Why savvy buying is still the REIT thing to do

A look at history tells us that assets are often mispriced and at times there is a loose connection between REIT prices and the property and business assets they hold.

I’m still buying A-REITs. Not all of them. But, selectively. There are still worthwhile investments. Further, I’m not taking profits yet. Well, maybe when I think they’re overvalued — but having to pay tax makes me think twice before selling. I’m an investor, not a trader. And that means I have to stop buying earlier.

Let me explain why I’m still a buyer. Basically, both commercial property and the strength of the REITs that hold them still have a long way to go. And REITs are the most liquid way of taking a position in property markets.

I know the days when REIT prices were well below NTA are over (except for some current retail REITs — I’ll look at them separately). That was an anomaly. Sharemarkets are much more sensitive to sentiment and can go out of kilter, staying mispriced for long periods.

Back then, I was buying undervalued assets with an eye to how those assets would perform as the cycles ran their course.

Now, with interest rates remaining low, property markets have further to run. Money is flowing in to equities. And that makes sense for investors.

What started out as a search for yield has now morphed into a search for total returns with the ability to cash in capital growth to provide income. I’m not comfortable with the logic of “the trend is your friend”, but there’s a lot more money to flow in driving further firming of yields from that source.

We have little choice but to follow the money while recognising money can flow out as well as in as circumstances change.

The trick is to understand when the cycle will end, but that’s years off. We are not overbuilding commercial property yet. And the danger of a rise in bond rates softening yields is still years off.

The REIT market is ideally suited for trading, but there are still opportunities for longer-term investors to buy mispriced assets and hold into the medium term.

There is an enormous variety of REITs, both in terms of portfolio composition of the trust component and what businesses are attached. And both the properties and the businesses are highly cyclical and out of sync, market by market.

We need to make a separate assessment of the two components — the property trust and the attached business.

The property trust component is the easy bit provided we have good forecasts of incomes and yields/prices for the property markets. We need to know the portfolio of each trust and assess how that will perform through the property cycles. And we need an assessment of the impact of bond rates on yields.

For the attached businesses, and they will differ substantially by REIT, we need to understand how their net incomes will perform through the property cycles.

They range over property funds management, commercial and residential development and building/construction and will often be subject to even more ­cyclical variation than building ownership, both in terms of turnover and profitability. For each business, there is a logic for what they should be doing at each stage of the cycle. The value of these businesses can, and often do, add substantially to the REIT price.

Mind you, some of the REITs are just a (geared) property trust with (internal or external) management and with no business attached. In that case, there is little additional value to the trust component and it’s hard to see why it should be significantly different from NTA. And sometimes, the trust component is dwarfed by the business, which can have a much higher value than the trust. Just look through the list of REITs and you’ll see what I mean.

If nothing else, a look at history tells us that assets are often mispriced and at times there is a loose connection between REIT prices and the property and business assets they hold.

That was true for a long time after the GFC-induced collapse when prices were below NTA with little value placed on the ­attached businesses. But it’s also true now for a number of REITs with prices above NTAs but which show little relation to prospective returns.

Now, most REIT prices are at a premium to NTA. The notable exception is retail property, where there can be substantial discounts. These are hard yards for the former darling of the property investment community. Not only are there notable challenges in adapting retail centres to a new trading environment, but sentiment has turned against retail.

Substantial significant institutional portfolios are being sold down as investors want to cash out and reduce exposure.

Money is still flowing out, yields softening and, with weak centre incomes, prices are starting to fall. The question is how far incomes and property values will fall. REIT prices are sensitive.

It’s often said they lead the real property market, but that’s not always true. Fear is an amazing thing in causing over-reaction in asset markets and, given the discounts on REITs, property values would have to fall a long way to validate those discounts.

There are probably bargains now among the retail REITs for those with a long horizon. I’m tempted. There will be a time to invest, but the money is still flowing out. I’ll wait and see.

Meanwhile, apart from retail, A-REIT prices are strong. Finally, after a medium-term setback, they have now exceeded the previous July 2019 peak.

I’ll leave consideration of prospects for property markets and property businesses for later articles. But, by and large, REIT prices will continue to rise.

This is not the end of the cycle. Money is continuing to flow in — to equities in general and to commercial property and REITs in particular. There are plenty of opportunities to invest in mis-priced assets. But selectively.

Frank Gelber is an economist.