Real estate’s Rocky moment?

Having taken a combination of macroeconomic blows over the last few years that sent the real estate market to the canvas, the sector appears set to stage a recovery – by Richard Williams

 
In true Rocky style, property seems to have beaten the 10 count and is back in the fight. There is always the threat of a knockout blow (in the form of a severe economic event à la GFC), but the bottom seems to have been reached.

It is always wise to watch the activity of the private equity giants in the real estate cycle, which have a canny knack of timing the recovery. And they have been raising billions for new mandates ready for an onslaught on the sector.

This confidence follows the bloodbath of valuation cuts experienced in the high-interest rate environment, and the anticipation that the opposite impact will take effect as rates fall.

It’s not just trophy assets they are lining up. Last week Starwood bid for Balanced Commercial Property Trust, while Brookfield has been sniffing around Tritax EuroBox. Meanwhile, Blackstone has been acquisitive in the space for a while.

It is a clear indication that the discounts to NAV that the majority of the UK listed sector trade on are far too wide. Many more opportunistic bids will likely follow if these discounts persist.

We have picked out three REITs trading on heavy discounts that we think should stage a recovery now the market is back on its feet and throwing punches again.
 

Picton Property (PCTN – 21.4% discount to NAV)

 
A lot of M&A activity has taken place in the diversified REIT category, but this internally managed REIT, which is heavily weighted towards the industrial sector (61.7% of the portfolio by value), is a stand-out among the peer group.

Led by chief executive Michael Morris, the company has been creative in dealing with its problem offices by attaining planning consent for change of use to more valuable asset classes like residential or student accommodation and selling them on, minimising capital value declines.

Values stabilised across its portfolio in the quarter to the end of June, posting a modest 0.4% uplift on a like-for-like basis. This mainly came from its industrial portfolio, which was up 0.8% in the quarter, outweighing weakness in the office portfolio (which makes up 27.1% of the portfolio). The industrial sub-sector is set to continue to outperform other property with supply-demand dynamics still favourable and rental growth prospects strong.

This puts PCTN in a good place for a recovery, as values in the logistics sector were hardest hit as interest rates rose from 2022. It should also help it to improve on the 23.6% NAV total return it has delivered over the last five years (which should not be sniffed at given the multiple issues to hit the sector in this period).

Another tick in the box for the company is its debt position, with a low loan-to-value (LTV) ratio of 24.9%, a weighted average cost of 3.7% and weighted average maturity of 7.5 years. Meanwhile it lifted its dividend target for the year (which is fully covered by earnings) and currently has a dividend yield of 4.8%.
 

Urban Logistics REIT (SHED – 24.6% discount)

 
Speaking of the favourable characteristics displayed in the industrial sector, SHED invests in one of the most supply constrained sub-sectors – urban logistics. It has performed strongly over the last few years (delivering a NAV total return of 51.6% over five years despite recent hefty valuation hits) as rents have soared. It operates in the smaller end of the logistics market, focused on the ‘last mile’ of the logistics supply chain. This means owning property close to major towns and cities where land constraints are exaggerated due to demand for sites from residential developers.

Its management team is focused on buying real estate with top-quality fundamentals that will stand the test of time through market cycles and always be attractive to occupiers. It also has around half of the portfolio categorised in the asset management bucket, where it can more easily push rents up to market value.

A relatively high debt cost (of about 4.2%), as well as higher than usual vacancy (mainly from one building) have seen earnings fall below its dividend level. However, management seems to be on top of this and has identified a pipeline of NAV and earnings accretive acquisitions and is progressing a plan to eliminate most of the vacancy.

Once dividend cover is achieved, and the market reopens and its manager can get back to doing its effective business of recycling the portfolio into value-add opportunities, a re-rating of its share price should follow.
 

Triple Point Social Housing REIT (SOHO – 41.3% discount)

 
Our last pick is SOHO, which languishes on the widest discount of the three. Some reasons for this are justifiable but others not so much in our view. The good news is that the justifiable reasons are being addressed by the manager. Two of its housing association tenants – Parasol and My Space – have been in rent arrears for some time having got into financial difficulties.

The manager has recently announced that all 38 of the leases on properties let to Parasol have been transferred to Westmoreland. The manager expects rent collection to increase to between 75% and 85% of the existing rent during the first 12 months, and increasing thereafter to up to at least 90%. The manager says that it undertook studious due diligence of Westmorland, which was previously issued a notice by the regulator regarding governance and financial issues, but is comfortable that a new, experienced management team is turning things around. This is reflected in Westmoreland’s accounts, which show four years of annual surplus and growing turnover and a steadily increasing cash position. SOHO’s manager will now look for a similar conclusion to the My Space-let portfolio.

It appears to us that SOHO may have been unfairly caught in the cross hairs of the negative headlines that have plagued the UK residential sector in recent years. In 2021, SOHO’s peer Civitas was the subject of a short-seller report – the meat of which was focused on undisclosed dealings by directors. Claims surrounding the strength of the tenants were flimsy at best. More recently, headlines on Home REIT have not helped either.

Despite share price weakness, the company has delivered a NAV total return over five years of 42.5%. Meanwhile, its balance sheet is the envy of the sector. It has a long-weighted average debt maturity of 9.1 years at a low, fixed rate of 2.74% and no maturity until 2028.

To tackle its wide discount, the company has said it will sell a £20m-ish portfolio and use the proceeds to repurchase shares. This will hopefully facilitate a deserved re-rating of its share price.
 
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