From the beginning of November – when the market decided that the Fed was hinting at rate cuts in Q1 of this year until the turn of the year – the quoted sector rallied by an astonishing 23%. The buying frenzy was indiscriminate, with no asset exposure correlation. In fact, some of the best performing shares both in the UK and Europe were those with the highest degrees of leverage. Short positions hurriedly closed and some fundamental buying meant that REITs spent 10 months of the year friendless and ended the year out-performing the All Share Index by 5%.
So far this year, 10-year gilt yields and the five-year swap rate have risen by 60 bps; the sector is back in under-performing mode and nervousness prevails. It’s indeed strange days with a virtual absence of investment interest in the direct market at a time when rental values in ALL sectors of the commercial and alternative markets are rising; albeit only for the so called prime or best-in-class assets.
The journey to price discovery has not yet ended, but I’m rather of the view that the investment market will start to stir when we eventually get a clear message on the timing and scale of rate cuts. After all, investors were happy to pay sub-5% yields for London offices when rents in most areas were static. Now I’m seeing prime rental values – and I stress prime – rising by up to 10% in the Square Mile, which sounds unlikely, but it’s true.
Demand for best-in-class space exceeds current, and likely future, supply so rental growth seems baked-in. The death of the office sector by WFH and “changes in working practice” may have led to rising vacancy rates, but that’s for sub-prime space, of which there’s plenty. For those, including REITs, which own and are developing new space then the death of the office market is turning into one hell of a wake.
Size matters
The main trend this year has been mergers. No “A” but lots of “M.” LondonMetric has set a high bar as its all-share merger with LXi creates potentially the UK’s fourth largest REIT, including an enlarged portfolio full of index-linked income to augment the reversionary potential in its logistics portfolio and a cost ratio of half that of much of the sector. A dividend-growing machine which from distant memory is what a REIT should be! This announcement was followed by Custodian REIT announcing a proposed merger with the “vowel-lite” Abrdn Property Income Trust to create a company with over £1 billion of relatively small lot size assets and a diversified asset type concentrating again on income and dividend growth.
Those deals were announced in December and January, so in February Tritax Big Box announced a proposed merger with UK Commercial Property Trust, another externally managed vehicle by Standard Life, owned by aforementioned Abrdn. Again, an all-share merger based on the two companies NAV’s. If it goes through, then it would create the fourth or fifth largest UK REIT with a portfolio approaching £6.5 billion. UKCPT owns a number of complementary logistics assets which is BBOX’s speciality but more of the “last mile” type than the national distribution mega boxes. There’s also £400 million of non-logistics assets which will doubtless be disposed over time.
Well the only saving grace of all of this is that at least the sector itself is not shrinking, in terms of market capitalisation, even if the number of companies is. The focus is very much on creating larger, more liquid REITs, which is to be applauded, and also with a heavy emphasis on dividend growing capacity, which again is to be applauded. There are plenty of other sub-scale REITs that don’t have the ability to grow – now that the pricing of their equity largely prevents them raising fresh equity capital – and the lack of liquidity in their current equity capital is a serious problem for many fund managers.
Some of these “small” REITs have very good asset management skills and “deserve” to be bigger and the only current way forward appears to be through all-share mergers. The problem with this is finding management teams willing to merge with the likely loss of their jobs, as well as finding complementary portfolios given the investment community’s preference for sector specialisation. Nonetheless other proposed mergers are almost certain to be mooted over the course of the year if the underlying real estate market remains healthy from an occupational perspective but moribund from an investment perspective.
So, shares are back to decent discounts, rental values for much of the sector are rising and likely to continue heading north, and there’s some corporate activity taking place. Oh, and despite the deferral of rate cuts, as inflation proves sticky at the 4% level, it’s a racing certainty that they will end the year lower. There’s a lot to like… isn’t there?
