Now could be the time to invest in property
More sensible investments with Dr John
With rising interest rates, real estate has been badly beaten up. REITS, in particular, have been hammered. But yields are now attractive. Is it time to be invest? Dr John is back today with some thoughts on investing in real estate. Enjoy his wisdom.
At the start of 2022 there was a fair amount of uncertainty in the markets and I remember a few famous investors talking about a diversified portfolio. Saxo Bank suggested a 100-year portfolio, which should have 20% in real-estate. The Motley Fool says that “Several studies have found that an optimal portfolio will include a 5% to 15% allocation to REITs”.
A REIT is just a Real Estate Investment Trust: a share traded in the stock market which owns real estate – offices, shops, industrial units, warehouses and logistics.
I duly followed this talk and had 5% of my portfolio in a diversified selection of property investment trusts.
What were they? How have they done?
Schroder Real Estate (LSE: SREI) was a favourite of mine. It started the year at 53p and ended at 42p. Likewise BMO Real Estate (LSE:CTPT) started the year at 85p and ended with a new name - CT Property Trust - and 20% lower at 68p. Palace Capital (LSE:PCA) was also down - 250p to 212p. Not wanting to be overly exposed to office or industrial I had an investment in Aberdeen Standard Logistics (LSE: ASLI) which went from 115p to 68p.
Ouch. And I thought of myself as a responsible long-term investor.
I knew that REITs are valued in two ways: On their net asset value (NAV), or a property version of it. The share price should approximate to the NAV longer term, as the underlying property investments rise or fall in value.
They are also valued on the dividend yield. You don’t buy property REITs for excitement, but rather for a gradual NAV rise and a reasonable yield in the interim.
This is the Schroder Real Estate (LSE: SREI) in the period up to and then during and after the COVID pan(dem)ic:
Up to the pandemic there was a relatively stable share price, and a nice dividend. But then panic set in.
When I first invested in mid-2021 I thought I was entering at a reasonable time as prices had already been hit because of COVID, but that was history now.
I, seemingly mistakenly, assumed that if inflation rose, then so would rents. And so would rebuild costs and net asset values. And some rents in the REIT sector are even inflation-protected.
What went wrong?
The simple answer is interest rates.
Nearly all property companies borrow money to spice return.
If you have £100 and get a 6% yield then after say 1% charges you can give your investors a 5% dividend. Not bad in the zero-interest world of the 2010s.
But what if you can borrow say another £100 at 2%? And buy more property with the debt?
Now you’re getting a 6% yield on £200, £12. You pay £2 of debt interest and you’re taking £2 of charges (based on 1% assets under management, nice!). That leaves £8 for your investors or an 8% dividend.
Not bad, you’ve increased the dividend by more than 50% and doubled your charges. Everyone’s happy.
(In case this is reminding you of the story about private equity a while back then yes, they are similar because, yes, things are about to go wrong).
Now, four things happen:
We are heading into recession, and occupancy rates fall to say 75% so you’re only getting £9 in rent.
Interest rates rise from 2% to 4% so you’re paying £4 of interest on that £100 loan.
You’re now competing with bonds that are yielding 3-4% with much less risk. There is a risk premium associated with holding real assets over financial ones as they are much less liquid. (Ever tried selling an office block with 10 tenants?). So, the dividend needs to rise.
You feel that you may be over-leveraged (too much debt) and you might have to sell some property. But everyone else is doing the same, so property values fall, and therefore your NAV falls.
Now you have income of £9 rent minus £4 debt payments minus £2 charges, or £3 left over to pay out to your investors. A 3% yield won’t cut it. We are supposed to be increasing the dividend to compete with bonds.
The only thing that can happen is that the share price must fall to allow the dividend yield to rise.
A share price of 100p on a dividend of 3p is yielding 3%. Let the price fall to 75p and it’s yielding 4%
What might be surprising here is that a price fall of 25% only increases the dividend by a measly 1%. That’s why the price action has been brutal for REITs: as interest rates have risen, prices have been marked down, compounded by fear of recession and falling asset values and lower occupancy rates.
And here it is for SREI since it peaked last April:
Does all this mean now is the time to buy?
The big question is: is now the time to invest, given the prices seemingly are recovering?
I’m going to yes, tentatively, with the following caveats.
REITs don’t just borrow money at prevailing rates, they often take the equivalent of fixed-rate-mortgages, locking in a rate for years. Look for trusts that have locked in cheap debt.
The property market is unforecastable. A while back everyone punted on logistics warehouses, but now Amazon are laying off people. Don’t try and second guess the market. Buy trusts that have a diversified portfolio preferably with office, industrial, warehouse and other assets.
Debt is a killer. Used wrongly, it kills private equity, companies, and property trusts. The leverage ratio of equity (100p in our example) to gross assets (200p) needs to be small. Buy trusts that are not over-leveraged.
And finally: buy good management.
So, where to invest now?
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