In The Matrix, Neo is offered a red pill that, if swallowed, will transport him to the harsh “truth of reality”, ie the real world, or a blue pill, which would take him back to a fantasy world of comfort and denial.

Mike Prew

It seems the real estate market is popping the blue tablets and equity investors are taking the red. Despite many pundits recommending REIT shares, they are trading 18% below their net asset value (NAV) and have done for nearly two years.

There are two problems. First, the cycle is ending with the weight of money being forced into UK commercial property being satisfied sooner or later and rents, we think, falling. Second, analysts are still juggling with the level of portfolio deflation implied in REIT shares, but they aren’t always good at guessing the next NAV.

Property capitalisation rates are widely used but now risk being discredited as guide-to-value investing. British Land’s sale of the Cheesegrater and Intu’s sale of its Bromley shopping centre are reference points but are time-stamped. And when was the last time a retail warehouse traded at 5%?

The only thing observable with any accuracy on a REIT’s balance sheet now is its debt, but debt economics are concealed by undisclosed financial derivatives. There’s currently too much guesswork on both sides of the balance sheet, which makes valuing REITs by their NAVs unreliable.

With UK gilts yields now at 1%, property valuations have become ultra-sensitive to rental growth and depreciation rates.

The only thing observable with any accuracy on a REIT’s balance sheet now is its debt

The UK closed-ended Channel Island real estate trusts are now trading at 13% above their pre-Brexit share prices, whereas REITs are down a net 6%.

The lesson is that REITs should be low-risk asset aggregators harvesting rents cheaply with low gearing and high yields — but most are not.

We invest on a ‘420 rule’ of 4% plus dividend yields growing at 2%-plus per year and 0% NAV, ie capital preservation.

The larger REITs by comparison may be high-dividend yielders, but are increasingly forced developers of dead offices and extenders of shopping centres. With flattening returns these hidden costs are now unmasked.

Point of low returns

The clock is chiming midnight, with 2017 reminiscent of 2007 as we wait for the ‘Cinderella’ appraisers to take their scalpels to portfolio valuations. Meanwhile, shareholders think that they are being paid enough with 4% to 5% REIT dividend yields to be patient, but we disagree.

In our latest memorandum, we demote the over-analysed balance sheet and profit-and-loss accounts for cashflow statements, which are ignored by other City analysts. Cash can’t lie like profits and asset valuations can.

Our conclusion is that REITs are in a weak position and weakening cash generation position and, over the longer term, the dividends some REITs are paying can’t be sustained.

The maths indicates that British Land, Hammerson, Intu and SEGRO are paying out 10% or more than their cash receipts can sustain, although in profit terms these dividends seem serviceable. Land Securities, by virtue of its pre-emptive de-gearing of its balance sheet and de-risking of its development programme, could possibly step up its dividend growth by 2% to 3% and a little goes a long way with 0% interest rates.

We have cut our dividend forecasts to stress the cash operating pressures, but these dividends won’t be cut. Instead, REITs can dodge the problem with scrip dividend issues by paying investors in more shares or subsidise dividends by selling buildings, but for established REITs, distributing capital is a heresy. In either case, some REITs aren’t living within their means, and that’s a problem where shareholders are yield sensitive.

REITs are in a weak position and the dividends some trusts are paying can’t be sustained

Appraisers’ theoretical estimated rental values don’t pay the bills and REIT financial statements are complicated by the accounting standards.

These allow the straight lining of lease incentives, which mean REITs can book more rent than they actually receive, and illustrations of future rental accumulation can lack clarity.

For example, British Land’s bond servicing costs are reduced by derivatives and Great Portland capitalises all its development interest, both of which are legitimate but increase profits. And Hammerson uses an alternative loan-to-value measure that doesn’t proportionately consolidate its associates.

Positioned for reflationary recovery

REITs had positioned themselves for a reflationary economic recovery, which isn’t happening. Profitability has been bought with high-yield asset purchases and refinancing with cheap debt.

We estimate that rents are about to fall across the London office market, mostly as a result of overbuilding and Brexit demand shock, as well as in shopping centres, thanks to consumer retrenchment as the post-Brexit spending bounce fades.

A decade on from its introduction, the REIT sector index is half of what it was in 2007 and as income-led investments REITs yield about the same as the wider equity market.

REITs have reached a suspension point with what appear to be wide discounts to NAV and high-dividend yields. Both may prove to be false prophets with the real risk of another leg down.

Mike Prew is managing director and head of real estate at Jefferies International