Last month I wrote my first cautious note on REITs for many years. Hitherto I had been an unrestrained bull. What changed?
From the depths in 2009, the sector has flown. Overseas capital bought safety, security and income. The pinch point of lease expiries stimulated tenant demand, rents rose, yields came down, development activity was muted, investment and tenant demand reloaded, developments gave turbo-charged returns and REITs soared to NAV premiums. Rate rises were kicked further down the road and real estate ticked all the boxes.
I think property yields are showing the dying embers of decline. Companies are still experiencing capital growth but at a slowing rate in their investment portfolios, relying more on development activity to boost NAVs. The occupier market is robust, with rents rising strongly outside the retail sector, but development involves risk. Investing in REITs when they are priced near perfection at a small premium to spot NAV and a 6% discount to our forecasts a year out also carries risk. The premium rating the sector has enjoyed is based on one thing: the pace of capital and NAV growth. And it is slowing.
Tax-advantaged REITs were created nine years ago to pass the income yield of property to equity investors, but the sector remains driven more by capital value performance than income. My concern is evident. When the pace of capital growth stalls, (IPF’s forecast for 2016 is a churlish 4%), what next? The sector’s dividend yield is just 2.8%; dividend growth is just 3-4% pa for the majors.
Rising and reversionary rents can finance dividend growth when the review cycle unfolds. But reversionary potential in portfolios, excluding developments, is sub-5% of existing contracted rent for the leaders. For the West End companies it is more than 20% but these shares yield 1.2% – the ultimate capital growth plays. Some companies have generated more income growth from debt refinancing and cost cutting than from rental growth. Simply put, when capital growth abates, discounts will emerge, and the dividend yield may not support the sector.
Apart from my long-held view on prime retail rents where translating consumer recovery into growing income seems a slow and opaque mechanism, I have few concerns about rentals in offices or logistics, but a concern where yields go. I have always argued that when this happens it will have nothing to do with interest rates, but will be something no one has forecast. So it may prove.
My cautious note included a “stock on offer” showing how much investment kit is for sale, mainly large-lot City of London offices. We are told there is £10bn-£40bn of “global capital” to invest in the London office market. We are about to find out if that is true. On my calculations £3.1bn of London assets were up for sale plus £2.1bn under offer. Of that under offer, £945m has been pulled. In the past three weeks I believe another £1.2bn can be added to the “for sale” list.
No wonder a City investment agent described the market as being at “saturation point”. These assets may be too big for most UK institutions. The irony is that no one predicted the catalyst for this first possible cause of a price correction coming from the very source responsible for pushing values up dramatically.
Here is a scenario. Some, or more, of these assets don’t sell or bids are below asking. Most is “good kit” as reflected in asking prices; a couple are sub-4%. Assume some are withdrawn with the usual “retaining for the long-term” or “maximising income growth” line. I wonder what happens to the value of the likes of the Cheesegrater (4.8%) or Walkie Talkie (4.6%), for example? When a valuer acknowledges the yield has moved adversely, even by a couple of basis points, shares won’t go better.
Hindsight may show we are on the plateau. Many take the view that NAV performance remains positive going forward but its components move towards rental growth contributing more than yield shift. The presumption is that yields will stop falling but not reverse. I fear a situation that challenges that presumption. When global capital meets local supply/demand imbalances, global capital wins. The pricing of the asset class is a bigger driver than rental movements. That has repercussions for a quoted sector still priced near perfection.
Alan Carter, managing director, specialist sales, Stifel Nicolaus Europe
