Special Opportunities Reit may not have succeeded in raising the £250 million it was seeking, but in the view of Marcus Phayre-Mudge, manager of the TR Property Investment Trust (LSE: TRY), the attempt marked a turning point in the sector’s fortunes. He was seeking to be a cornerstone investor in the stock market flotation of a new real-estate investment trust internally managed by a proven and highly regarded team. It wanted to take advantage of opportunities in a market that, although not experiencing the distress of 2009, is seeing selling from open-ended property funds, shrinking defined benefit pension schemes and private-equity funds with debt, all of whom want to liquidate.
However, investors were reluctant to pay £1 for shares that, until invested, would hold 98p of cash when so many Reits are trading at large discounts to net asset value (NAV). TRY itself trades on a discount of 8%, yet is almost entirely invested in listed Reits, which, on average, trade at a 25% discount. Phayre-Mudge warns that “valuations are still falling, but the pace of [decline] has slowed or stopped”. Property valuations are based on transactions in the market, so they are always backward-looking.
Special Opportunities Reit was not the first to see the looming turn in the market. Earlier this year, Segro raised £900 million at a discount to NAV of just over 10% to finance a substantial development pipeline in industrial property, notably logistics warehouses and data centres.
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More recently, Great Portland Estates (GPE), with a development and investment portfolio of London offices, followed suit. It raised £350 million through a three-for-five rights issue of new shares at a huge discount of 45% to its prevailing share price and 63% to its asset value. Such fundraisings are deeply unpopular with investors, especially when the firm is not in distress, as they involve significant dilution of NAV per share, in this case 8%. This forces investors to increase their holdings, which, as GPE’s directors will know, can only be justified if the opportunities for investment are exceptional.
Finding value in the commercial property sector
Phayre-Mudge points out that offices now only account for 5% of the assets of global Reits. “We all fixate about offices,” he says, “because we are in one, but not only have they fallen in value due to working from home, but there has also been growth in other sectors, such as residential, data centres, telecom towers, industrial, logistics, self-storage, student accommodation and healthcare. We have virtually no exposure to offices in London, but we do in Europe where the return-to the-office trend has been stronger [owing] to short commutes and heated or air-conditioned work places.”
Against this, “we are settling down to a hybrid working week of three to four days in the office. No businesses are increasing their work-from-home proportion. The problem is that rents have not risen much in the last 20 years and employers have to offer best-in-class working environments. Vacancy rates are zero in the West End, 10%-15% in the City and Docklands and much higher for secondary and tertiary property in the regions”. Listed real-estate companies own very little secondary or tertiary property, which is just as well as much of it is “not fit for purpose”. Very large shopping centres in the UK “still have problems, but we are getting close to a turning point, with Land Securities having just taken control of BlueWater”. It has bought another 17.5% of it for £120 million.
In Europe, shopping centres are full and there is very little failure among tenants. This is leading to rental growth, which Phayre-Mudge says “is the key to a good investment”. He looks for rising demand from tenants combined with a lack of supply, helped by the valuation of many assets being below what it would cost to rebuild them. “Ultimately, property is an income-based asset,” he says, “and you need income growth as capital returns are cyclical.”
Data centres stoke demand
Income growth is most apparent in industrial property, which accounts for over 20% of TRY’s portfolio. “Industrial”, in this context, doesn’t mean factories, but data centres for the internet and distribution warehouses on arterial roads for retail chains, online shopping and rapid component delivery. German residential property accounts for 17%, including over 10% in Vonovia, the largest holding, but there is also a holding in London-listed Phoenix Spree. It trades on a discount to “real” NAV of over 40% (Phayre-Mudge thinks the official NAV is overstated) and owns a large portfolio of mid-market rental property in Berlin.
The Berlin market “is in great shape”, with properties worth more empty than let. When vacant, these can be sold at a large premium to valuation, an attempt by the regional government to control rents having been struck down at federal level. “Rent control chokes the development pipeline,” as governments around the world, such as in Scotland, discover every time they introduce it – but they never learn from the experience of others. That makes Phayre-Mudge very wary of UK rental property.
As TRY is a pan-European investor, 66% of the portfolio is in continental Europe and 31% in the UK, although that is more than in the pan-European property-sector benchmark. Direct investments in British property represent another 3.6%. Phayre-Mudge’s confidence in the outlook is demonstrated by borrowings of 8.6% of NAV, in addition to the debt in the companies in the portfolio.
Since he took over the management of TRY in 2011, the trust’s performance has compounded at over 4% more than the benchmark index. He notes that 2022 was an “annus horribilis” for the sector. The benchmark index fell by 42%. A subsequent recovery proved to be a false dawn, but since last autumn the index has risen by 26%. TRY returned -35.5% in the year to 31 March 2023, a little behind the index, but 21% in the latest full year, 6% ahead. Since then, performance has been solid, showing that it is back in form. The shares are supported by a yield of 5%, although nearly a quarter of this comes from capital rather than the net income of the trust. A return to a fully covered dividend looks likely next year, if not this.
As to the outlook, “we expect to see capital values recover from a low base”. This is starting to be anticipated by discounts in the sector narrowing from an average of 45% to below 30%: “Markets require large discounts to falling net asset values, but they snap back at inflection points for valuations”.
Steady economic growth should help the sector, as should consolidation and lower interest rates. “We need fewer larger companies, but there needs to be a commercial justification for mergers.” Pan-European companies do not always work “as local knowledge and expertise is key”. Phayre-Mudge wants to invest in local specialists, not broad-based generalists.
Even with a strong recovery, many areas will be left behind. The national vacancy rate for offices in the US is nearly 20%, according to Bloomberg, and expected to rise to 24%. In the UK, local authorities invested heavily in commercial property, a strategy that for several of them has gone horribly wrong. Others have a dilemma: do they spend heavily to try to revive areas full of empty shops and workspaces, which they have little expertise in, or do they stand back and see empty buildings become derelict?
The point is that many people think they are experts at property, but few really are. It’s often a case of buy in haste, repent at leisure. That makes investment in property Reits a sensible alternative, but choosing the right one in the right segment of the market in the UK is a challenge. TRY offers a portfolio managed by experts with a proven record spread across the most attractive segments of not just the UK, but also European property. The share price is still 40% below its high of three years ago. There is much more to go for, and an attractive dividend yield as well.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.