Should you buy real estate investment trusts at a discount?

The real estate sector took a hit in 2022, with commercial real estate in particular taking a big hit.

It has caused companies in the sector to see significant declines in their share prices, and rising interest rates combined with last month’s banking saga have done little to slow the decline.

Reits – real estate investment trusts – have seen their share prices plummet in recent months due to the economic situation and fallout from the Home Reit saga, allowing them to trade at huge discounts.

Is the Reit’s sell-off, with higher dividend yields and generally stable dividend income, overstated?

Why has there been a sale of Reit?

There are over 40 Reits listed on the London Stock Exchange, some offering more general real estate exposure, while others specialize in one or two segments.

As returns from real estate are highly correlated with economic growth, the sector is struggling as the impact of higher interest rates is seen to spill over into valuations.

The fallout from the collapse of Silicon Valley Bank last month also raised fears of possible defaults in the commercial real estate sector.

Numis analyst Andrew Rees said: ‘Inflation appears to be lower than the market perceives, so even though stock prices [of Reits] generally strengthened in April after weakness due to further concerns about access to credit amid the SVB/broad banking crisis in March. We believe significant reductions in the rate of inflation are likely to be needed for industry stock prices to rise significantly.”

Reit’s sale this year was random. While logistics and warehousing have faced more headwinds as companies shrink space, the entire industry has suffered.

The FTSE EPRA Nareit UK index, which tracks the performance of property companies and Reits listed on the London Stock Exchange, fell 8 percent in March. This compares to a 2.8 percent drop for the FTSE All-Share. It is currently 30 percent lower than the year.

While the economic situation hasn’t helped the industry as a whole, the impact of the Home Reit saga has helped little.

Social housing specialists such as Triple Point Social Housing and Civitas Social Housing have been hit particularly hard. They are currently trading at a discount of 62 percent and 52 percent respectively to their net asset value.

However, they hope their track record of stable earnings and high collection rates will give investors some confidence.

Andrew Dawber, group director of Civitas, claims that given limited NHS beds and an aging population, ‘demographic demand is very strong’.

As investors question Reits’ social housing rental model, other specialists have also suffered.

Life Science Reit, which invests in biotech companies in the ‘Golden Triangle’ of Oxford, Cambridge and London, is currently trading at a 25 percent discount.

Simon Farnsworth, general manager of Life Science Reit’s investment advisor Ironstone, thinks life sciences is largely isolated from other headwinds.

‘It is not very sensitive to consumer spending or house prices. It’s not even hugely sensitive to interest rates because many companies aren’t set up.

“So we actually see it as a very natural protection against other occupation bases that might be a little more vulnerable to some of the more widespread macroeconomic issues that are out there right now.”

He added, “I think what’s happened is the real estate market has reacted much more quickly this time around in terms of downside value in real estate. It’s been pretty short and sharp. We see it stabilizing pretty quickly. And I think people realize where the underlying value of the real estate is now, and I think that’s very important.’

Do Reits represent value?

While mutual funds as a whole have traded at a discount in recent months, those in the real estate sector have been among the largest.

Stifel’s John Cahill said current stock prices “represent some pockets of deep value” given the industry’s asset-backed returns.

Under the Reit regime, three-quarters of the company’s assets must be rental property and 75 percent of profits must come from rental income.

Because of this, many Reits sign long-term leases, meaning the income is usually quite reliable, and most of this is distributed in the form of dividend payments.

But a low stock price and high dividend yield doesn’t necessarily mean it represents value.

Jason Hollands, Managing Director of Bestinvest said: “I am currently cautious on real estate… the steep discounts on Reits reflect market expectations that the value of those assets will come under pressure given the challenging headwinds facing the economy and the lingering risk of a recession as real incomes fall, borrowing costs rise and the impact of higher taxes begins to be felt.

Those focusing on the juicy discounts and undoubtedly high dividend yields on Reits should also take a look at the gearing levels. This is a measure of the size of loans versus assets.

The average gearing of UK property companies is 21 per cent, but some are much higher. Gearing is a source of risk and can become even greater if the value of the assets backing the loan falls. If you’re prone to pedaling a Reit, avoid the one with a high gear.”

The economic backdrop will play a major role in Reits’ recovery. As insolvencies start to pick up, companies will look to store and office closures, leaving Reits with rising vacancy rates.

Andrew Rees of Numis said: “We believe investors will do well to focus on companies with strong earnings visibility that can support attractive and growing dividends. Positive: strong occupational dynamics in a number of sectors (industry, private rented sector[PRS]retail warehousing) provide many Reits with a platform to grow their top rental income.

“We therefore prefer funds with conservative balance sheets (low gearing), without any short-term refinancing risk.”