What is a REIT? Are they a good investment today?

Hello, I’m Chris Salih, investment research analyst at FundCalibre, and today I’m delighted to be joined by Marcus Phayre-Mudge, manager of the Elite Rated TR Property Investment Trust. Marcus, as always, thank you for joining us today.

Well, thanks Chris. Nice to be here.

So, today we’re talking about real estate investment trusts or REITs for short. Like so many other sort of asset classes and areas, they didn’t have the best of years, last year. You know, there’s been a bit of a juxtaposition in terms of the environment, you know, government bonds were yielding 1% and REITs were giving off sort of 4-5% income, which was an attractive environment. 

By contrast today, you know, government bond yields are sort of 3% plus [and] there doesn’t seem to be as much of an incentive to take the risk for that little bit more reward? And we’ve also got on top of that, higher interest rates [which] also mean borrowing costs are up. So, there’s less money for these companies to give away in the form of dividends or to grow their businesses. I mean, that’s the pessimist’s view, it makes the asset class seem quite bleak. I think the first question I’ll throw your way is, can you turn my glass half empty into a glass half full? Are there any positive thoughts you can give me on the asset class?

Yeah, absolutely. I mean, you, everything you’ve said is quite correct. 2022 was a terrible, annus horribilis for real estate equities. And as you point out, a combination of essentially the increase in the cost of money having a serious impact on expected valuations. But the reality is that equity markets always tend to overreact, both on the downside and on the upside. And in fact, since the 1st of January, we’ve had a kind of 10% rally. And essentially, what this is all about, is the fact that an awful lot of companies out there, and particularly the ones we invest in, a lot of them had sensible finance directors who have hedged or capped the increase in their costs of debt, particularly. So, no different to you or I being super clever and somewhere in the middle of last year, taking out a fixed-rate mortgage at kind of a one, one and a half percent as opposed to, you know, floating rates today at you know, closer to four [per cent].

On top of that, of course, the top line, so your earnings have for a lot of our companies, particularly all of our European companies and some of our UK ones, benefited from indexation [Indexation is a system or technique used by organizations or governments to connect prices and asset values. This is done by linking adjustments made to the value of a good, price of a service, or another specified value to a predetermined price or composite index]. So, for example, in Sweden, which is a poster child of high leverage, but in compensation, they have had indexation, which they’ve been able to push onto tenants, of close to 9%. Elsewhere in Europe, you get different amounts of that indexation. But it’s pretty positive everywhere. So, essentially what we’ve got is there are a bunch of companies that we are invested in, where their earnings are going up and their cost of debt is reasonably fixed for a period of time, and that’s actually benefiting their bottom line. 

I was going to say, just quickly, you mentioned the bounce back there. Are you still seeing valuations as extremely attractive?

Yeah, I think they were extremely attractive. We’ve now had a 10% rally, so I would still class them as attractive. We’re still collectively trading on discounts of 25-30% to the last published asset value [Net Asset Value, NAV, which represents the underlying value of the stocks in the portfolio]. Now, before everyone rushes out to buy, we’re not expecting these stocks to necessarily trade back at premiums to asset value, but that discount is incredibly healthy. What we’re also very, very focused on is the basically, the free cash earnings yield. And, you know, that is for lots of our companies, very, very resilient. And quite simply, this feeds onto the fact that, as the recession that we can see coming down the track, is expected to be quite mild, if you look at previous cycles very few companies actually go to the wall in that period; it’s only in a very severe recession that we actually see a lot more corporate collapse. 

At the same time, a hangover from the GFC [Global Financial Crisis] and then obviously through Covid etc., we saw a really, very restricted development cycle. So, we have this unusual situation where, at the moment, yields are rising, but rents are also rising and they’re rising not only because of indexation, but also because companies are always moving and upgrading their space, etc. And actually [there] isn’t a huge amount of supply in many of our submarkets. In fact, there’s a shortage of supply in quite a few submarkets, which I’m sure we’ll talk about.

More pessimism from me. So, it looks like we’re heading into a recession or at least the economy is taking shape for some type of recession, be it shallow or deep. You touched on it briefly earlier, perhaps let’s go into a bit more detail, how would you expect residential and commercial properties to perform in that environment?

Yeah, it’s a very good question and essentially what we’re all sort of waiting for, is for the central banks – doesn’t matter if it’s the Fed or the Bank of England, or the ECB – to reach a point of stability in terms of where we’re seeing short-term rates peak. And I think that’s already having a big impact. If you look at spreads on 10-year bonds, be it sovereign or investment grade, we’re seeing spreads come down hugely. And that’s very important, and the bond markets are beginning to open up. So, actually, that’s therefore an improving situation for our companies that need to continue to raise capital or go through refinancing. 

In terms of the difference in commercial and residential markets – residential are essentially two types: one we invest in and one, we don’t. One is the Owner Occupier, you know, [that is] what’s happening in the housing market where people are buying and selling houses that are empty and they’re moving into them, where we think that’s going to be very much a function of local mortgage markets. We tend to invest in PRS [Private Rented Sector]. So, this is private residential/private rented [property], but on a very large scale. And in Germany and Sweden, rents are restricted. So, essentially you have a situation where rents can only grow by a certain amount, which is generally somewhere between sort of 2-3%. So, it’s quite modest. And as a result, those names have been hit quite hard. But there is a long waiting list for every single one of these apartments. And so, that’s the key point, is you’ve got no new supply coming through. So, actually, we don’t see any likelihood of drop in value of those assets. 

On the commercial side, it very much all depends which sub-sector you are picking. So, let’s pick a sector where we think things are quite binary and that’s prime offices. Here, we think that there is a huge surge of demand for energy efficiency, green buildings, low carbon emission, etc. And we’re seeing, new rent records being set in central London, central Paris, central Madrid, central Milan. If you then were to flip over to a 1980s office building, probably in a suburban location, that’s a real problem asset going forward because the EPC – the Energy Performance Certificate – regime – this is in the UK but applies all over Europe as well, different regulations – means you’ve got to upgrade these buildings before 2030 in order to be able to let them. So, you know, those buildings have essentially got a refurbishment CapEx [Capital Expenditure] sort of wave coming over them in a few years’ time. And therefore, we are very negative about those what we call brown buildings, [those] older ones. So … but I can run through each market, but we probably haven’t got time for that, but I would say it’s very much a mixed bag but certainly some places of optimism.

Okay. And I guess just lastly, if we sort of bring it all together, I mean we’ve talked about valuations, the idea of, you know, potential recession and some of the opportunities I guess that are coming out of that in tandem with the volatility. I mean, again, it’s a bit of a crystal ball question, but what is your outlook for the asset class over the sort of the next sort of mid-to-long-term, medium, sort of three to five years?

Yeah, our central case is that, post the GFC, we had a long period of free money as central banks attempted to make sure that the world didn’t fall into some sort of ice age. And we’re paying the price of that. There has been inflation coming through and we are going to need to live with higher rates. In fact, we think inflation, particularly for the service sector, is going to be quite sticky. We think that inflation in Europe, particularly where there’s a very strong social contract, and where we expect that State wages are going to push on up at sort of an average of 4 [p%] or even 5%, this is going to maintain quite high levels of inflation.

And in fact, that’s where real estate fits quite well in that kind of environment. Because ultimately, an awful lot of our income is index-linked. So, actually we think that where you’ve got businesses where they’ve managed their debt book, they’ve got lots of – at least in the short run – fixed price of debt, and they’re investing in an asset class where there is essentially demand with limited supply. I’m feeling quite positive about it. In fact, after my house my, my ownership of TR Property Investment Trust is my next largest asset and I actually bought more shares last week. So, that’s how positive I’m feeling on a three-to-five-year basis. 

Marcus, as always, thank you very much for your time.

Thanks Chris.

And if you’d like to learn more about the TR Property Investment Trust, please visit FundCalibre.com