Hunting for bargains: REITs trading at big discounts

It’s impossible to look at the property market today without considering the impact of higher interest rates. All else being equal, higher rates put pressure on property prices.

Housebuilders are one obvious area of interest, but I’ve also been looking at REITs. These property investment vehicles allow investors to generate income from a much wider range of property classes.

Looking at the UK Residential & Commercial REIT sub-sector right now, almost all of the 50 REITs listed are trading at a discount to book value. In many cases, the discount is over 25%. My research suggests the FTSE 350 REIT sector is trading at a level not seen since 2012.

This cautious market view contrasts with the confident-sounding trading updates issued by many REITs in recent months. Median stats for the sector also look fairly benign:

Are today’s discounted valuations a sign that bigger problems lie ahead, or has the market sell-off gone too far and created opportunities for savvy investors? I think the answer is probably a bit of both, as I’ll explain.

In the remainder of this piece, I’ll highlight some potential concerns and explain what I look for when analysing REIT accounts.

I’ll also highlight some examples of REITs that I think offer good value and a reasonable safety in today’s market.

What’s a REIT?

Before I go any further, I think it’s worth taking a brief look at what distinguishes a REIT from a regular company.

A REIT – or Real Estate Investment Trust – uses shareholder equity and debt to invest in property.

As with a regular investment trust, shares in a REIT are bought and sold without affecting the underlying assets, which belong to the REIT itself. Shares can trade at a discount or premium to their book value.

REITs are exempt from corporation tax on profits from their rental business and certain property disposal gains. In return, they’re required to distribute at least 90% of their profit from property rental to shareholders.

Cash is normally returned to shareholders as dividends. Payouts funded by tax-exempt profits are classified as Property Income Distribution (PID), while payouts from REITs taxed profits are classified as regular dividends.

PIDs and normal dividends are treated slightly differently for UK tax purposes. This may be worth investigating if you expect to receive substantial income from REITs.

FTSE 100 members British Land (LON:BLND) and Land Securities (LON:LAND) were among the first to adopt the structure when it was introduced to the UK in 2007. But the number of listed REITs has mushroomed since the REIT regime was relaxed somewhat in 2012.

This coincided with the start of an unprecedented period of low interest rates. As a result, many of today’s REITs are untested in a normalised interest rate environment.

Source: Bank of England

What could go wrong?

REITs aim to generate a profit from the spread between their funding costs (dividends and interest payments) and rental yields on the property they own.

I think REITs can be a great way for individual investors to generate an income from different types of property. But I think it’s inevitable that some of them will run into problems in this changing financial environment.

Funding challenges: Borrowing costs, rental yields and property prices are all interlinked.

Higher borrowing costs mean that the rental yield required from a property also rises. This means either that rental income must rise, or that property prices must fall. As with fixed-rate home mortgages, there’s some lag on this feeding into the system. But it has to happen.

If the gap between rental income and borrowing costs is permanently compressed, then REITs’ dividend-paying capacity will be reduced, unless they can reduce leverage.

However, raising capital in this environment isn’t easy. In general, raising equity when shares are trading below book value is very difficult.

The only other way to raise funds and reduce gearing is often to sell property. We’re already seeing some of that, albeit often under the guise of ‘capital recycling’ or ‘portfolio optimisation’.

Environmental ratings: sustainability requirements are another concern. Starting in April 2023, commercial property for let in the UK requires an EPC rating of E. In 2027, this requirement will rise to an EPS rating of C, and in 2030 it will be B.

To meet these standards, much of the UK’s commercial property will need significant refurbishment. In some cases, it won’t be cost effective or even possible. Assessing the likely cost and feasibility of these improvements isn’t easy.

Understandably, tenants aren’t keen to sign leases that could see them occupying non-compliant property in a few years’ time.

What seems to be happening is that tighter environmental standards are combining with lower post-pandemic office occupancy to create a two-tier market.

High quality, modern office space in London and other primary locations is doing just fine. Occupancy is high and rents are rising – Landsec’s London office properties are 99% let.

Older and less well-located office property is not doing so well at all. Small cap Regional REIT (LON:RGL) – which describes itself as a regional office specialist – saw its net asset value fall by 25% in 2022. More than 15% of its property, by rental value, is vacant.

I’ve focused on offices here. But other dynamics again may apply in sectors such as healthcare, logistics, and residential property.

The challenge is that many of these factors will interact and vary in ways that we can’t yet predict.

For this reason, my approach at the moment is to take a fairly conservative view when analysing REITs.

Near-term risks may not yet be fully evident – I think it makes sense to look for a generous margin of safety.

What I look for in REIT accounts

Property accounting includes a number of metrics that you won’t find in other sectors. I think it’s worth getting to grips with a few of these. They make it easier to understand the financial risks and compare different REITs.

• Loan-to-value (LTV): net debt as a percentage of the value of the property portfolio. As a rule of thumb, I’d say under 30% is low and over 50% is very high. Loans often include a LTV covenant, often at around 50%. Remember that the LTV ratio can rise if property values fall, even if debt remains unchanged.

• Weighted Average Unexpired Lease Term (WAULT): the average lease term remaining across the portfolio, weighted by rental income. A higher WAULT should provide security of income – unless tenants can’t pay.

• Average debt cost: this needs to be funded from net rental income, preferably leaving enough over to fund dividends as well.

• Weighted average debt maturity: the average remaining time until the REIT needs to refinance its debt. Typically, this metric masks a much wider range of individual maturities, so it can provide a false sense of reassurance. But it’s a useful metric.

• Fixed rate or floating rate: if interest rates have been fixed or hedged, then the REIT will enjoy stable debt payments for the remaining period of the fix. Payments may then rise. Floating rates mean interest payments have probably already risen - check the next set of accounts.

• EPRA vs IFRS: EPRA is the European Public Real Estate Association. It provides a methodology for calculating underlying earnings and net asset value that provides a more realistic view of the underlying rental performance of a REIT than standard IFRS earnings.

Other measures frequently seen include Estimated Rental Value or ERV, which is the expected rent if a property was let today.

ERV often appears close to measures of reversion, which is the theoretical gain (or loss) in rental yield that would result if the portfolio was fully re-let at the ERV. Reversionary gains often sound attractive, but can take many years to achieve.

3 REITs I’d consider today

What kind of REITs would I consider buying today? I’m sure there are opportunities in beaten-up small-cap REITs right now, but I don’t think I have the sector knowledge needed to reliably identify them.

For me, this is the time to focus on quality. Some of the metrics I’d look for today are:

• A sub-30% LTV

• A sizeable discount to book value

• Average debt maturity that is comparable to WAULT

• Ideally, four or more years of predictable rental income from existing tenants

• Good quality, modern property portfolio

The good news is that REITs satisfying these criteria aren’t hard to find at the moment. Here are three I’d consider today:

Landsec: this FTSE 100 REIT has a LTV of 32%, a WAULT of 6.5 years and average debt maturity of over 10 years. Occupancy of the group’s modern London offices is 99.5%, retail is around 95%.

This investment-grade package is currently available at a 35% discount to NAV, with a 6.4% dividend yield. Risks remain, but I think this looks a fairly safe choice.

SEGRO (LON:SGRO): I bought these shares at 250p in 2013 and (sadly) sold much too soon. But the market heavyweight in the warehouse sector has seen its share price halve since 2021 and is now trading more than 20% below book value - the biggest discount since 2012.

Long leases, stable financing and high occupancy suggest lowish risk. My main concern is Segro’s substantial pipeline of new developments. If occupier demand softens, this could become a drag on profitability and cause borrowing to rise.

Derwent London (LON:DLN) - not as big as Landsec, but with a quality portfolio of well-invested office property in London’s West End. Q1 lettings were 6.6% above ERV and the portfolio’s vacancy rate is under 5%.

The LTV of 23% looks reassuring to me. Portfolio WAULT and average debt maturity are both c.6 years. Derwent London shares currently trade at a 40% discount to December 2022 NAV and offer a yield of nearly 4%. These metrics were last seen in 2008.

I think there’s value here, unless I’m missing something.

Final thoughts

I think investors can find good value in UK REITs at the moment, but it’s important to be selective. Some of the very high yields on offer look risky to me.

Landlords are going through a period of adjustment to higher rates that could last for several years. In my view, the main risk is that this process could be longer and deeper than anyone is yet expecting. The outlook for sub-standard commercial property in secondary locations seems particularly unclear.

While I favour a systematic approach to investing, I think this is a situation where investors need to dig into the accounts to find the best opportunities.

However, with high-quality REITs trading at discounts not seen since the financial crisis, I think it’s possible to take a conservative approach and still find attractive valuations.

If I’m right, I think patient investors could enjoy attractive medium-term returns, without needing to take on too much speculative risk.