REITs offer opportunities for investors looking for bargains

Real estate investment trusts (REITs) are attracting the attention of professional investors and analysts. David Prosser explains why, and names investment trusts to play this area of the market. 

Whisper it quietly, but the UK’s bombed out property sector may be showing some signs of life. After a torrid 2022 – the FTSE 350 Real Estate Index lost 19% over the year as a whole – share prices have stabilised in the early months of this year. In some parts of the market, there is early evidence of a positive re-rating.

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Real estate investment trusts (REITs), in particular, are attracting attention. “We believe we are entering a more favourable environment for REIT investing after a year that has been particularly challenging for listed real estate as it repriced quickly to the new interest rate regime and the anticipated recession,” argues Rich Hill, head of real estate strategy at the US investment firm Cohen & Steers.

That might seem surprising: at first sight, the outlook for property does not look promising. In a rising interest rate environment – and the Bank of England is still predicting further rate increases – the yields that property must deliver to remain competitive with other asset classes climb higher. All other things being equal, that means lower share prices.

Nor does the macroeconomic landscape appear to offer encouragement. Slower economic growth means less demand for most types of commercial property: businesses rent less office space, retail outlets close, industrial premises operate below capacity. And residential property suffers too; house prices in the UK are already 3% off the peak seen last summer according to Halifax Bank.

Reasons for optimism

However, it’s not all doom and gloom. Many economists think inflation in the UK is now slowing at a faster rate than previously expected, which may limit the need for higher interest rates to come. And there is growing hope the deep recession predicted by the Bank of England will actually turn out to be relatively shallow. In which case, the sell-off in the property sector may have been overdone.

Moreover, the REIT structure provides a highly tax-efficient way to invest in property (see explanation at end of article). REITs leave you free to use your dividend tax allowance – the amount of dividends you can earn tax-free each year – for other investments. This allowance is worth £2,000 in the 2022-23 tax year, but will fall to £1,000 in 2023-24.

Also, if you hold your REIT shares in an individual savings account (ISA) or private pension, which both shelter investments from tax, there will be no income tax to pay on the distributions you receive. So not only will the REIT have a bigger pool from which to pay out income, since it pays no corporation tax, but also, you won’t have to pay any tax when you receive this payout.

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In fact, some REITs have already begun to recover from the lows seen in 2022, when deteriorating investor sentiment saw share prices in the sector widen to double-digit discounts to the value of the underlying assets.

A potential re-rating would not come as a surprise to sector analysts such as Colette Ord of Numis. “We believe the UK property investment companies offer a range of opportunities for income-focused investors willing to ride out potential near-term share price volatility,” she says. “In our view, prospective capital weakness is already more than reflected in share prices of many funds within the diversified peer group.”

Higher yields, but danger of catching falling knife

Roger Skeldon, a fund manager at property-specialist TIME Investments, also believes there is a case to make for well-managed REITs. “Many are trading at discounts to consensus forecasts for net asset values, and for many, this now probably represents an attractive entry point,” he argues.

He adds: “The repricing of UK real estate values is the fastest on record and there is optimism that the bottom is near.

“This re-pricing means many REITs are trading at attractive yields, especially when married with those showing positive rental growth prospects and lower risk around tenant vacancies or debt structures.”

This is not to suggest recovery is guaranteed – or even that there will not be further bumps along the way.

Winterflood Investment Trusts’ head of research Emma Bird is cautious – yields on many funds still look too low she warns – the weighted average yield of the Property UK Commercial peer group was 5.99% at the end of February, a 2.16 percentage point spread over yields on 10-year UK gilts, which is below the long-term average.

“This may suggest there is no catalyst for a notable sector-wide re-rating in the absence of a fall in gilt yields,” says Bird.

She adds: “Alternatively, in a new higher interest rate paradigm, required spreads may simply reset at a lower level in the medium term, allowing scope for some share price re-rating.”

The key will therefore be to be selective. UK-listed REITs cover a multitude of areas, ranging from generalists investing in a wide range of commercial property assets to more specialist vehicle focused on specific sectors.

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TIME’s Skeldon is particularly interested in REITs with exposure to the industrial and logistics sectors, where asset prices fell particularly hard last year. “There are some positive signals coming from recent transactional activity, and from an occupational perspective, the outlook and rental growth prospects remain optimistic,” he says.

He also likes the look of property assets in the healthcare sector, which tend to be less cyclical, singling out Assura (LSE:AGR) and Primary Health Properties (LSE:PHP).

By contrast, Skeldon is concerned about REITs exposed to the consumer – retail-focused vehicles, for example. “With continued pressure on household budgets, those sectors most exposed to consumer spending could face significant challenges around tenant vacancies and rental collection,” he warns.

At Numis, meanwhile, Ord picks out two generalist REITs as the analyst’s preferred holdings. “Custodian Property Income REIT (LSE:CREI) delivers high and stable dividends to investors, with a current dividend yield of 6.3%; we believe this consistency of income return will be increasingly attractive, plus the asset and tenant diversification provide natural downside protection,” she says. It is trading on a discount of 10%.

Numis’s second pick is LXI REIT (LSE:LXI), currently on a discount of around 30% - “an attractive entry point for a diversified portfolio of business-critical assets and a dynamic management team that has consistently generated returns ahead of target”. Its dividend yield is 6.4%.

More specialist plays favoured by Numis include Industrials REIT Ltd (LSE:MLI), which focuses on industrial property assets with multiple units to let to tenants, and Urban Logistics REIT (LSE:SHED), which invests in warehouses.

One final point for investors to consider is whether an open-ended fund might be an alternative route into the property sector, even though such vehicles lack the tax-efficient structure of REITs.

However, Annabel Brodie-Smith, communications director of the Association of Investment Companies (AIC), urges investors to be cautious.

She says: “Investment companies are particularly suitable for investing in hard-to-sell assets like property because they have a permanent pool of capital.

“Whereas major open-ended direct property funds have been forced to suspend trading a number of times; this is because open-ended funds have to sell their assets to meet investors’ redemptions.”

REITs explained

Not all businesses that invest in property are structured as real estate investment trusts (REITs). To qualify, a company must own commercial or residential property that it rents out, and it must distribute 90% of the profits it makes from this rental business to shareholders.

Assuming that’s the case, REITs do not have to pay corporation tax on their profits – instead, investors are liable for income tax, rather than dividend tax, on the distributions they receive; the concept is that investors are taxed as if they own the properties themselves.

In practice, there are two types of REIT in operation today. First, most investment trusts set up to invest in property in the UK have elected to become REITs given the tax efficiency of the structure (investment trusts that invest in property overseas do not use the REIT structure). Second, there are a number of property development companies listed on the London Stock Exchange with REIT status, such as Land Securities Group (LSE:LAND).

REITs may be incorporated in the UK, or in other locations such as the Channel Islands. Wherever they are incorporated, they are treated for tax purposes as if they are based in the UK, with one exception: there is no stamp duty to pay when buying shares in non-UK incorporated investment companies.