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Finally, slowly, interest rates are set to fall — probably to between 4 and 4.75 per cent in the UK and the US. That’s refocused investors’ attention on rate-sensitive sectors. And, since they are built on mountains of debt, you don’t get much more rate-sensitive than real estate investment trusts, or Reits, companies that own, operate or finance income-producing properties.
The industry certainly has its challenges — especially in the office sector, where worries about working from home persist. We’ve already seen a tightening in the discounts on many well-established Reits, but some funds seem to have missed the limited revival.
At one, PRS Reit, shareholders are in open rebellion. An activist group, annoyed about the fund’s 35 per cent discount to net asset value (NAV), is attempting to force through a range of changes, including installing as directors Robert Naylor, formerly chair at music rights group Hipgnosis Songs, and veteran City investor Christopher Mills.
It’s at the slightly troubled end of the spectrum of Reits that I want to turn my attention, focusing on three funds that have fallen out of favour in the UK market but deserve closer inspection.
I’ll rank these by my sense of their riskiness, starting with Impact Healthcare, which I have been buying fairly consistently for the past few weeks for an income portfolio. The shares trade at 88.5p, with a discount of around 25 per cent to NAV. They have a net yield of about 7.9 per cent, fully covered by earnings. The core of the business is care homes, mostly for the elderly.
Positives include a low loan-to-value ratio (a measure of debt to net assets) of roughly 28 per cent, no imminent refinancing concerns, a dividend that has been growing consistently, increasing property valuations, and a total return since listing a few years back of around 8.8 per cent a year. I won’t bother overegging the obvious structural demographic driver here: by 2040, it’s estimated that one in seven UK residents will be over 75, and there’s a shortage of care home beds.
The challenge is what’s clinically called “counterparty risk” — that the care home operators a company leases to don’t fulfil their obligations. I’m sure we all have our views on profit versus non-profit operators, but I don’t see how we can solve the shortage of care homes without private capital somewhere in the mix, offering new purpose-built properties with all right the facilities.
That won’t stop operator defaults, which have already hit this fund. One, called Silverline, defaulted on its rent to Impact Healthcare on seven homes in January 2023, but the fund has replaced it.
Residential Secure Income is a much smaller fund, with a market cap of just £99.2mn on a portfolio of, you guessed it, residential units worth £141mn. This fund owns a portfolio of shared ownership homes (mainly flats) and independent retirement rental homes — the fund says it is the UK’s largest provider of independent retirement rental management services. The share price at 53p boasts a yield of 7.8 per cent on a discount of around 30 per cent.
Given the weak growth in UK house prices in recent years, the fund has reported some recent declines in NAV, although earnings look to be growing solidly, since rent inflation is still very high. One of the concerns with this fund, apart from its subscale size and worries about the housing market, has been the level of debt, with an LTV at roughly 53 per cent. Those worries are valid, as I think anything much above 45 per cent is a worry. Also, the fund does have to repay some debt at the end of this year, which it hopes can be funded by selling a portfolio of assets leased to a local authority.
These concerns are mainly about timing, though, and are a bit overcooked in my view as the underlying cash flows are strong and the dividends well covered. Note that the dividend has been reduced recently to put the fund’s cash flow on a secure footing, and the manager has also chipped in with a fee reduction. One other positive is that although declining inflation might undercut rent growth, lower inflation will also reduce a slug of inflation-linked debt.
Talking of “challenges”, I think it’s fair to say that Regional Reit has had its fair share in recent months. It owns a series of regional offices, 135 in total, with 1,344 office units and 906 tenants, dotted around the UK.
80%Office occupancy rates
Some of its difficulties you can probably guess at. WFH has hit occupancy rates, running at about 80 per cent, while many regional cities have also experienced fragile markets for office spaces. There’s also the sustainability challenge, which consists of new lessees insisting on high sustainability ratings — 18 per cent of the portfolio comes in at a “D” EPC rating or lower, with another 25.9 per cent at a “C” rating. You can increase the rating by refurbishing it, but this is costly.
Another problem has been debt, with the LTV running well above 50 per cent at one point, which fairly frequent valuation haircuts have not helped over the past year or so. And to make matters worse, it had to repay a retail bond in August worth £50mn.
Add it all up, and investors ran a mile, with a chronic discount of well over 50 per cent. That all prompted an emergency fundraising, which massively diluted the investor base and brought in a well-known housing entrepreneur Steve Morgan as the biggest shareholder. The LTV is now back down much closer to 40 per cent, though that could rise again if there are more valuation markdowns, which I think is possible.
It isn’t easy to get a handle on the likely rebased dividend in the next year — some, like analysts at Numis, quote above 20 per cent, but I would guess it will be in the double digits. So, troubled, yes, but Regional Reit is well positioned if there is an uptick in the UK economy and interest rates do come down, stabilising property prices. Plenty could still go wrong, but for the properly adventurous there could be the possibility of mid-teens total returns here.
David Stevenson is an active private investor. He owns shares in Impact Healthcare and formerly owned Regional Reit retail bonds. Email: [email protected]. X: @advinvestor.