The best way to invest in Britain’s property market today

Generally speaking, we don't think that property is a good investment at the moment. House prices look way too high to us and rental yields too low. Yes, it's possible to pick up some bargains in certain parts of the country but that's not without risk as I noted here.

But there is a part of the property market where you might be able to get a reasonable return on your money. I'm talking about real estate investment trusts - Reits for short.

Reits (pronounced 'reets') are property companies listed on the stock exchange. They invest in rental properties. These can be commercial properties such as offices, warehouses or shops. Alternatively, they can invest in flats or apartments. Reits were established in the UK in 2007 and offer investors a way to own property assets without buying them directly.

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How do they work?

Many of the UK's largest landlords have converted to Reit status. The main reason for this is that they pay less tax to the government. All the rental profits and capital gains on rental properties are exempt from corporation tax.

However, there are strings attached: 90% of the rental profits must be paid out in dividends to shareholders each year, and any profits from property development are subject to normal rates of corporation tax.

Dividends from Reits

Reits pay a special type of dividend. This is known as a property income distribution (PID). They are slightly different from the dividends paid on most ordinary shares.

With an ordinary dividend, a tax charge of 10% is withheld and paid to the government. So if you have received £90 in dividends from a company, the actual dividend paid by the company was £100 (£90/0.9). £10 has been paid to the government in tax. As a basic rate taxpayer, you do not have to pay any more tax on your £90.

PID's are different. Here 20% of the dividend is withheld and paid to the government. However, if you hold the shares of a Reit in an Isa or a Sipp, your broker can help you avoid this tax so that you receive all of the PID. This usually involves filling in a form and informing the Reit of your tax status.

Some Reits also pay normal dividends on top of PIDs. The normal tax treatment will apply to this part of your dividend.

So are Reits a good investment?

They certainly can be. They offer many advantages over buying and renting a property yourself. The most obvious benefit is that you don't have to worry about collecting rents, finding tenants and doing repairs. The Reit does that for you.

But probably the best thing about Reits is that, unlike a buy-to-let property, you can buy and sell them quickly. This is because you can trade them in the same way as ordinary shares. A few clicks of a mouse and you can sell your interest in the rental properties.

It's not all plain sailing though. Depending on the economy and the type of property being rented, rental incomes could go up and down a lot. Also, expect the net asset value (NAV - assets less debt and other liabilities) to move around a lot too. Reits will have to regularly revalue their assets.

Changes in certain markets can also have a big effect on balance sheet values. For example, if selling prices of rental properties fall and/or interest rates rise, then the NAV of the Reit will probably go down. This would likely be reflected in a fall in the value of your shares.

Are any Reits worth buying?

I've had a look around the UK Reit sector. And at the moment it seems that there are some companies that look quite interesting. They offer attractive dividend yields and trade at or sometimes below NAV.

And unlike many buy-to-let property investors, these Reits are not aggressively financed with lots of debt. If the dividend is sustainable and the NAV is realistic, then there could be some investment opportunities.

Put another way, we think you will get more income and less risk from owning a Reit than most buy-to-let investments.

prices as of 12/09/2012

We think that the UK Reit sector is at an interesting stage in its development. The weak economy poses lots of risks for investors but also opportunities. Banks are looking to reduce their exposure to commercial property and strengthen their balance sheets. This could lead to some attractively priced assets coming on to the market and into the Reit sector.

Our top pick is London & Stamford Property (LSE:LSP).We like the asset mix of the company with its strong focus on London and the south east of England. It owns good quality warehouse assets and central London offices with good tenants. It has recently made big investments in central London residential properties. This could be a good decision given the strength of the rental market in the capital.

We also like the record of the company's founders, Raymond Mould and Patrick Vaughan. Both are seasoned investors with a proven ability to make money for shareholders. London & Stamford also doesn't have a lot of debt which gives it the firepower to make more shrewd purchases.

Retail looks like it's going to be a tough market for some time to come. The weakness of the sector means that there could be a lot of pressure on rental incomes here. For that reason, we would probably avoid Town Centre Securities (LSE: TCSC)which has a heavy exposure to retail and offices in northern England. That said, the big discount to NAV probably reflects a lot of the risks here.

However, if you want exposure to retail, then British Land (LSE: BLND)might be a safer bet. It has some good assets such as Tesco and Sainsbury's supermarkets along with London offices such as Broadgate.

The rest of our selection of high-yielding Reits has much more exposure to the industrial sector. Hansteen Holdings (LSE: HSTN) is a big play on European (especially Germany) industrial properties, whereas AJ Mucklow (LSE: MKLW)has a similar focus in the West Midlands.

An interesting company is SEGRO (LSE: SGRO)formerly known as Slough Estates. The company has struggled due to its high exposure to low-yielding industrial estates. It is selling a lot of these assets and reinvesting into things like logistics parks and data centres where the rental yields and occupancy rates are better. The big discount to NAV reflects the poor industrial assets but could also represent an opportunity. SEGRO could be a cheap turnaround play.