The third bearish argument is that recession is likely to lead to lower rental income. Many have been vocal with their outlook on the UK’s economic state, with the Office for Budget Responsibility highlighting that the economy is “tipping into a recession”, and the Bank of England stating that there is a “very challenging” outlook. Bloomberg provides a UK recession probability index 1-year out, and this is currently running at 90% probability (see fig. 2).
(Fig. 2 – data as at 18th November 2022, source: Gravis Advisory Research, Bloomberg)
The recession we are presently facing however, appears to be a technical recession – a ‘full employment’ recession. The number of vacancies is currently exceeding the number of people searching for work. If the expectation is that we’re heading towards a traditional recession, with mass unemployment, employers unable to rent office space, and people losing their homes, then REITs are not the area for you.
Whilst there are certainly a few arguments for the bear case, as mentioned, we at Gravis are finding that there are many more reasons to be bullish, with five key factors contributing to this view.
Firstly, valuation yields are at attractive levels. As mentioned earlier, if you consider the UK Market as a whole, REITs are trading at a wide discount to the historic average. Historically REITs have traded at an average c.12% discount to NAV, whereas we’re currently seeing them trading at a c.32% discount1 (fig. 3), up from c.40% in September.
(Fig. 3 – data as at 18th November 2022, source: EPRA)
When looking historically at other instances of wider than average discounts, contrarian investors have often been rewarded for investing around points of maximum bearishness. From times when valuations have first reached a 20% discount to NAV in the last 10 years, UK REITs have regularly provided strong future returns (over both 12-month and 24-month periods, see fig. 4). Whilst there is a wide dispersion in returns all outcomes have been positive.
(Fig. 4 – data as at 18th November 2022, source: Gravis Advisory Research, Bloomberg)
Whilst there’s the potential for opportunity in terms of valuations levels looking attractive, stock picking remains key, with a stressed importance on identifying underlying sub-sectors demonstrating strong fundamentals. REITs supported by the ageing population trend (those such as, Assura and Primary Health Properties) are trading at an average c.11% discount to NAV, whilst those falling in the retail space (a sector which Gravis have no exposure to) are trading at a c.43% discount3. Whilst this might suggest that there is the greatest opportunity within retail REITs, we do not hold much conviction that the sector will rebound in the same way as the others.
At a stock level, equity markets are already pricing in significant outward property valuation shifts. The market is pricing in moves in yields beyond those that have already been seen. Warehouse REIT, for example, recently reported a 0.41%4 change in valuers yield from peak value, versus the market implying a likely change in valuers yield of c.1.06%5. The underlying dynamics remain strong for logistics, rent collection and growth are both good. The market looks overly bearish.
