio make the shares worth locking away. Buy.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com at £16.95 each plus P&P of £4.95, or £25 plus P&P of £5.75 for both books.