COMMENT The first half of 2007 was a momentous period for two new innovations: Apple launched its first iPhone and the UK launched its very own REIT regime.
The first iPhone was a tremendous invention that has been an unqualified success, marked by the recent release of version 11. REITs, on the other hand, had a more difficult start. Almost immediately after their launch the global financial crisis took hold and the share prices of nearly all recently converted REITs had a steep decline, only bottoming out in the beginning of 2009.
In the same way that Apple launched the iPhone to give consumers something they thought the modern world needed, REITs were launched with much the same idea – to persuade investors of the attractiveness of a reliable, repetitive and growing income stream by giving them a proxy to the underlying properties that delivered this type of return. They encouraged real estate companies, through tax advantages, to be more income-focused by allowing them to pass net rental income from their occupiers to shareholders as efficiently as possible, a principle that had been successfully adopted in more mature REIT markets such as the US and Australia.
For decades, the UK property sector had been populated by active asset managers, incentivised agents, motivated bankers, hyperactive developer traders and high leverage. For traditional property companies, income was never really on the agenda. However, the new REIT market was going to challenge them to reconsider their strategies and embrace more enthusiastically, the compounding attractions of reliable real estate income.
While for many this was going to be a new approach to property investing, it was entirely rational, offering an attractive tax regime and supported by data demonstrating that the majority of historical property returns over the long term had been delivered by income. This would encourage a more selective approach to development, it would reduce the frictional costs of hyperactive buying and selling, encourage lower leverage and see higher pay-out ratios to shareholders through a more patient and low-energy approach.
Roll forward 12 years and there are plenty of examples of new property companies that have fully embraced the true REIT principles. Today, we have a range of specialists focused on the student and supermarket sectors, long income, healthcare, PRS, self-storage and warehouses. Nearly all of these specialists have embraced the compounding attractions that reliable, repetitive and growing income can deliver to shareholders, particularly in an environment of virtually zero interest rates.
“The first rule of compounding is don’t interrupt it unnecessarily”, which can be particularly challenging in the real estate world when investors are surrounded by advisers encouraging them to swing the bat at nearly every ball
The right properties, let to the right occupiers, can become a phenomenal compounding machine. Albert Einstein once said: “Compounding is the 8th Wonder of the World… he who understands it, earns it… he who doesn’t pays it”. It is very true.
It’s obviously not appropriate for all real estate companies to pivot their strategies, and there is still a place for world-class developers delivering fantastic cutting-edge buildings. However, it is equally clear that more property companies should have have taken the true REIT principles more seriously and pivoted their approach away from hyperactivity. The truth is that smart investing always focuses on the quantity, quality and timing of when your money will be returned to you. Worrying about for how much and when someone else will buy your building is more akin to speculating.
A compounding strategy is different and relies on taking a more patient and rational approach. Compounding is exponential and builds as it grows, meaning that investing time horizons are longer and, ultimately, that it is not always necessary to do extraordinary things to achieve extraordinary results.
As Charlie Munger of Berkshire Hathaway fame once said: “The first rule of compounding is don’t interrupt it unnecessarily”, which can be particularly challenging in the real estate world when investors are surrounded by advisers encouraging them to swing the bat at nearly every ball.
So, historically, while real estate investors were continually trying to deliver brilliant returns with a more hyperactive approach (1+2+4-3+0+5-2 = 7), the new REIT investors are more patient in getting to the same number (1+1+1+1+1+1+1 = 7).
One of my favourite examples that demonstrates the power of compounding is the “Rule of 72” – the formula that is used to estimate the number of years required to double an investment’s value. Assuming an annual return of 6%, an investor doubles their money every 12 years and compounding at 8% pa their money doubles every nine years.
The merits of this approach are clear to see in the pricing of such vehicles in the public markets. In the US, Triple Net REITs enjoy on average a premium rating of 40% to their underlying NAV (compared to a sector average of 9%). This premium rating can also be seen in the UK market where NNN proxy stocks trade on an average premium of 22% (compared to a sector average of -4%). The expectation must therefore be that this part of the market will continue to grow as more companies pivot their investment strategies.
In an uncertain world of very low interest rates with an ageing population, the attractive compounding qualities of strong and long income will become clearer and hopefully more will see the benefits from these unrecognised simplicities. To ensure this works within the REIT environment, you have to ensure that your income is repetitive, reliable and durable. But in an increasingly disruptive world a reliable and repetitive return is no longer as easy as it may sound, as many sectors are increasingly disrupted by technology, changing consumer patterns and new innovation, which can leave some property assets looking more like melting icebergs.
I’ve said it numerous times before in my shareholder updates, but we think the demand for an income yield and its attractive compounding qualities is the defining characteristic of this decade’s investment environment. It is this belief in the power of income compounding that frames our thoughts and drives our own ambitions to become a dividend aristocrat and hopefully grow rich slowly.
Andrew Jones is chief executive of LondonMetric
