UK REITs – real estate investment trusts – have drastically underperformed the wider market over the past year. The FTSE All-Share index excluding investment trusts has produced a total return of around 22%, while industrial REITs – the largest group in the sector – has returned just 6.8%, mostly from income.
However, while investors are clearly not interested in the sector, trade buyers and private equity are. Five years ago, there were 82 listed REITs. More than half have since been acquired or liquidated. Private-equity giant Blackstone has been especially active, first taking out St. Modwen Properties and Industrials REIT. It then beat Tritax Big Box (LSE: BBOX) in a battle for Warehouse REIT, before selling assets to Tritax in exchange for a 9% stake.
The trend looks set to continue. Earlier this year, British Land (LSE: BLND) acquired Life Science REIT. More recently, LondonMetric Property (LSE: LMP) – which has completed several deals in recent years – and Schroder Reit (LSE: SREI) have teamed up on a bid for Picton Property Income (LSE: PICT), although the outcome remains unclear. Last week, some of Picton's shareholders told the Investors' Chronicle that they are unhappy with the proposed terms.
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Unwarranted discounts on UK REITs
Derwent London (LSE: DLN) offers one of the best examples of value in the sector. The company owns a portfolio of high-quality offices in central London and trades at a 47% discount to net asset value (NAV), with a 4.6% yield. In an attempt to close the discount, management recently announced a £50 million share buyback, signalling it believes this is a better use of capital than buying additional assets. You can't criticise management for buying back stock – it's the equivalent of buying a new building at a 50% discount.
Yet it's clear that something has gone horribly wrong in this market, given that London is set to run out of high-quality office space within the next few years and rents are breaking records.
Grainger (LSE: GRI) offers another example. This is one of the largest residential landlords in the country and can't build new properties fast enough to meet demand. It has consistently reported an occupancy rate in the high 90s and last year recorded overall rental income growth of 7.8%. Yet the shares have fallen 29% over the past 12 months and now trade at nearly 50% discount to NAV, with a yield of 5.4%. Mike Ashley, founder of retail group Frasers, has been buying as others are selling. He owns just under 5% of the company via derivatives.
The value catalyst
Other examples include the likes of Great Portland Estates (LSE: GPE), which is trading at 60% of NAV (it focuses on development more than income, so has a lower 2.7% yield). Even relatively popular REITs such as LondonMetric and Supermarket Income (LSE: SUPR) are trading at around 90% of NAV, with yields of around 7%.
In general, UK REITs are changing hands at some of the lowest valuations in recent memory. Yes, they could get cheaper, but sooner or later they are just going to be too good for trade buyers and private equity to pass up. This should be compelling for value investors, since value investing works best if there is a clear potential catalyst to realise that value. Given the continued liquidation of the London equity market, it could only be a matter of time before every remaining deeply discounted REIT gets taken out.
If and when that occurs, investors who buy at today's valuations could see attractive capital gains. In the meantime, while they wait they can pick up dividend yields of 5%-7% – in many cases derived from long-term contracts with high-quality tenants.
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