There are three factors which could impact the outlook for the real estate investment trust (REIT) market: there's a bull case out there, there's a bear case out there or there's another wildcard scenario.
The bear case
The bear case is receding: the bear case is high inflation, high base rates leading to increasing funding costs.
The one-month SONIA (sterling overnight index average) rate remains above 4% for 2023. In September 2022 there was the ‘mini budget’ shock when UK short rates were up at 5-5.5%. We have clearly retreated from that level. The most recent data is that economists and traders are forecasting the Bank of England base rate to peak at 4.5% in Q2.
If you want to be bearish you have to believe in a return to Truss-enomics but the market is not expecting that right now.
The second element to the bear case, and again showing some signs of receding, is a recession that leads to lower rental income. The most vulnerable and impactful type of recession for real estate would be a full-blown mass unemployment recession.
Currently however, it looks much more like a technical recession, ie two consecutive quarters of negative GDP growth. The Office for Budget Responsibility says that economic downturn is set to be “shorter and shallower” and that the economy “still faces significant structural challenges”. The Bloomberg UK Recession Probability Index is surprising in that it has come off from a near 100% certainty of a recession down to 75%.
That's why we say the bear case for real estate appears to be receding.
The bull case
The bull case really starts with valuations and valuation levels are very attractive. For UK REITs, according to the European Real Estate Association (EPRA), the discount to net asset value basis in the UK has historically averaged about a 13% discount; today REITs trade at around a 30% discount to net asset value. I think that discount gap will close in two ways; the first will be asset values coming down and we are seeing year end valuations of assets declining.
The second way is a rebound in REIT share prices leading to the closing of gaps.
Clearly picking the right sectors and the right stocks is key to generating superior returns and in certain areas, high-quality real estate is trading at a wide discount to reported net asset values.
In the ageing population sector we see REITs at a 14% discount to net asset value. Generation Rent, one of the fastest growing areas, offers 20% discount to net asset value and Digitalization a 23% discount to net asset value. But beware the discount traps: retail is very cheap with 50% discount to net asset values but there's more pain to come there – there is more re-basing of rents definitely in secondary locations.
Also, while there are the liquidity issues for certain banks out there, lending standards are high so there isn't a liquidity issue for commercial real estate.
Still, it is important that investors focus on those areas where we see really good rental growth so the rental growth can offset any increased cost in financing but I don’t think we are seeing distressed sellers.
With regard to rental growth, one way to offset an increased cost of financing is obviously contractual rental growth but in addition to that is imbedded rent reversion – i.e. in-place rents below market rents – this rent reversion you can capture where the lease comes up for renewal. It helps to offset any outward shift in the valuation yield and it helps offset any rising financing costs.
The wildcard as we see it is what happens when the Bank of England pauses increasing interest rates and what happens to REITs when central banks pivot. It’s about time in the market, which is more important than timing the market.
We can't time precisely when the Bank of England will pause its current rate increase cycle. For example, the trouble in the international banking sector may bring that pause closer. Disinflation may lead to an easing cycle whatever the trigger is.
But the key thing is to be invested in the market. If you had missed out on just the 10 best days for UK REITs over the last decade your return would have dropped from 3.3% annualised return to - 2%.
Matthew Norris is an investment adviser at Gravis, adviser to the VT Gravis UK Listed Property fund. The views expressed above should not be taken an investment advice.