The case for seeking income in real estate has a long and convincing history. The credit crunch put a well documented stain on this record. Between 2007 and 2009 the UK property market lost 45% of its value. A number of property investment trusts saw their net asset value drop below zero due to high degrees of leveraging, and an even larger proportion of the property securities market ceased to distribute dividends.
Since the credit crunch storm quietened, the UK property market has gradually picked up in line with the broader economy, though this process has been slow and arduous and the recovery remains fragile. To discuss the latest developments on the real estate equity front and the role of property investments in an income-focused portfolio, we spoke to Alex Moss, Head of Global Property Securities Analytics at Macquarie. The following are excerpts from this interview, in which Moss explains why he believes the UK property market is poised to return stable and modest growth of dividend yields and highlights the need to understand the liquidity of your holdings when investing in real estate securities.
Prices and Dividend Yields Stabilising on the UK Property Market
At the moment, Moss sees the UK property market as relatively stable. He pointed out that dividend yields were unsustainable in the second half of 2008 and going into the first quarter of 2009. Since then, companies have undergone major recapitalisations or rescue rights issues and reset their dividends to a sustainable level. As there has been so much yield compression in the UK, forecasts for real estate companies to achieve capital value increases over the coming years are relatively modest, as a result of which greater emphasis is being placed on the income component. That said, the first signs have emerged of dividends poised for growth in the next few years as market rents recover, though this growth is unlikely to be aggressive.
UK Property Companies in a Rising Rate Environment
The property sector has a history of high gearing levels, but Moss explained that property companies have become more mindful of their exposure to debt after the financial crisis. Following the 45% decline in property values in the UK from June 2007 to June 2009, which triggered some companies to make forced sales under rescue rights issues, most companies now keep a close eye on to what degree property values can fall before their banking covenants are threatened. As such, property groups remain very conscious of their gearing and are much less likely to be highly leveraged than they have been previously.
In addition, the impact of an increase in interest rates on property companies’ balance sheets is limited. The majority of property companies have very little variable rate exposure as the majority of their debt rates are either fixed or swapped out, and for most it is not the LIBOR rate but the cost of debt that can constitute a problem. That said, companies have not been going out aggressively with development programmes that haven’t already been funded.
The Appeal of REITs for Income Seekers
Post the introduction of real estate investment trust (REIT) legislation in the UK in January 2007, and with it the requirement to pay out a certain level of the trusts’ profits, real estate investments have become popular income-delivering vehicles. REITs are more closely aligned to the cash flow of the properties they invest in, rather than acting as highly geared, low payout property investment vehicles.
A number of challenges remain on the UK REIT market. The UK REITs are much younger than their equivalent structures in the US and Australia, and UK property companies that took on REIT status did so at a time when property yields were at an all-time low. This explains to a degree why, within the property space at present, some UK-listed investment trusts might offer higher yields than REITs. Going forward, however, Moss believes the REIT legal structure lends itself well to income investing. The 2011 Budget has also provided for a number of regulatory changes to this legal structure which should improve its investment appeal. Moss suspects, as do many other industry experts, that there will be a number of REIT IPOs once those changes come into effect.
Investment Companies Explore Capital Structures After the Credit Crunch
The investment industry is starting to look across different capital structures. Historically, the private and public property sectors, as well as the real estate debt and equity spaces, have been perceived as very much separate entities. In the past, unlisted real estate companies had to face the challenge of illiquid underlying holdings, but in a bull market with little demand for redemptions this was not a problem and property companies would mirror the underlying progress of the property market. Listed companies, on the other hand, have been scrutinised for their volatility as their past performance has reflected broader equity market sentiment in addition to changes in the value of their underlying holdings.
The credit crunch revealed a virtually unprecedented convergence of correlation between all the asset classes within real estate. In the current low interest rate environment, the objective of maximising income from real estate, while also enjoying the benefits of liquidity and options for gearing, can be met by combining elements of the “four quadrants” – debt, equity, public and private. Moss believes that investment product providers will start to combine these “four quadrants” of the real estate market and come up with vehicles that can smooth returns and give far better risk adjusted performance. He pointed out that few such offers are already available but highlighted the Schroder Global Property Security Income Maximiser, which enhances income by writing call options, and noted that Brookfield has also gone down this route.
Seeking Yield in Property Markets Outside the UK
A number of countries have growth models and legal structures that favour real estate dividends. Macquarie property research for April shows South African, Canadian and Japanese REITs as having the highest dividend yields in the company’s research universe. As of April 4, Canadian and J-REITs were yielding between 5% and 6% on average, and South African REITs were category frontrunners with over 9% average yield. For comparison, the average UK REIT is yielding close to 4%. There are several explanations for these figures. In the case of South Africa, the underlying market is well placed for growth. In the case of J-REITs, their legal structure mandates the redistribution of a high percentage of income, which makes them high yielders even in the aftermath of Japan’s earthquake. The extent to which the latter will suffer a long-term blow to their profitability in the aftermath of the natural disaster is still uncertain.
Three Key Takeaways for Investors
Moss concludes that investors should always be aware of the liquidity of their investment, with the recent geopolitical and macroeconomic market shocks underscoring the importance of this liquidity. Secondly, the sustainability of a dividend yield is also paramount. And thirdly, investors should look for funds and companies with a dividend capable of growth, so that the investment retains an equity characteristic as well as a high income component.
