Long-term property returns derive from income and its compounding potential – that’s precisely what REITs were created to deliver
During the first half of 2007, Apple launched its first iPhone and the UK government introduced the REIT regime for the UK property sector, following on from successful REIT regimes in both Australia and the US.
Over the subsequent 12 years, the fortunes of REITs and iPhones have contrasted significantly. While the iPhone, now on its 11th reiteration, has been an unqualified success, the launch of REITs coincided with the onset of the global financial crisis and one of the deepest real estate recessions in living memory.
The rationale behind the introduction of REITs in the UK was simple. Firstly, it was backed by undeniable evidence that long-term property returns are largely derived from income. Secondly, it was to persuade investors of the attractiveness of a repetitive and growing income stream from property where they could benefit from the tremendous compounding potential of repetitive rental income. Thirdly, it aimed to encourage real estate companies to have a more patient and income-focused approach to investing by oﬀering tax advantages to allow rents to pass from occupiers to shareholders without the friction of double taxation.
The expectation was that by introducing the REIT regime, UK property companies would take a selective approach to development, minimise trading activity, encourage lower leverage and maintain high pay-out ratios to shareholders.
Encouragingly, a number of companies, particularly more recently launched ones, have fully embraced the REIT regime. These have invested across many real estate sectors: we now have student, supermarket, long- income, healthcare, private rental sector, self-storage and warehouse REITs, with nearly all building portfolios designed to deliver compounding returns in an environment of virtually zero interest rates. However, the wider REIT sector is still populated by legacy companies adopting the same hyperactive trading, asset management and development strategies today as they did in a pre-REIT world. They have to a large extent failed to adapt, and their failure to prioritise income returns has seen many deliver disappointing shareholder returns.
While there is still a place for world-class developers delivering cutting-edge buildings and highly desirable environments, worrying about when and for how much someone else will buy your building feels like speculating. The income-compounding theory espoused by true REIT adopters relies on a more patient and rational approach. After all, compounding is exponential and builds as it grows, meaning that investment time horizons are longer and ultimately proving that it is not always necessary to do extraordinary things to achieve extraordinary results.
As Charlie Munger of Berkshire Hathaway once said, “The first rule of compounding is: don’t interrupt it unnecessarily.” So while historically real estate companies were continually trying to deliver brilliant returns with a more hyperactive approach of 1+2+4-3+0+5-2=7, the new REITs are more patient and more content with 1+1+1+1+1+1+1=7, understanding that an annual return of 6% will double their money every 12 years and that 8% a year will double their money every nine years.
The merits of this approach are clear to see. US Triple Net (NNN) REITs enjoy an average premium-to-NAV rating of around 40%, compared with a sector average of about 10%. In the UK, NNN proxy stocks trade on an average premium of around 20%, compared with a roughly 5% discount for the sector. Therefore, the expectation must be for the NNN proxy market to grow further as more companies embrace compounding strategies and premium- rated paper is used. Certainly, in an uncertain world of very low interest rates and an ageing population, shareholder appetite for strong, long and compounded income returns remains undiminished.
Within real estate, however, a rapidly changing world means that delivering a reliable and repetitive return is no longer as easy as it once was. As many sectors are increasingly disrupted by technology, changing consumer patterns and new innovation, some property assets have been looking more like melting icebergs.
Physical retail has obviously seen the most significant disruption and value destruction. I’m often asked to opine on whether we’ve reached the bottom and if there is embedded value. The simple truth is that I cannot price an asset until I know at what level rents will reset, what tenant incentives are required and for how long an occupier is willing to commit. With the strong occupiers such as Next, Primark and H&M only signing five-year leases and at about 30% headline rental reductions, I have no certainty on income sustainability. Therefore I expect cap rates to carry on expanding to reflect that uncertainty and, most likely, a continuing fall in the trajectory of rents.