The commercial real estate sector has taken a battering in the past 12 months, as highlighted by a 17.7 per cent decline in average values between 1 July 2022 and 31 March 2023.
Higher interest rates have impeded debt-backed buyers and increased refinancing risk for many borrowers, with a related fall in equity and bond prices leaving some institutions overallocated to real estate. The resultant fall in values has increased average real estate net initial yields (NIY) from 3.8 per cent in June 2022 to 4.7 per cent today.
However, occupational markets have remained resilient, with UK real estate delivering average nominal rental value growth of 2.5 per cent in the past year. That’s worth noting because there is a strong positive long-term correlation between rental growth rates and inflation, with sectors benefiting from structural demand drivers and lower vacancy rates delivering rental growth well above the long-term average of 0.9 per cent. For example, in contrast to the sharp decline in capital values, average industrial rental values have increased by 5.9 per cent since June 2022.
Importantly, there are signs that the investment market is now stabilising as the two percentage point gap between property yields and 10-year gilts approaches the long-term average for fair value. Combined with a more stable political backdrop and currency, this should attract domestic and international capital flows back to the sector.
On the hunt for high-yield property bargains
Schroder Real Estate Investment Trust (SREI:45p) has not been immune to the challenging market environment as the steep shift in bond yields has led to a 1.5 percentage point hike in the equivalent yield to 7.8 per cent embedded in the portfolio valuation.
However, the yield expansion-driven negative valuation movement was partly offset by 9.2 per cent growth in the estimated rental value (ERV) of the group’s portfolio, well ahead of the 3.4 per cent increase in the MSCI Benchmark. New lettings, rent reviews and renewals generated £2.3mn of additional annual rent on a reversionary portfolio that has an ERV of £37.8mn, up from £33.8mn in March 2022 – well above the annualised rental income of £29.2mn currently earned from 312 tenants. The portfolio’s above-average income yield and asset management initiatives to support rental income growth explain why the underlying portfolio only declined 7.9 per cent in the 12-month period compared with the 13.5 per cent fall in the MSCI Benchmark.
Moreover, Schroder Reit’s low-cost fixed-term debt gives it a competitive advantage as 90 per cent of group borrowings are either fixed or hedged against interest rate movements. The £178mn debt secured against the £470mn portfolio has an average maturity of more than 10 years and average interest cost of 2.9 per cent. What this means is that the investment manager can recycle cash into selective acquisitions to exploit its low-cost funding lines to enhance rental income. For instance, the £14.7mn acquisition of a mixed-use office and retail property in Manchester City Centre was acquired on a NIY of 7.8 per cent, reversionary yield of 9.1 per cent and low average capital value of £283 per square foot.
The additional rental income generated from rent reviews and capital recycling are being passed on to shareholders, hence the 14 per cent increase in the annual payout to 3.22p per share. Based on the fourth quarter dividend of 0.836p (ex-dividend date of 15 June), the shares offer an attractive dividend yield of 7.4 per cent in addition to a 27 per cent discount to net asset value (NAV). The true share price discount to NAV is deeper still. 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 £300.7mn (61.5p).
The high dividend yield and reversionary nature of a portfolio, which has a strong bias towards industrial and retail warehouses, explain why the holding has held up well since I covered the interim results (‘Positioning for a commercial market downturn’, 16 November 2022). Furthermore, with the gap between property yields and 10-year gilts close to the long term average for fair value, then there should now be scope for capital upside as rental growth drives valuations higher. Buy.
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