Ian Cowie: a sector with plenty of bargains for income investors

Our columnist considers whether bargain-basement prices for these investment trusts represents good value, or are they merely cheap for a reason?

Working from home (WFH) will empty offices permanently and knock 38% off London property prices, the American investment bank Citi predicted this week.

As if to demonstrate that WFH is not the only threat to commercial real estate valuations, the next day Fenwick announced the closure of its flagship store on Bond Street, with the rise of online shopping being blamed.

No wonder the average share in the Association of Investment Companies (AIC) ‘Property: UK Commercial’ sector is priced 24% below its net asset value (NAV). Such depressed valuations have pushed up the average dividend yield these investment trusts offer to nearly 6%.

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So income-seekers should consider whether today’s bargain-basement prices represent good value, or are these shares merely cheap for a reason? Is this a passing phase or a permanent change in the way we work and spend our time and money?

Some folk argue that WFH could prove a post-Covid fad. Recessionary fears might force more workers back into offices for ‘face time’ with the boss, on the basis that it’s easier for her - or him - to sack the staff they never see.

Not so many people predict any reversal in the rising popularity of shopping online. Convenience and lower costs are big advantages for digital retailers but successful bricks and mortar rivals continue to offer ‘retail therapy’ that cannot be replicated online.

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Either way, commercial property investment trusts provide professionally managed exposure to assets that only the wealthiest folk could dream of accessing directly. Better still, while office blocks and shopping malls can prove difficult to sell in a hurry, closed-end funds - such as investment trusts - enjoy an important structural advantage over open-ended funds - such as unit trusts.

Investment trust managers and their shareholders need never be forced to dispose of assets at firesale prices, just because sentiment has turned against the sector. Instead, the share price can take the strain.

By contrast, unit trusts have on many occasions over the years suspended trading because of this fundamental mismatch between illiquid underlying assets and the notion that unit holders can always get back into cash.

Lest that distinction sound like a technicality, Mark Carney, a former governor of the Bank of England, described unit trusts’ potential problem quite plainly a few years ago. He said: “These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren't liquid.”

Here and now, the top-performing investment trust in the UK property sector over the last five years has delivered total returns of 54% over that period, followed by losses of nearly 4% over the last year and it continues to yield just over 8% dividend income. AEW UK REIT Ord (LSE:AEWU) has an underlying portfolio of smaller commercial properties led by Central Six Retail Park in Coventry; Eastpoint Business Park, Oxford; and Gresford Industrial Estate, Wrexham. AEWU’s shares are currently priced 18% below their NAV.

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Second in this sector over the same period is LXI REIT (LSE:LXI), which aims for income and capital growth over the medium term by specialising in “long-term index linked leases with institutional-grade tenants”. This produced total returns of 45% over the last five years, followed by losses of nearly 16% with a current dividend yield of 5.4%. LXI shares trade 17% below their NAV.

The self-descriptive Supermarket Income REIT (LSE:SUPR) ranks third over the same period with a five-year return of 38% and a one-year loss of 8%, while yielding 5.6% income. Apart from joint ventures that account for 10% of its underlying assets, this fund’s top three supermarkets are based in Ashford, Kent; Beaumont Leys, Leicestershire; and Scunthorpe, Lincolnshire. SUPR shares cost 8% less than their NAV.

None of the above has a 10-year track record. By contrast, the top performer in this sector over that period is CT Property Trust Ord (LSE:CTPT), which achieved a total return of 106% over the last decade, followed by losses of 9% and 11% over the last five and one-year periods. CTPT yields 5.5% and is priced 41% below its NAV.

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The runner-up over that decade was Schroder Real Estate Invest (LSE:SREI), which delivered a total return of 98%, followed by losses of nearly 2% and 5% over five and one-year periods. SREI yields 6.5% and trades at a 39% discount to NAV.

Bargain-hunters should beware that some NAV estimates are more accurate and up-to-date than others. Commercial property surveyors can be just as prone to error as their residential counterparts.

It is also important to remember that dividends are not guaranteed and can be cut or cancelled without notice. However, these yields might pay investors to be patient, while we wait to see whether the widely anticipated economic recession proves better or worse than expected. 

Many shareholders are also homeowners and may feel we already have enough exposure to residential bricks and mortar. But commercial real estate is a very different asset class - producing dividends, rather than repair bills - and current prices could produce real returns for medium to long-term investors.

Ian Cowie is a freelance contributor and not a direct employee of interactive investor.