In the UK we love property. For most people, the biggest asset they’ll ever own is their house, and buy-to-let investing has become somewhat of a national pastime.
Ask most people if they invest in stocks and shares, and the answer is usually “no, it’s too risky”. But ask them if they invest in property, and if they’re not already a buy-to-let investor, the chances are they’ll say they want to be – although whether or not this remains a sensible option with interest rates where they are today remains to be seen.
If you need evidence that the UK loves property more than anything else, consider that the value of the UK’s housing stock hit a high of £8.7trn last year, according to real estate firm Savills. That’s around three times the size of the UK equity market (£2.4trn at the end of February 2023) and pension savings (around £3trn).
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Yet while the UK loves to own and invest in physical property, real estate investment trusts (Reits) are often overlooked, despite offering attractive tax treatment, solid income and a useful way to diversify a portfolio.
The Reit opportunity
At the end of February, the largest UK-listed Reits were trading at an average discount to NAV of 13%, according to analysts at Stifel, with some trading at a discount of as much as 50%.
So why are Reits so cheap? It comes back to interest rates and the cost of capital. The Bank of England base rate sits at 4.25% and could rise as high as 5%. This is part of the reason why Reits have fallen out of favour. Higher interest rates will hurt property prices, and this will hit NAVs.
However, high-quality assets, let to tenants on inflation-proofed rental agreements, are beginning to look very attractive amid the current market turmoil.
10 Reits to invest in
Traditionally, in the UK commercial property market, rents would be reviewed on a set timetable, usually every five years. However, it’s increasingly moving towards the European model whereby rental agreements are index-linked, bringing a level of stability and predictability to the market. In a high-inflation environment, these index-linked contracts are highly attractive – especially when companies have been able to fix their debt at a low rate of interest.
Moving tenants off five-yearly upward-only rental review contracts onto index-linked agreements is a slow process, but some companies are already ahead of the curve. Supermarket Income Reit (LSE: SUPR) and LXi Reit (LSE: LXI) are two trusts with long-duration portfolios (ie, long leases) that have been built around the index-linked European model.
As well as inflation-linked income streams, some Reits own unique assets, which are only gaining in value. The future of the office market has been subject to a lot of speculation over the past three years as the pandemic has upended working habits. However, it’s becoming clear that the office isn’t dead – it’s just evolved.
Rents in central London are rising as demand is rising and supply is constrained. Since 1994, the total stock of offices in the West End has actually declined even though the number of office workers has risen nearly 80%, according to Great Portland Estates (LSE: GPE), one of the largest-listed London landlords with a large portfolio of properties in the West End. It’s no wonder rental growth has risen 180% during this time, far outpacing inflation.
This trend is going to get worse. The number of office buildings in the pipeline is below average for the next three years, even though demand is picking up. In parts of the capital, GPE reckons there’s less than ten months of office demand in the pipeline. A lack of supply, which can’t easily be cured, rising demand and rising rents mean all of the London-focused Reits look attractive, says Marcus Phayre-Mudge, the manager of the TR Property Investment Trust. GPE, Derwent London (LSE: DLN) and Helical (LSE: HLCL) are the three pure-play companies with exposure to the London market.
Another way to play the office theme is through Workspace (LSE: WKP). The group is London’s leading provider of sustainable, flexible work space, which is becoming increasingly sought after as businesses try to adapt their office footprint to more flexible ways of working.
Healthcare Reits such as Primary Health Properties (LSE: PHP) and Assura (LSE: AGR) also look attractive after recent declines. These companies own primary healthcare facilities, which are leased to the NHS and other providers.
This gives them two desirable qualities. They’re unique assets (GP surgeries are designed to be healthcare facilities and it requires a lot of work to change it for other uses), and rents are backed by the government in a market that’s only growing.
Neither Assura nor PHP have been able to escape the recent sector sell-off, but their attractive qualities mean they’re both worth taking a closer look at. They yield roughly 6.4%.
There are plenty of Reits with unique offerings in the sector, but if you’d rather not pick sector winners, one of the large, diversified players, such as British Land (LSE: BLND) or Land Securities (LSE: LAND) could be a good alternative.
British Land reported an EPRA NAV of 695p at the end of September and Landsec’s stood at 1,010p.
Both stocks are trading at 40%-50% discounts to these figures. We might see some downward revaluations over the coming year, especially with warehouses and offices in the portfolio, but such a substantial decline in NAV is unlikely, suggesting there’s value to be had here. They yield 5.6% and 6.2% respectively.
For a double discount, Phayre-Mudge’s TR Property (LSE: TRY) is selling at a 8% discount to NAV with a 5.2% dividend yield. This FTSE 250 constituent is unique in the investment trust sector, focusing on property stocks and property-related companies. It owns a range of European and UK Reits, as well as a small collection of physical properties. As a way to invest in the whole sector, and lean on the experience of a well-connected manager, it’s certainly worth a look.
What are Reits?
Put simply, Reits are property companies with tax benefits. They don’t need to pay capital gains tax on property sales, and there’s no tax on rental income as long as 90% of income earned from rents is returned to shareholders. These benefits make Reits an incredibly tax-efficient strategy for investing in property.
Reits pay property income distributions (PIDs), which are similar to dividends, but qualify as property income, not dividends. Therefore, they’re taxed differently (at your normal rate of income tax, not the dividend tax rate). Basic-rate tax (20%) is withheld at source and you are liable to additional tax if you fall into a higher tax bracket.
However, if held in an individual savings account (Isa) or self-invested personal pension (Sipp), Reit distributions are tax-free – some platforms arrange for the PID to be paid gross, others reclaim it later. That means as long as the Reit is returning 90% outfits qualifying rental income to investors, there’s no tax at the company or investor level.
To put that into perspective, a non-Reit returning all its profits to investors via dividends would only be able to return 75p of every £1 earned. A Reit would be able to return the whole £1 of rental income. Even basic and higher-rate taxpayers would be better off receiving income from a Reit rather than a standard UK company.
As well as these tax benefits, Reits also come with stamp duty benefits compared with other routes to investing directly in property – stamp duty on share transactions is only 0.5%. For non-residential property transactions, the rate is 5% for properties worth more than £250,000.
And if you’re a residential buy-to-let investor, the rate is 8% over £250,000. On these tax benefits alone, it’s worth considering Reits for your portfolio. However, they also help investors gain exposure to sectors they’d usually be unable to buy access to without a huge pool of capital. For example, few small investors are going to be able to buy a portfolio of central London offices and residential properties, but you can do just that with a Reit.
Rupert owns shares in GPE and TR Property.
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