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With inflation soaring, some investors are turning to Real Estate Investment Trusts. We look at what they offer investors and how to value them.

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

With inflation continuing to dominate the global conversation, investing in real estate could be appealing. Rental income has proven to be a good way of coping with the effects of inflation in the past. But the risk and upfront cost associated with becoming a landlord isn’t for everyone.

That’s where Real Estate Investment Trusts (REITs) come in. These are property investment companies that allow investors to pool their money in order to buy real estate assets. For the most part, these tend to be commercial real estate investments. REITs can be bought and sold on the stock market just like any other investment. They offer ordinary investors a way to invest in property.

To qualify as a REIT, at least 75% of profits must come from property rental and 75% of the company’s assets must be involved in the rental business. REITs must also pay out 90% of their rental income to investors. In exchange for meeting these criteria, REITs don’t have to pay corporation or capital gains tax on their property investments.

Paying out 90% of rental income means REITs can be an option for an income-seeking investment portfolio. Their special tax arrangements mean dividends are only hit with tax once – when they reach investors, meaning the REIT won’t have to pay them.

In addition to imposing regular rent reviews, lots of REITs also have long-term lease contracts. This usually translates into relatively reliable income and dividends, though as always, nothing is guaranteed. They, like the value of your investment, can fall as well as rise in value, so you could still get back less than you invest.

You can work out how long a particular REIT’s average lease terms are using the Weighted Average Unexpired Lease Term (WAULT). Shorter leases can be beneficial if the market’s on the way up but longer leases can offer more reliability.

That doesn’t mean all REITs are in for booming returns when inflation rises though. Generally speaking, inflation has tended to push wages up. This in turn increases budgets for renting and allows landlords to up their prices. However, the type of inflation makes a big difference. In the scenario above, inflation is driven by economic growth, and increases at a steady rate. Some estimate inflation between 2% and 3.5% is most accommodative.

What we’re seeing right now is inflation rising well beyond that level, alongside a stagnant, rather than growing, economy.

Source: Refinitiv, 20/07/22 and Office of National Statistics.

That means wages are unlikely to rise at the same rate as inflation, potentially lowering rental budgets. With that in mind, it’s important to assess which rental markets could still be primed for growth. For the most part, REITs tend to focus on a particular segment, but how focused they are can differ.

Generalist REITs encompass a wide range of diverse properties. This type of REIT has a more passive management style, investing in a wide range of properties. This offers some protection if one sector starts to deteriorate.

There are some drawbacks to casting a wide net though. The less focused nature of the portfolio means managers don’t have specialised experience. That can make it more difficult to move quickly on property purchases and sales, because managers aren’t entrenched in a particular industry.

Others are specialist, meaning they invest in a particular sector like healthcare or residential real estate. Their managers tend to have a lot of experience within the sector. This means they can sometimes get better deals on property purchases through ‘off market’ transactions.

These pure-plays are also more exposed to a downturn. Residential real estate, for example, could struggle going forward as the cost-of-living crisis dampens landlords’ ability to raise rents. Other sectors, like logistics, are expected to continue growing, allowing for more room for rental income growth.

This article isn’t advice. If you’re not sure what’s right for you, seek advice. Investments and any income they produce rise and fall in value, so you could get back less than you invest. Income is variable and not guaranteed. Remember, tax rules can change and any benefits depend on your circumstances.

While REITs trade the same as any other stock, there are some key differences when it comes to valuing them.

In addition to dividends, REITs can also create shareholder value through their Net Asset Value (NAV). This is a measure of the value of the assets owned by the REIT. For example, if the assets owned by the REIT, less any debt, are worth £1m and there are one million shares in issue, the NAV per share is £1.

If the value of the properties increases, either through market movements or development activity, the REIT’s NAV will grow.

A REIT can trade above or below its NAV, called a premium and discount respectively. A REITs that consistently grows its NAV can trade at a premium because investors have faith in management’s ability to drive growth. If the market sees a particular sector struggling, REITs focused on that area might trade at a discount.

There are many different ways REITs can grow their NAV. The simplest is to buy property that appreciates in value over time. Other times REITs will buy and develop a project for a specific purpose. Both options cost money to execute.

Paying out 90% of their income makes it difficult for REITs to build up a war chest to invest in growth. With that in mind, there are two main ways to fund new growth – selling new shares or taking on debt.

Selling new shares often dilutes the value of current investors’ holdings. So, it’s a tactic REITs might not want to employ frequently.

REIT debt can be measured through what’s called loan-to-value (LTV). It measures the proportion of the portfolio that’s funded by debt and compares borrowings against NAV. The higher the ratio, the more leverage. This translates into more risk.

Property prices wax and wane with the economy, so a REIT with a high level of debt might find its LTV march higher if its portfolio loses value. If the downturn also hits rental income, it can make it much harder to repay debt.

If LTV is over 40%, we think that generally should be considered a red flag. If LTV is around this level or higher, it’s a good indication that a share sale will be the preferred fundraising method going forward. That can be a negative as it has the potential to dilute existing holdings.

REITs can be a good way to generate income through periods of high inflation if they’re able to grow rental income at the same pace. But like any other investment, there are no guarantees.

Given the uncertainty ahead, we think needs-based real estate offers the best opportunity for REIT investors. That means industries like health, storage and logistics.

The REITs themselves should come with a strong balance sheet, low LTV, and a proven track record of growing NAV. Just as you would with any other stock, taking a long-term view is essential.

Investors should only invest in REITs if they have the time and knowledge to carefully select and monitor them. As always, they should be held as part of a diversified portfolio.

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This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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