In the last few weeks central bank watchers claim to have detected a new mood emerging from this summer’s gathering of the clan. A desire to follow the Fed down a path which leads to ‘normalisation’ of interest rates and the unwinding of QE in an informal ‘Sintra pact’. Even our own Mark Carney has added his two penneth with a heavily conditional hint that if the UK economy survives Brexit, it will be necessary to raise rates. That would be a nice problem to have. In the meantime, we are going to need all the help we can get.
The upshot was another taper tantrum, taking the US ten year from 2.15% to nearly 2.40%, the German Bund from 0.25% to 0.55% and our own ten year gilt yield from 1.00% to 1.30%. These are big moves by any standards but it is important to keep them in context: the ten year gilt was 1.50% at Christmas. The damage to the listed real estate sector was modest but it did take the major REITs back to levels last seen a year ago in the wake of the Brexit vote.
In past cycles the tone has been set by the majors which sustained premia to NAV when property values were expected to grow quickly and discounts when they were expected to decline. Fast growing smaller companies traded at bigger premia in the upswings and bigger discounts in the downswings. It all made sense. Which makes it all the more difficult to rationalise current pricing across the sector.
The traditional property companies – now transformed into REITs – are behaving as one would expect them to: they sustained premia, in some cases significant premia, when investors could only see growth and then de-rated in 2015 when it became clear that the market was levelling off. Post referendum any signs of life are treated as one-offs at best or backward looking at worst because many people believe that it’s only a matter of time before values fall. Investors have priced the sector accordingly.
In the meanwhile, the new income focused REITs seem to be living a charmed life. The best are trading at significant premia and there seems to be an unlimited demand for follow on issues and new IPOs. To be fair, the ones with the biggest premia are mostly operating in those areas of the market which are generating structural growth like distribution warehouses, student accommodation and doctor’s surgeries. So, there is some logic to it, but it is unusual for such extreme valuation disparities to coexist.
There are many possible explanations. One which I find increasingly attractive is that the two groups of stocks attract very different audiences. The income focused REITs are the preserve of private investors, either directly or via their wealth managers. To quote a friend of mine who knows this area well, demand for the sort of dividend yield secured by robust cash flows which these vehicles offer is ‘almost infinite’ from people who rely on investment income to pay for the weekly shopping. They are owned for the long term and trade off their dividend yields. The traditional majors have much more diverse share registers, are managed for total return rather than just for income and have to fight for an audience with the rest of the equity market. Discounts, which are as wide as 34% in the case of British Land* and Intu, suggest that they are losing the battle.
However, at these levels they must be starting to look attractive to income buyers with both stocks currently yielding 5%. Admittedly, they are much more volatile than the pure income REITs but this is because they are much more liquid and much more widely owned, two characteristics which mean that investors are more likely to be able to change their minds, should they ever wish to do so.
*Clerkenwell Matterhorn Fund, where Adrian Elwood acts as the designated fund manager, has a holding in this company
