All change in UK REIT Land (September 2018)
Director, Centre for Real Estate Research, Cass Business School
Returning recently from the EPRA (European Public Real Estate Association) conference in Berlin I was struck by the accelerating pace of change that is now (finally) underway within the UK REIT sector. A sector, it is fair to say, that has not always been regarded by generalist equity fund managers as being at the forefront of innovation, strategic vision and adaptation. The changes have been brewing for several years but are now both visible, and, most importantly, shaping the strategies of both investors and corporates for the 2020s. So, what are the key forces that are work, and how might they play out over the coming years. I think they can be summarised as follows:
- The diminishing relative importance of the UK market
- Changing sector preferences
- Reduced emphasis on NAV metrics
Let us examine these issues in turn:
A diminishing relative importance of the UK market
When I first started scribbling away as a property equity analyst in the City the UK listed real estate was larger than that of the US. Honestly! Now (as per end August EPRA Global Developed Index weightings) the UK represents 4.87% of the universe compared to 53.69% for the US. In other words during the last 25 years the US has moved from under parity to be 11 times the size of the UK market. Many people forget that although REITs has been in existence in the US since the 1960’s it was only in 1992/3 with the advent of the Modern REIT era that it started to gain meaningful scale. Given the size of the US market overall, however, the trend of the relative sizes is not surprising. However, what is surprising to many people is that the UK is now no longer the largest listed real estate sector in Europe. It is worth remembering that only 5 years ago Germany had virtually no listed real estate companies. From a standing start the German sector is now larger than the long established UK sector (4.97% vs 4.87% of the global market). It is also worth noting that the largest German company (Vonovia) is now approximately the same size as the largest three UK companies put together, and is the 4th largest company in the EPRA Global Index, and the largest French based - Dutch listed company (Unibail Rodamco Westfield) is the 5th largest. This is not due purely to the performance of the direct property market. In London the market has proved remarkably resilient post EU referendum. Similarly it does not lie in structure. The German listed sector, unusually for a Western developed market, is not predominantly a REIT market. So the reason must lie in the relative attractiveness of the risk/return characteristics from the underlying real estate held by these companies, together with the equity valuation methodology.
Changing Sector Preferences
Perhaps the most widely used graph in the sector of the last 18 months has shown the massive relative out-performance of industrial property companies such as Prologis in the US and Segro in the UK, compared to retail property companies such as Simon Property in the US and Intu in the UK .
It illustrates not only the underlying socio-economic change (towards online shopping and away from physical retail) but also the valuation difference that a sector with growth and that is popular with generalist investors can enjoy. As an example industrial property companies can trade at c. 10% premiums to NAV whilst in extremis retail property companies can trade at 50% + discounts, i.e. a 60% stock market valuation divergence against a common, widely established and regarded third party property valuation. This illustrates a fundamental shift in sector preferences which is expected to continue. It is worth noting that an industrial property company, Segro, is now, for the first time ever, the largest listed real estate company in the UK. Because of the structural headwinds facing the traditional retail and office sectors there has been a huge growth in the so-called alternative sectors (Healthcare, student accommodation etc.) in both the listed and the unlisted market. I would argue that they are no longer “alternative” as they have been widely adopted and are now part of the mainstream, albeit smaller in size than say office and retail. For the purpose of this article let’s use the term “emergent” to describe them, compared to the “mature” sectors of retail and office. To illustrate the point, of the largest ten companies globally there are specialists in self-storage, data centres, healthcare, Wireless (or Cell) Towers, multi-family apartments but no office companies. An exposure to the global listed sector used to represent a structural overweight position in shopping centres and offices as most of the largest companies were overweight in these areas. Now, and I believe going forward it will represent an exposure to the fastest growing sectors in terms of income, which also have a real estate base.
Reduced emphasis on NAV metrics
UK (and to a lesser extent European) investors have long been fixated with NAV. This has proved an anchor for both equity valuations, and a benchmark for both equity raising and takeover expectations. It is not a hugely relevant statistic in the US where, because US GAAP is the accounting practice rather than IFRS , valuations are not incorporated into the balance sheet, i.e. there is no mark-to market. However there is reason to believe that its role as the number one valuation metric nay be on the wane. The reasons for this are as follows:
- The faster growing emergent sectors are typically operationally focussed with an asset backing. This is entirely different from a passive property investment vehicle. Therefore, to capture the growth of the companies a valuation that is based on forecast cash flow generation rather than historic investment value is most appropriate.
- NAVs are an extremely important figure at times when market values are moving quickly (in both directions). This is not the case in the UK at the moment (with the possible exception of negative movements in capital values of secondary shopping centres in the second half of 2018).
In conclusion, whilst the underlying trends mentioned have been known for a while, we are now starting to see the manifestation of these changes impacting the market at an increasing pace, and expect this to continue into the next decade with implications for investors and corporates alike.