Jefferies Mike Prew on how policy is switching to defusing inflation

REITs’ NAV discounts have since compacted to 25%, given a tow from the bond market, where 10-year gilt yields recovered from 4.5% to 3%, although they have since backtracked to 3.6%.

In terms of wider macro-economic trends, there is growing uncertainty over how long it will take the economy to reach and sustain the UK government’s target of 2% inflation, while the US is back to ‘higher for longer’ interest rates, with pricing of Fed Funds – the overnight lending rate between commercial banks – peaking at 5.2% in July.

After 30 years of defusing deflationary shocks from the Asian crisis (1997), tech bust (2000), GFC (2008), commodity bust (2015), and Covid-19 (2020), governments’ macro-economic policy is switching to defusing inflation, but central banks are out of practice.

UK food prices are up 16% year on year with olive oil, sugar, and milk up 40%, and some vegetables were rationed by supermarkets. UK inflation might have eased to 10.1% from an 11.1% peak, but this is due to a fall in fuel costs, and the inflation rate is proving ‘sticky’.

Meanwhile, in the REITs sector, the centre of gravity used to be Landsec and British Land, but is now SEGRO which, with a market capitalisation of £10bn, is larger than Landsec and British Land combined. SEGRO quadrupled in value during the decade of cheap borrowing, whereas Landsec and British Land contracted 20%.

SEGRO’s NAV came in at 966p per share at the end of December, compared to an analysts’ consensus of 983p and our estimate of 951p, but there was a range from 905p to 1,185p. The latter was an unlikely increase on a NAV of 1,137p at the end of 2021 and looked a tad optimistic, given that fellow industrial REIT Tritax Big Box’s valuation fell 15% in the second half of 2022.

Yet operationally, SEGRO remains extremely strong, with a 23% uplift on rent reviews and renewals, 6.7% like-for-like growth and a portfolio at 96% occupancy. Logistics supply/demand balance remains taut, as lower e-commerce demand is supplemented by demand from a wide variety of other sectors.

Overall, SEGRO’s portfolio was revalued down 11%, but importantly, its gearing remains moderate, at 32%, and is structurally diverse and very long-dated.

Therefore, conjecture that SEGRO might carry out a rights issue at a 13% discount to NAV proved overly pessimistic. SEGRO itself noted confidence and liquidity returning to the market. More generally, REITs are now focusing on the ‘3Rs’ – rents, redevelopment and regearing – to help offset swings in portfolio valuations.

With the highest income growth priced in for low-yielding logistics REITs, they had most to lose as interest rates rose, whereas retail had the least, with offices somewhere in-between. There are some motivated sellers of REIT shares, but no balance sheet distress – at least in the public real estate market.

The consensus knee-jerk REIT NAV downgrades following the September mini-Budget now look like being reversed.

The consensus knee-jerk REIT NAV downgrades following the September mini-Budget now look like being reversed. And when it comes to the long term economic outlook, the Bank of England and Office for Budget Responsibility are now heading towards projecting inflation at 0.5% by 2025. Long-term real gilt yields stand at 2% and 10-year gilts at 2.5%, while the property risk premium is around 3%.

On these assumptions, real estate fair value is 5.5%, less whatever rental growth you care to plug in to reduce the yield. This compares with the MSCI ‘All Property’ net initial yield of 5.2% in January and equivalent yield – the IRR to the next rent review – of 6.2%.

So in theory, there isn’t much downside to REIT values, but the arithmetic gets more complicated when you add the missing ingredient of buildings’ depreciation. Bonds are redeemed at par, but buildings lose value. A new office building has a useful economic life of around 25 years – but now we have to add the cost of meeting new Energy Performance Certificate standards by 2030.

For REITs, this is largely a case of upgrading or replacing light bulbs and boilers – and therein lies the rub. There is no depreciation charge in UK REIT profit and loss accounts, thus after a mandatory 90% dividend payout, there isn’t much cash left over for this kind of portfolio upkeep.

 Mike Prew is managing director at investment banking firm Jefferies