Unglamorous profits from offices and shop premises

In the property world, the vast majority of the market is made up of mundane, functional buildings that provide businesses with premises at a reasonable cost. Real estate investment trusts (Reits) that invest in these can be attractive for income seekers.

AEW UK Reit (LSE: AEWU), for example, is the highest-yielding fund in the property sector. It pays a quarterly dividend of 2p, fully covered by earnings. With a share price of 91p and a 2% discount to net asset value (NAV), the shares yield 8.8%, from which it might be assumed that the fund was in trouble and the dividend under threat. Yet of this there is no sign. A portfolio of £196m at the end of 2019 was financed by £147m of equity, though another £7m of share capital has since been raised and borrowings of £51.5m, 90% of the interest on which is capped at 2% until late 2023. Half the property portfolio is industrial, a quarter comprises offices and the rest is divided between retail and leisure.

Strong rental growth

The fund is nearly five years old and the managers, AEW, are no novices, overseeing some £60bn worldwide. Alex Short, the fund’s manager, describes the industrial properties as “good quality, second hand and very well located, different from the prime logistics sites that yield just 4%. Our properties have generally been bought on yields of 8%. [Gross] rents are £3.50 per square foot but we have seen some very, very strong rental growth and there is more of this to come”. AEW tends to buy properties “with a slightly shorter-than-average lease, which very often enables us to unlock significant value on re-letting. In some of these cases, across all the asset classes, we [have doubled] the value of the assets”. This accounts for annual returns of 10% so, understandably, AEW is keen to grow the fund. It has a pipeline of opportunities totalling about £100m, which must make the outcome of the recent fund-raising disappointing. This reflects on AEW’s poor timing rather than its record or outlook.

The supermarkets recover

When the Supermarket Income Reit (LSE: SUPR) was launched three years ago, supermarkets were emerging from a period of difficult trading caused by overexpansion, competition from the discount stores and the rise of online deliveries. Investors in a fund renting to the supermarket chains might have worried that leases would not be renewed and stores closed. A share price of 107p, 10% above NAV, shows that any such worries have disappeared. The shares still yield 5.4%.

The fund raised £100m of additional equity in late 2019, increasing net assets to £328m. This extra capital has now been deployed, yet SUPR is still looking at acquisitions. The portfolio consists of nine stores with an average of 18 years outstanding on their lease agreements.

SUPR’s business model is to acquire properties on a net initial yield (net rental income as a proportion of the gross property value) of about 5%, with rents rising in line with inflation. About 60% of the group’s business is financed by equity and 40% by debt with an average cost of 2.2%. The result is a return on equity of nearly 7%, which pays for the (rather high) management fees of 0.95% of net asset value and other costs, leaving dividends covered by earnings. A yield above 5%, rising in line with inflation, should ensure continued steady capital appreciation.

Neither fund is exciting, but the yields are generous and dependable. The AEW fund looks cheap, while market weakness is a good opportunity to buy SUPR.