Are REITs my Property Income Answer?

Real estate invesment trusts (REIT) have been popular for years in the United States and were introduced in 2007 in the UK. REITs are listed companies whose share prices move around daily, sharing the same characteristics of investment trusts. They are collective investment vehicles that pool investors’ money to own a diverse portfolio of direct property assets.

In terms of liquidity, the largest names are worth billions (see table) and are easy to buy and sell and get prices for. By buying in, you get direct exposure to commercial property with millions of square footage of floor space. If you look at a REIT’s portfolio you may see addresses rather than company names. Like most stock market investments, they offer a neat way of getting exposure to something you couldn’t afford outright yourself – like an oil company (Shell), a Formula 1 team (Ferrari) or football team (Juventus). You can't buy the Shard or Gherkin, but you can own a small percentage of these buildings' future income and capital growth.

Another similar approach is to own a property investment trust and this may own property equities and REITS anyway – a collective approach to a collective investment. For, example. TR Property (TRY) is an investment trust that is rated as Silver by Morningstar.

REITS are a convenient badge for investors to recognise but have grown in size and number in recent years and do different things: some focus on retail exposure, others in industrial spaces, warehouses and even self-storage.

These are quite specialist niches and don't offer broad property exposure. They are often subject to fashion and external factors: no one wanted retail outlets during lockdown for obvious reasons, but everyone wanted to own warehouses for the ecommerce boom. Now offices outside of prime city locations are being given the cold shoulder. Naturally retail investors are late to trends and tend invest when the market has moved on.

Ben Yearsley, investment director at Shore Financial Planning, cautions against having too much exposure to individual REITs. "The problem with buying an individual REIT is they can be quite specialist which is fine if you’re buying a basket, but not one," he says.

REITs get tax breaks from the government as long as they distribute the majority of their taxable income to investors. They can be held in Sipps and ISAs, but make sure you understand the relationship between share prices and Net Asset Values (NAV), how much gearing (borrowing) the trust uses and what it actually invests in. Like all investment trusts, they can trade at a discount or premium to NAV. It's also worth pointing out that, despite their income focus, REITs can cut or cancel dividends like shares and many did this in 2020.

(I've narrowed the list of REITs to those with a market cap above £1 billion.)

Another retail option is to invest in a property fund, or property authorised investment fund (PAIF). These have been controversial in recent years, not least for suspending dealings in times of crisis such as the pandemic in 2020, meaning investors couldn’t access cash.

The Financial Conduct Authority thinks "open-ended" property funds are not suitable for investing directly in property because of the "liquidity mismatch" between their assets and the need for daily pricing. The sector has seen outflows in recent years and performance has been lacklustre.

Experts say closed-end vehicles like REITs are better suited to more illiquid assets like buildings, which are harder to sell in short spaces of time; open-ended funds, in contrast, need to sell fund units to meet redemption requests. If you own an open-ended property fund, it's worth checking what it owns, as it may also own REITs. If you prefer equity exposure rather than direct commercial property assets, you can also buy property or  property income funds that own housebuilder shares.

Volatility Watch

While REITs have been a popular way to access certain themes such as the warehouse boom in 2020-2021, they can be volatile.

Pre-pandemic, office owners would assume high occupancy rates of buildings in cities like London, Birmingham and Manchester. That’s less clearcut now as hybrid working continues; companies want less office space but employees want better offices, according to JP Morgan Global Core Real Assets (JARA) manager Phil Waller. Owners of high-quality office space can now charge more, while others may struggle to attract tenants. In high-demand locations, occupancy rates are much higher than the empty commuter trains on a Monday suggest.

But building owners also face a number of exceptional and rising costs: after the Grenfell Tower fire in 2017, there’s now a renewed focus on removing cladding and upgrading building safety. The word "retrofitting" is the latest buzzword. Plus, buildings are part of the UK’s rush to net-zero, and that means more money spent on thermal efficiency, energy certification etc. Who pays for this is a controversial issue; sometimes it's the landlord (the trust) and sometimes the tenant foots the bill.

There could be worse to come for the sector: in its recent Q1 update, Lloyds Banking Group predicted heavy falls in commercial property values in the coming quarters. 

You might see this list of risks and compile a large bear case for funds and trusts exposed to property. Certainly some of the recent performance figures suggest a short-term volatility that could deter the more risk averse income investor. 

Does the income make it worthwhile? In an inflationary world, there are some advantages to owning commercial property, says JARA’s Waller: some landlords have contracts that allow them to inflation link rent increases. Commercial property also tends to outperform relative to other asset classes in times of prolonged inflation – and show smaller correlation.

All Round Delivery

Some REIT yields look tempting. FTSE 100 shares can’t really match these so what’s the catch? REITs also pays something called a distribution yield, which is similar to a dividend yield but isn’t a like-for-like comparison; the Corporate Finance Institute explains this complicated calculation in more detail. This % figure can be flattering and less easy to understand than a share price yield – which is a simple function of the payout and the current share price (eg. a 100p share paying 10p is yielding 10%). For simplicity, we've included the dividend yield in our table.

Open-ended funds tend to show lower yields – M&G Property Portfolio, one of the sector’s largest, has a 12-month yield of 3.37%, roughly in line with the FTSE All Share.

Property funds also tend to be very cylical – when the global economy is doing well, offices and shops are full and house prices boom. Perhaps there’s a contrarian argument for holding property for long-term capital appreciation, because it's got an amazing track record of doing just that. Most of the REITS in our table are sitting at a discount to their NAV, a feature of investment trusts that enhances returns when the market cycle turns. But the income argument is perhaps less convincing in the short term.

For income investors, there are plenty of alternative products out there that can offer relatively low risk and predictable income streams. Dividend ETFs, income funds, income and growth funds have all shown lower volatility than property shares, funds and trusts. Yearsely prefers hybrid funds, which own physical property and equities. As such, he likes CT UK Property Growth & Income fund as an "all rounder" for property exposure.