This year I’ve been looking at UK real-estate investment trusts (REITs) in an attempt to uncover some hidden gems in a troubled sector. Over the past two years investors have dumped REITs on a scale not seen since 2008. Interest-rate hikes are to blame. Fifteen years of ultra-easy monetary policy by central banks in Europe and the US distorted property markets and rewarded the misallocation of capital.
Investors could borrow cheaply, and as long as they covered interest payments with rental income, they were happy. It seemed as if property prices would go up forever: there would always be a greater fool willing to pay more. Higher interest rates have now upended this model. The higher cost of capital means investors are reconsidering their exposure. Value is now more important than just rental income and covering the cost of capital; property values are adjusting to reflect this.
Adjusting to a new market
REITs have been hit especially hard, as the market does not yet understand what the future will look like. Equity markets are forward-looking, always trying to price developments before they happen, leading to indiscriminate selling across the REIT sector in the UK, US and Europe. This is where the opportunity lies for investors who are willing to take a longer-term view and dig into the numbers and market fundamentals.
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Europe is particularly interesting. One of the main differences between the UK and European commercial-property markets is how leases are constructed. In Europe they are index-linked. In Britain they tend to come with upward- only rent revisions with caps of, say, 3%. This is especially important in today’s market, and if you think interest rates (and inflation) will remain elevated.
This is one of the reasons Tritax EuroBox (LSE: EBOX) looks appealing. Managed by Tritax, which looks after £8bn of real-estate assets across Europe, Tritax EuroBox owns 25 logistics properties, mainly in central Europe, but also in Stockholm and Barcelona. Around 90% of the company’s rental income comes from index-linked contracts. The logistics market itself is interesting because it is developing rapidly. Most of the growth in this market in the UK has been driven by the rise in online shopping over the past decade. In Britain online sales are set to keep rising at an annual pace of 7% until 2025, says Savills; in European markets, growth of between 14% and 19% is expected.
This is one of the reasons why Savills believes demand for logistics assets will pick up in the coming years, despite the slump in the first quarter. Its European Logistics Outlook report for May 2023 notes that the average vacancy rate, “which had been gradually declining in recent years”, ticked up in the first quarter of 2023, mainly driven by “the completion of pipeline projects”. Some occupiers have also been moving out of excess space as they try to keep costs under control.
But occupiers mothballing space “expect to reclaim it within the next one to two years” and the pipeline of new projects is withering as the cost of construction grows. That could be why “despite the rising vacancy rates in recent quarters, growth in prime rents has remained robust” this year. Occupiers can see that demand for logistics assets will remain high, and they want to keep hold of the best ones.
Much of the demand for new warehouse space has been driven by the growing e-commerce market, and this boom still has “quite a long way to go”, says Phil Redding, CEO of Tritax EuroBox. It will remain a market tailwind for “some time to come”.
A cheap property stock
These fundamentals suggest Tritax EuroBox is cheap. The stock’s net asset value (NAV, the value of all property assets minus liabilities) stands at 88p compared with the current price of 54p, and the dividend yield is 8%. The firm has already booked a decline in the value of its assets to reflect higher rates, but the market fundamentals suggest further declines should be limited.
Redding notes that historically “you would look at an equilibrium yield [where yields ‘should be’ to reflect the prevailing market conditions] of around 6%” for industrial warehouse assets in a normal interest-rate environment. Today, considering the supply/ demand fundamentals, he believes “equilibrium yields of around 5%” could be more appropriate. So Tritax trading with a yield of 8% seems undervalued – and that’s without giving any credit to the company’s index-linked rental contracts. “There is an opportunity in continental Europe if you’re looking at that index-linking,” says Redding.
The company is also nowhere near endangering banking covenants and it has no major debt refinancings until 2025, giving it plenty of time to adjust if interest rates remain high. While the outlook for the global property market is likely to remain cloudy as the world gets used to dearer money, there is already plenty of uncertainty baked into the stock.
Its discount to NAV provides a margin of safety, while the 8% yield means investors will be paid handsome dividends. These are only likely to grow thanks to the strong fundamentals of the underlying European logistics market and index-linked contracts. The stock is unlikely to shoot the lights out when it comes to growth, but as a cheap income play, it looks attractive.
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