In September, an event of some significance happened for the quoted REIT sector: MSCI, the global index provider, expanded its headline Global Industry Classification Standard index from 11 equity sectors to 12. This will affect the S&P Dow Jones indices, but not the FTSE Russell indices. The UK FTSE-A index will still have 11 sectors, with REITs and property companies being two respective sub-sectors under Financials. This change, however, reflects the growing importance of REITs and property companies in the equities market and may well have the effect of increasing trading activity and encouraging flotations.
There are, however, significant differences between the US and UK REIT sectors. In the former, there are already many specialist REITs, investing in hotels, offices, shopping malls, and perhaps most interestingly, property debt and mortgages. In contrast, UK REITs and property companies tend to be more general, albeit most of them have gradually moved into more sector-focused areas of investment and/or development.
Land Securities and British Land, the two biggest REITs, still remain reasonably diversified, investing mainly in London offices, regional shopping centres, retail warehouses and logistics units. The third biggest, Hammerson, which has always had a strategy of holding a limited number of large assets, has now become solely invested in shopping centres and other retail. In addition to these and the smaller REITs, there are a number of property companies which either do not qualify as REITs, with tax-transparent status, but still invest in property, although this sector also includes property services companies, such as agents. However, for the purposes of this article, I will just deal with the asset-holders and include all of these under the broad REIT heading.
Normal or traditional methods of valuing equity stocks only have limited application to REITs. Over the years, various analysts have tried to value and measure performance on the basis of earnings, but the markets stubbornly adhere to valuing on the basis of net asset value (NAV) performance. There is a good fundamental reason for this: REITs are a substitute for direct property and, therefore, pricing against the direct market values provides a reference point. This is really only possible because we have, in the UK, a credible system of valuation, regulated by the Royal Institution of Chartered Surveyors. REITs are obliged to have external valuations, at least once a year, and investors can generally rely on those to provide a reasonably accurate assessment of value.
Of course, the prices of the stocks are rarely equal to their NAVs. The market will take a view on the prospects for growth or falls in values of the assets, as well as the profit (or loss) to be made from developments, and the addition of rental income (most of which needs to be paid as dividends in legally-recognised REITs), and apply a discount or premium to the NAV. Property values go through a clear cycle, in which rental values (and, in due course, rental income) are strongly correlated with GDP growth and availability of vacant space, although the market values will be anticipating changes in those factors as far as possible.
The property market reprices through changes in the capitalisation yield – a form of discount rate – which is applied to the rental income and values, which reduces when rental growth is expected to be high – and vice versa. The effect of changes in both the rental values and the capitalisation yield, albeit not quite in synchronisation, is a compounding one on values, which depresses prices in the down-phases and enhances them in the up-phases. The effect on pricing of stocks in the equities markets is that they can swing from being priced at a ‘discount to NAV’ to and from a ‘premium to NAV’, although stocks tend to spend more of their time at a discount.
The latest NAVs can be obtained from company accounts or presentations, together with information on the performance of the assets. But the NAV can be up to a year out of date. The sell-side analysts will extrapolate the asset values (after deducting debt) to a current position using their intelligence from the direct market to calculate a growth rate, but it is rather difficult and very time consuming for individual investors to do the same for each individual stock.
Part two of this article will deal with REITs’ drivers of value and part three will look at the prospects for the sector
Credit to Diana Patterson
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