Property investors should cast their eye to REITs

As cheap money dries up, investors will have to work harder to find real diversification and long-term value across all asset classes. There are still compelling pockets of value in the property sector for the discerning investor that spends the time to identify the real differentiators and allocates with conviction.

Since March 2020, the property investment landscape has been blighted by news of gated bricks and mortar funds, wild sub-sector rotations as lockdowns churned sentiment, and unpredictable income streams from uninhabited or under-utilised properties. Sectors that proved resilient quickly became fully valued, so the prescient question for investors seeking diversification and stability from property is: where does real value lie in property now?

As cheap money dries up, investors will have to work harder to find real diversification and long-term value across all asset classes

As the global economy emerges from the pandemic, investors find themselves in a more geopolitically uncertain world with more hawkish central bank policies. Property investors should seek liquid property assets active in global growth industries that have inflation-protected and secure income streams from highly credit worthy counterparties that are leaders in sustainability. 

The single most important imperative for property investors that use open-ended funds is to solve the liquidity mismatch. Investors should not accept the risk that hard-to-sell assets are held in daily traded structures that appear to deliver low volatility because of actuarial quirks and infrequent valuations. Investors that can accept a modest level of volatility that more accurately reflects the fundamental value of their investment are likely to find value in the real estate investment trust structure, which is both tax efficient and transparent.

Critics dismiss REITs as exhibiting higher levels of volatility and correlation to equities, while proponents point out that this is the cost of constant price discovery and liquidity. It is also preferable to the alternative of being locked in a gated fund with low confidence of underlying asset value.

In the context of raging inflation, pronounced geopolitical risks and persisting supply chain imbalances, investors need inflation protection and secure income streams more than ever for diversification within their portfolios. Healthcare REITs such as Medical Properties Trust in the US that owns and operates critical medical facilities is a good example of a property company that benefits from embedded inflation protection from their assets while also benefiting from secure income from very strong counterparties and low credit risk.

Sustainability

Sustainability in the property sector is still an underappreciated and undervalued characteristic. Not only do investors demand increasingly high standards of sustainability, but tenants demand sustainability from their landlords on cost and efficiency grounds as well as the sustainability demands of their own investors.

Sustainable building materials and energy efficiency credentials give assets owners significant pricing power, the highest quality tenants, and low levels of tenant churn. Logistics REITs such as Dream Industrial have world-class sustainability initiatives ranging from renewable energy generation, biodiversity protection and cutting-edge energy efficiency ratings. Sustainable leaders benefit from better priced debt, better tenants and better occupancy levels.

Sustainable forestry and timber REITs are also a highly attractive proposition in the current economic climate. High levels of inflation is likely to keep lumber prices high, which benefits North American forestry REITs Potlatch Deltic and Weyerhaeuser. The increased focus of sequestration and use of sustainable wood products in building materials provides tailwinds for this sector that remains underappreciated by UK-based property investors.

The FP Foresight Sustainable Real Estate Securities Fund invests in listed and liquid REITs. The fund invests in REITs that own properties in industries that are set to benefit from changing consumer habits (data centres), that have sustainability at the core of the proposition (forestry and timber), that have highly credit-worthy counterparties and secure income streams (e-commerce logistics facilities) and that benefit from high levels of mechanical inflation linkage and are critical to the functioning of society (healthcare). 

Some consumer habits have changed forever but some are slowly reverting to normal, sub-sector rotations are less likely to influence returns as dramatically or as quickly as they have been during the past two years.

The focus now needs to be on quality operators of sustainable property assets in global growth sectors with inflation protection. Most importantly they need to be liquid.

Nick Scullion is a partner at Foresight Group