The second bull case element is that inflation looks to be peaking. CPI is expected to peak at a 40-year high of 11% this quarter6, the Bank of England is forecasting 2.2% inflation in two years’ time and implied futures rates are forecasting a decline in inflation going forwards.
The third argument is that companies continue to have strong balance sheets. During the Global Financial Crisis, UK REITs had a much higher loan to value (LTV) levels, valuations declined and RETIs were forced into emergency rights issues, destroying value for investors. REITs learnt their lesson, and at present LTVs are lower – portfolios can withstand significant value declines without the REITs having to take any remedial action – and the cost of debt for many REITs is fixed at comparatively low levels for long durations, meaning balance sheets are strong.
The penultimate reason to be bullish is the prospect of rental growth, driven by two factors. The first is contractual rental increases, with many REITs benefitting from indexation and rental escalators built into leases. Impact Healthcare for example has a weighted average leases length (WAULT) of nearly 20 years, with inflation linkage built in. The ability to increase income with inflation, should in turn lead to growth in dividends for investors.
The second factor playing into rental growth can be attributed to rent reversion, market rents are higher than current ‘in place’ rents, and as these expire with time, the leases are renewing at higher rates. This can be seen as embedded growth, helping to offset any outwards shift in valuation yields and rising financing costs.
The fifth and final bull case is signs of capitulation in the market. September and October saw the effects of the ‘mini-budget’, triggering selling and high levels of volatility in the REIT market. What can be seen though is that when an event has had a similar effect on the market in the past, for example the Brexit referendum and the Covid-19 lockdown, we often witness some of the best days in terms of performance in the immediate aftermath.
Whilst at a surface level glance there might appear to be reasons to be bearish with the UK REIT market currently, we believe that these have already been factored into pricing in most cases. Identifying stocks with robust fundamentals combined with the attractiveness of valuation levels, peaking inflation, strong balance sheets, rental growth and signs of capitulation, all indicate that current market conditions could in fact provide an opportunity for REIT investors.
