25/02/2007
Trust in REITs to boost returns from property
Classically, it has not been easy for a retail investor to access commercial property except via a pension fund. However, there have been important developments in the UK in recent years which have opened up more opportunities, including Real Estate Investment Trusts (REITs), property derivatives and globally diversified funds. This article considers the advantages and disadvantages of global versus domestic property, and what role REITs may have in a client portfolio.
The historic benefits of holding property have been two fold, a rental yield usually well above cash, and rental movements normally reflecting general inflationary trends over the medium term. More recently a positive re-valuation of commercial property against other asset classes has further enhanced returns. In our view, as we discuss below in more detail, these drivers are now well priced in. Nevertheless, looking ahead, there are still reasons why property should form part of a diversified portfolio, namely improvements in liquidity and opportunities to enter new markets.
REITs have operated in the US, Australia and Holland for several decades. In the UK, after a lengthy discussion period, the Treasury finally allowed REITs conversion from January 2007. So far about 15 UK companies have converted, such as Land Securities and British Land. They make up some three quarters of the sector worth over £45bn. In general, there are certain tax advantages for investors over other opportunities such as 'buy to let' property. In particular, UK REITs have income tax and stamp duty benefits. Almost all of its earnings must be paid out to shareholders, a structure which reduces the discount which property shares historically trade against net asset value.
Such vehicles will provide the opportunity to buy a wider range of assets, which were previously less accessible, such as shopping centres or City offices. This aspect is likely to develop further, for example as residential property REITs are made available. Another alternative could be sector specific funds, so that more sophisticated investors or advisers could choose defined sectors such as logistics or out of town retail parks. However, as with buying any house 'location, location, location' is vital and a diversified portfolio would still be required.
The immediate response from investors to the changes in the UK market was positive, with share prices for many of the 'REITs-to-be' companies rising some 40% in 2006. However, the timing of the government's announcement on UK REITs was unfortunate in other respects. It came at the end of a decade of good property returns, as the UK adapted to becoming a low inflation, low interest rate economy. Hence, the now well known valuation metric between rental yields and swaps or gilts rates has turned negative. Accordingly, looking forward our House View expects more moderate returns from UK commercial property. We are currently Light in UK property and Heavy in UK and more defensive overseas equities.
However, the House View still sees attractive valuations in many, though not all areas, of global property. In this respect, our Focus on Change analysis is paying more attention to the longer term drivers of diversification and liquidity opportunities, which are still supportive for global property vehicles. Geographical diversification is essential as the majority of UK investors will have a large amount of their overall wealth already tied up in one asset – their house.
As yield is a key feature of REITs, it is important to look at the range of yields on offer. In the UK, they currently range from 2-4%, broadly in line with UK dividend yield, as many trusts focus on achieving capital growth. This is below the yields which can be seen elsewhere, say in Japan (3-6%) or Australia (5-6%). Property, whether commercial or residential, should be seen as a long-term investment. A major attraction of such assets is rolling up dividend payments and re-investing over a period of years.
Looking ahead, improved liquidity is an important factor. Investors are likely to accept lower yields in return for increased trading levels, greater transparency and the availability of valuation data provided by established REIT markets. As REITs have evolved, so too has the ownership structure of commercial property. In mature markets such as the US and Netherlands the corporate community, for which property is not a core investment, own and occupy between 30% and 40% of real estate. In markets without REITs, such as Germany, as much as 70% is still held by corporates; in some non-REIT Asian markets it is as high as 80%.
The trading liquidity of global REITs is good; we predict it will improve further as the global market evolves. In the established REIT markets of North America and Asia-Pacific, between 9% and 10% of the underlying estimated entire property market is listed on stock exchanges. Currently in Europe the equivalent is only 3%. The adoption of more tax transparent structures in the UK and Germany has important implications. If we assume that over the next 5 years the potential for European countries introducing REIT structures is to expand to the global average excluding Europe (i.e. between 9-10%), then in the UK and Germany the estimated combined size of the listed property market could double to €200bn.
In conclusion, our Focus on Change approach indicates that global property remains an attractive asset class, as liquidity and transparency improves, but investors must pay increasingly close attention to valuation concerns, which are deteriorating in a number of areas. Hence there is a need for strong active fund management to take advantage of divergent regional property cycles.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Scotland on Sunday on 25 February 2007.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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