The most revealing comments of any chairman or chief executive from the recent UK results season came from Nick Vetch, executive chairman of Big Yellow.
Vetch described a world where NAV is irrelevant to investors and what matters is sustainable, quality earnings and dividends on lowly geared and focused business models.
Andrew Jones, chief executive of LondonMetric, also set out the importance of income generation and the benefits of compounded income returns. They are both spot on, not just given where we are in the capital cycle, but this is what REIT legislation is designed to give investors: large, liquid, less volatile earnings and dividend machines for both specialist and generalist equity investors.
And the merits of an income strategy can clearly be seen from recent sector performance, with stocks such as Big Yellow, Tritax, PHP, Unite and LondonMetric clearly outperforming the sector over the last 12 months during volatile markets and with the majority trading at NAV or premiums. Provided the quality of earnings is good and the capital structures robust, investors will continue to look upon these stocks favourably.
Conversely the UK majors sit on discounts and I am often asked why this is. Sometimes it is for liquidity reasons, but the overriding reason is that equity investors require a greater return from equities than can be delivered from the current NAV basis, and if the majors are unable to compensate investors with higher earnings and dividends then discounts to NAV will persist.
Even on circa 20% discounts, the UK majors sit on average dividend yields of only circa 4%, compared to Unibail on a similar yield but trading at a significant premium to NAV.
The answer is that the UK companies are still affected by legacy issues, in spite of considerable progress by chief financial officers in recent years: relatively high cost of debt, property cost inefficiencies, in some cases relatively high admin, and mixed payout ratios. One way to look at this is to take the rental income of the majors and see what percentage actually flows through to investors as dividend. This can be a tricky analysis as the latest data may understate the income upside still to come from current developments (from prelets), and may overstate income where assets have recently been sold. And therefore looking at forecasts two years out probably gives better indicators, although accounting for joint ventures, capitalised interest and rent-frees also complicates the analysis.
The answers are informative. Taking the four UK majors as Land Securities, British Land, Hammerson and intu, and leafing through the excellent UK research from the Lazarus Partnership, the average expected ratio of dividend payouts to rental income is less than 50% (British Land the highest and above 50%, intu the lowest in the low 40s). Compare this to Unibail at around 60%. All the UK majors no doubt continue to work hard to improve their efficiency but how can they do more?
There are no easy answers, and in some cases it could require some further painful adjustments to NAV for example, selling less efficient real estate, refinancing expensive legacy debt, and reducing cost bases where teams are not beating their cost of capital, possibly via mergers and synergies.
And a note here on the EPRA cost ratio for, while a low ratio is no doubt worthy, what matters is whether the management team and the stock is performing.
These are difficult subjects for boards and advisers to grapple with, but with the capital cycle mostly played out, the income world Vetch and Jones so elegantly described is going to demand more emphasis and progress on income, earnings and dividends from the UK sector. And if boards are not proactive then the M&A departments of the major international investment banks will be.
Meanwhile, the mid-cap REITs without legacy issues, with the benefit of low marginal cost of debt, efficient business models and focused earnings and dividend strategies, backed up in some cases by strong in-built reversions, are well set to be the majors of the future.
