Real Estate: Discounts and the long-term resilience of REITs

Real estate has historically delivered strong and consistent returns to investors. For example, the MSCI UK Monthly Property Index has shown annualised returns of 8.6% in the 10 years to February 2020 (MSCI). These returns are split between capital, which can be quite variable, and an income component. This income stream is usually more predictable and can be particularly attractive to investors in this low interest rate environment. Property has achieved this while offering a comparatively low correlation with equities when held over three years or more, which can reduce the overall risk of an investment portfolio.

However, in the recent market turmoil we have seen financial markets sell off globally, including some significant moves in the more “defensive” listed real estate investments (REITs), in many cases more than their equity peers. In this piece we delve a little deeper into this, and provide some reassurance for our clients.

The Smith & Williamson Real Estate team has long been advocates for clients achieving their property exposure via REITs and not via the larger open-ended property funds. The key difference, put simply, is that REITs have a set amount of capital and a share price while open ended funds price daily, with the amount of capital moving day by day as investors add or withdraw funds. This daily price is set at the Net Asset Value of the cash and property held by the fund. At best this means open-ended funds often underperform the market due to a large percentage of the fund being in cash to meet redemptions, at worse it can cause significant liquidity problem if many investors want their investment back at speed. As any homeowner will know, property sales are very rarely a swift process if you want a fair price!

Because of this mismatch, we have seen three main points in the last 15 years where these ‘open’ ended funds have simply had to close and deny investors the ability to redeem their capital: the financial crisis, Brexit, and now the Covid-19 pandemic. Last week four major property fund managers gated their funds, preventing any redemptions whatsoever.

In contrast, a REIT will never close from redemptions, as an investor wishing to crystallise their capital is not taking this from the trust but selling a share to another investor. While there is a market, an Investor should be able to find a price. Let us imagine a scenario in which a REIT has 100 properties valued at £1m each. This will mean the REIT is worth £100m and if it has one million shares each should be worth £100. The cost to an investor however for this flexibility is that the share price can move away from the underlying value of the fund’s property. Sometimes this can be for valid reasons, like a belief that at the next valuation point the properties will have fallen in value, or sometimes for reasons that are less clear or rational.

At present the UK Commercial REIT market is trading at a 35% discount to NAV (Peel Hunt, March 23rd 2020), effectively pricing in a 35% fall in property values, with many REITs trading at even deeper discounts on their individual idiosyncrasies. This discount we believe combines both of the above reasons. Clearly Covid-19 will affect the ability to sell property, and many properties will see tenants unable to pay rent, hurting income.

However, the fact that the sector initially held up in value, combined with the ability for them to still be sold suggest many investors saw them as a source of capital in this uncertain time. This selling pressure has effectively created a further discount and a dislocation between the share price and the underlying fair value of the trust’s property.

While the property valuations may see falls in the coming months, and it is always unsettling to see discounts widen significantly, the key takeaway for investors is that trusts are not forced sellers in a difficult market, and this is a good thing for the preservation of capital. Their property remains intact, as do our investment in them.

In the longer term, the ability for REITs to not have to sell assets at depressed prices to meet redemptions should in fact see them emerge from this crisis stronger than their open-ended peers, and in a more robust financial position. As the market begins to regain its poise and investors return we should see better pricing of REITs.

Henry Elston, Head of Property Collectives, Smith & Williamson Investment Management LLP

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Risk warning
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.

Notes to editors
Smith & Williamson is a leading financial and professional services firm providing a comprehensive range of investment management, tax, financial advisory and accountancy services to private clients and their business interests. The firm’s c1,800 people operate from a network of 11 offices: London, Belfast, Birmingham, Bristol, Dublin (City and Sandyford), Glasgow, Guildford, Jersey, Salisbury and Southampton. Smith & Williamson is part of The Tilney Smith & Williamson Group.

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

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