Discounts remain wide across the entire property investment company sector, according to Deutsche Numis, which says there is an an average 32% discount on the listed trust. The broker said last week that it felt this reflected uncertainty over the potential impact of further capital value declines and higher financing costs on near term returns.
“Whilst we do not rule out further NAV declines, we believe these will be relatively modest for most [funds] in our universe,” said Andrew Rees, an analyst at Deutsche Numis.
Deutsche Numis also said that gearing levels were “generally manageable” within the property investment companies sector and those funds which undertake active management of their balance sheets should continue to deliver stable earnings.
How will higher debt costs impact property funds?
However, there are higher debt costs now to think about: these could impact near term earnings. Current dividend targets within the sector offer an average 7.5% yield at the moment. Assuming interest rates are close to their peak, this sector could offer selective value. Sustained dividend growth in the near term could be limited to the listed funds that can drive manageable top line rental growth to offset the impact of higher borrowing costs on earnings.
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Deutsche Numis is taking the view that the Bank of England has in fact finished hiking and will move towards cutting interest rates next year. “Although there remains a risk to this path from further inflationary surprises or unexpected fiscal policy – as highlighted by last year’s infamous mini-budget – we believe the risk of significant further valuation declines for most commercial property sectors is decreasing,” the broker said in a note last week.
Investor sentiment within the listed property sector remains weak. Debt levels are considered to be at a largely comfortable level, both relative to history and to current debt covenants. Loan-to-value thresholds range from 50-60% and the minimum interest cover ratio is around 1.5x to 2.0x. Deutsche Numis feels most funds retain significant headroom to their LTV covenants. Even if further valuation declines are to occur, it is unlikely that we are going to see widespread LTV covenant breaches.
Cost of debt can hit earnings in listed property funds
The steep rise in interest rates does mean that the cost of debt will meaningfully impact the earnings for these funds. Some funds have entered the current rate hike cycle with structural debt in place that uses fixed rate facilities. A good example is the Picton Property Income fund. Other funds are using hedging instruments to replace floating rate debt.
Fund managers obviously want to be able to have some clarity over earnings, hence the emphasis on hedging, sometimes at considerable cost to the fund. With discounts on funds this wide, it does not currently seem harmful to pay out of NAV to fix interest costs as lower than market rates. If rates are to remain higher for longer though, periodically paying out of a fund’s capital to renew hedges is not likely to be sustainable.
Currently most of the mainstream property funds have little to no exposure to further interest rate rises based on their current debt facilities. The stand out exception is abrdn Property Income, which has the highest proportion of floating rate exposure in the sector, at around 37%.
