This article was taken from the Autumn 2024 issue of The 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
Property is somewhat of an obsession for the British, with home ownership a common aspiration and owning rental properties often seen as an attractive method of generating income. For those looking for a diversified and liquid way of investing in property markets, Real Estate Investment Trusts (REITs) can be a valuable addition to portfolios for both capital and income returns, not so much on the capital side in recent years, however.
UK based investors generally take a more nuanced approach to valuating these vehicles, preferring to focus on the discount to Net Tangible Assets (NTA), the tangible assets minus the business’ liabilities. Within the UK listed REIT sector we note an interesting situation with some investment vehicles trading at small premiums, while others trade on wide discounts. A more value focused investor may lean into the company, trading at a discount, seeing greater value than the other but there may be a case, however, for buying the premium trading company.
Running with a live example of two REITs covered within research, in this article we’ll complete a short comparison, renaming the REITs as Company A and Company B. Both are UK listed with assets of more than £1bn, more than five years of trading history and dividends that are fully covered by earnings. Company A holds a diversified portfolio of property assets across the industrial and commercial sectors. The current dividend yield is 5.6% and the shares trade at a premium to the NTA. Company B holds a portfolio of supermarket assets. The yield is 8.3% and the shares trade at a 19.2% discount to NTA. The reason behind one company’s share price trading at a premium and the other at a discount can be driven by many factors, from size and liquidity to the sector within which they operate, the latter arguably the more important factor given the impact of sentiment on financial markets. Linked to the sector within which the REIT operates is the dividend growth outlook, with the market in some situations pricing faster dividend growth companies with a lower yield over the slow or no dividend growth companies where a more premium initial yield may be required by investors.
The concept of reversionary yield, the yield figure achieved when the current rent meets the estimated rental value, is important when thinking about the earnings and dividend growth. Having a reversionary yield figure, higher than the portfolio’s current net initial yield, indicates potential for future rental growth that can feed through to higher dividend distributions, provided there’s strong cost control and profit margins remain stable or improve.
To give a live example of reversion, Company A recently announced the acquisition of an urban logistics portfolio for a net initial yield of 5.8%. On the £78m purchase price this equates to rental income of roughly £4.8m per annum. The reversionary yield over the next two years on the assets was announced as 6.9%, meaning that the income generated could rise from £4.8m per annum to £5.8m, or a 9.9% compounded growth rate. This is an earnings accretive acquisition that can aid in the compounding of earnings and dividends through time. Within the company’s logistics portfolio, the reversionary yield isn’t released in the annual report. There was, however, comment on the estimated rental value of the logistics assets that account for 43% of the whole portfolio being 26% ahead of the current passing rent. This indicates a greater level of income that can be captured in the coming years that can feed through to higher earnings and dividend distributions.
In the case of Company B, annual results showed a 5.1% reversionary yield on the portfolio compared to the 5.9% net initial yield, indicating overrenting, where the current rent is higher than a market comparable. The underlying leases paid by tenants in this portfolio are predominantly inflation linked with a cap on the rate of increase, so we know the rental income will grow but, come a lease renewal, there’s potential that the rental income could decline to the market rate. In this situation, growing dividend distributions becomes more difficult and can result in markets pricing the shares lower, than the net tangible assets, to compensate investors for a lack of dividend growth with a more premium yield.
Which company might be bought within a portfolio is very individual. For an investor needing a more immediate high yield, Company B is likely to be the answer, taking the greater current dividend distribution and sacrificing the future distribution growth. For an investor with a longer timeline and less yield requirement, Company A can potentially provide a compounding income stream through time. For a similar investment amount, Company B will provide a greater level of income, but with compounding of dividend growth over time, distributions received from Company A could catch up and surpass.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance. The information and views were correct at time of writing but may have changed at point of reading.