In the face of declining retail property values and highly leveraged companies, a new structure might be needed
Real Estate Investment Trusts (REITs) have been a huge success globally, providing an income-producing, liquid, tax-efficient structure for investors to participate in real estate. The key to their success is the high dividend pay-out ratio, which provides an ongoing cash return to shareholders. Globally, shopping centres have been the key asset class of some of the largest REITs, and indeed the sector has been structurally overweight in shopping centres. Why so? Because shopping centres are multi-tenanted, large assets, requiring ongoing capital expenditure, producing historically stable cash flows, and asset management opportunities. As such, they were ideally suited to both asset owners and investors.
However, two UK REITs (Intu and Redefine) have recently announced that, due to currently high leverage and declining retail property values, they would cut their dividend to preserve cashflow. In traditional corporate finance theory, which looks across all 11 equity sector groupings, there is some debate (i.e., conflicting evidence) as to the importance of dividend pay-out ratios on corporate valuations. However, for a REIT, there can be no such debate. The fundamental purpose, and indeed the reason for the tax efficient REIT structure, is that a high, fixed percentage of taxable rental income is paid out to shareholders. To cut the dividend, albeit potentially temporarily, is therefore an admission that the vehicle is no longer capable of producing cash (i.e., dividend) income returns for shareholders. At a time of declining property values, and thus declines in forecast net asset value, the dividend pay-out has traditionally provided an anchor, or floor, for the equity valuation. Removing this floor changes the nature of the equity from an income producing REIT, to a non-income producing option. Therefore, the question becomes; is this part of a wider problem regarding corporate structure, or is this merely a couple of examples of over leveraged companies operating in structurally declining markets, with over dependence upon weak covenants?
Given the divergence in performance between sectors, particularly retail and industrial, and indeed in the parallel asset pricing model,between the listed sector and the direct market, it is worth examining whether REITs are the appropriate structure to hold UK shopping centres.
The alternatives can be broadly split into the following binary categories:
- No Leverage/High Leverage.
- Open Ended Fund/Closed Ended Fund.
- Perpetual/finite Life.
- Core/CorePlus/Value Add/Opportunistic.
In the current UK environment five factors are known: