As interest rates peak it’s time for a fresh look at commercial property

With too narrow a focus on bricks-and-mortar investors might be missing out on mispricing opportunities

Matt Norris GULP

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With the Bank of England having raised interest rates last week to 4.25% – the tenth consecutive hike – residential property owners will be keenly aware of the potential effects on their own finances. But what of commercial property – does a higher rate environment spell disaster for the UK real estate investment trust (Reit) sector, or should investors sit tight or even increase their allocation?

Figures from Winterflood Investment Trusts show that property funds have been among the worst-performing in the closed-ended space, down 12.6% year-to-date (to 28 March). But with the latest rate hikes on both sides of the Atlantic being widely seen as perhaps marking a peak in the current cycle, Matt Norris (pictured), manager of the VT Gravis UK Listed Property Fund (GULP) is optimistic on both income and growth prospects for the sector.

GULP is an open-ended fund that invests in UK Reits, taking a thematic approach based on four megatrends: ageing population, digitalisation, urbanisation and ‘Generation Rent’. This leads it to invest in such areas as healthcare (primary care and care homes), logistics, flexible office space and student accommodation. Norris describes the resulting portfolio as “growth income, not fixed income”, with forecast dividend growth from the underlying holdings of 5-9% in 2023 (versus inflation expectations of 7.1%), compared with 12.5% and 10.1% in 2022 and 2021 respectively (figures from Gravis using Bloomberg data).

Property trusts have fallen from favour in recent months since the Truss/Kwarteng budget caused bond yields to surge in September and October 2022, with the full force of increased uncertainty being seen in Q422 real estate valuations. The AIC Property – UK Commercial sector has returned an average of -29.5% (share price total return) over the last 12 months and stands at a 31.4% discount to net asset value.

However, Norris says that too narrow a focus on bricks-and-mortar valuations (which in any case are subject to valuer sentiment) means investors may be missing significant mispricing opportunities. GULP uses a ‘warranted value’ approach, including the value of operating platforms (for example, the digital front-end system owned by Unite Group, through which prospective students can find accommodation), or property development arms. This means it sees even wider discounts to warranted value than the current already appreciable discounts to EPRA NTA (the most widely used measure of net asset value for Reits).

The fall in Reit share prices over the past year – for example, logistics warehouse operator Tritax Big Box Reit (BBOX) has moved from a double-digit premium to NAV to a discount of around 30% – has helped push up the dividend yields on offer, with BBOX currently yielding 5.4% and the broad AIC UK sector offering an average yield of 7.1%. While this looks attractive relative even to the now higher rates available on risk-free assets, it is important to note that trailing yields would fall if share prices recover, hence the importance of dividend growth potential.

The last time closed-ended UK property funds traded on such wide average discount to NAV was in the wake of the global financial crisis in 2008/9. However, the introduction of quantitative easing leading to a prolonged period of near-zero interest rates sparked a swift re-rating, as investors flocked to the attractive yields on offer, pushing many Reit share prices to a premium to NAV.

Norris notes that despite the recent wobbles in the global banking sector, this is not a rerun of the GFC, with property funds benefiting from lower levels of leverage, and a wider range of lease maturities (weighted average unexpired lease term of 7.4 years for the GULP portfolio) meaning short-term interest rate fluctuations will have limited impact. Furthermore, increased focus on environmental credentials from potential occupiers means “green is the new prime”, according to the manager, with tenants paying a premium to rent buildings with the highest BREEAM ratings (a measure of environmental impact).

Without the tailwind of QE, what could spark a reassessment of the unloved real estate sector? An increasing view that the rate cycle has peaked is one potential positive (Norris says a catalyst could be when the Bank of England stops raising rates or a major central bank pivots to cutting rates), but the manager also points to the potential takeover attraction of discounted high-quality assets with embedded rental growth. Singapore’s sovereign wealth fund, GIC, recently completed the joint-venture purchase of Canadian Reit Summit Industrial Income for $5.9bn (£4.8bn), a 31% premium to Summit’s pre-bid valuation. “This is a pot of capital that may come knocking in the UK too,” says Norris.

See also: Home Reit tenants slide into liquidation

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