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UK REITs sector could be poised for comeback when rates are cut


After a torrid couple of years, there are signs that appetite for UK REITs is picking up. Property prices in many sectors are stabilising – although parts of the office sector remain challenged – and many assets across the spectrum are enjoying robust rental growth. This in turn is helping underpin attractive yields, averaging 8%, in the commercial property sector.

There has been a flurry of takeovers and mergers in the property sectors this year as directors seek scale and liquidity in a bid to cut costs, strengthen balance sheets and appeal to big institutional investors. However, the average discount of the AIC’s Property – UK Commercial sector remains close to levels seen in the global financial crisis. It stands at 24% currently, the AIC (Association of Investment Companies) reported recently.

“The market is throwing up a selection of opportunities,” explained Andrew Rees, Investment Trust Research Associate at Deutsche Numis. “The worst of the correction in asset prices is largely over, with the exception of some offices which continue to see some price weakness. The industrial and logistics sector is still performing well, even after the spike during the pandemic, because demand for last-mile logistics facilities is still strong. Funds investing in these properties are still capturing healthy rent uplifts on lease expiry which is helping to deliver sustained earnings growth.”

Double digit rent increases

Similarly, the private rented sector, incorporating rented residential property, is benefitting from near double-digit rent increases as the UK’s supply/demand dynamics force up costs. The Office of National Statistics said that rents for new and existing tenancies rose by over 9% in the year to March 2024.

“You can sense the pent-up demand on the sidelines,” said Emma Bird, Head of Investment Trust Research at Winterflood Securities. “In November last year, share prices spiked when UK ten-year gilt yields fell by 39 basis points as hopes of peak rates were supported by better-than-expected inflation prints, and rates were kept on hold by both the Fed and Bank of England.”

On that news, the UK Commercial Property sector rebounded, with the FTSE EPRA NAREIT UK Index returning 12.6% – the best absolute monthly return, and the best relative performance vs the FTSE All Share, since August 2009. While that bounce has since unwound, it suggests that there is a notable amount of capital waiting to re-enter the property sector once the macro outlook becomes clearer.

“The only way is up,” says Richard Shepherd-Cross, Managing Director at Custodian Property Income REIT. “This isn’t just about sentiment. What’s driving this is the health of occupational markets – vacancy rates are falling, and rents are growing within all sectors, including well-located, higher-spec offices.”

Is it time to start allocating to UK REITs though?

Investors should focus on the most robust sectors with strongest rental growth, since that is what will drive the bulk of the returns over time. Right now those are most likely the private rented sector and industrial and logistics sectors. Many investors might instinctively look at dividend yields as a guide to a good investment, but these can be deceptive if taken in isolation. You need to check how they are being paid – from earnings or capital – and if they are fully covered. The level of debt REITs carry should also be a consideration.

Investors can check the trust’s history of maintaining and increasing dividends, and whether the yields are covered by earnings. If they are not, the REITs may be dipping into capital to maintain dividend payments which is unlikely to be sustainable in the long run.

It is important to also note that earnings growth is a function of rental growth but also costs, so if they have rising costs (such as vacancies, debt, capital expenditure) this can impact earnings negatively even if rental income is growing.

“In terms of rental growth, this varies by sector, with industrial assets generally seen as having much stronger rental growth prospects than regional offices, for example,” explains Bird at Winterflood Securities. “And then by lease structure, with some leases subject to annual inflation-linked uplifts and others only reviewing five-yearly and being based on open market rent reviews. Investors should seek answers to these kinds of questions before parting with their money.”

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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