Why I think these Reits deserve a second look

Eventually, slowly, interest rates will come down — probably to 4 and 4.75% in the UK and the US. This has refocused investors’ attention on rate-sensitive sectors. And because they’re built on mountains of debt, they don’t become much more sensitive to rates than real estate investment trusts or Reits, companies that own, operate or finance income-producing properties.

The industry certainly has its challenges – particularly in the office sector, where concerns about working from home persist. We have already seen a tightening of discounts in many well-established REITs, but some funds seem to have missed out on the limited revival.

At one, PRS Reit, shareholders are in open rebellion. An activist group, angered by the fund’s 35% reduction in net asset value (NAV), is trying to push through a series of changes, including installing Robert Naylor, former chairman of music rights group Hipgnosis, as director Songs and veteran City investor. Christopher Mills.

It is at the slightly troubled end of the Reits spectrum that I want to turn my attention, focusing on three funds that have fallen out of favor with the UK market but deserve closer inspection.

I don’t see how we can solve the care home shortage without private capital somewhere in the mix

I’ll rank these by my sense of risk, starting with Impact Healthcare, which I’ve been buying pretty consistently over the past few weeks for an income portfolio. Shares are trading at 88.5p, a discount of around 25% to NAV. They have a net yield of about 7.9 percent, fully covered by earnings. The core of the business is care homes, especially for the elderly.

Positives include a low loan-to-value ratio (a measure of debt to net assets) of around 28%, no imminent refinancing issues, a dividend that has grown steadily, rising property valuations and a total return since listing to name a few . years ago by about 8.8 percent per year. I won’t bother to exaggerate the obvious structural demographic factor here: by 2040, one in seven UK residents is expected to be over 75, and there is a shortage of care home beds.

The challenge is what is clinically called “counterparty risk” – that care home operators that a company hires default on their obligations. I’m sure we all have our views on for-profit versus not-for-profit operators, but I don’t see how we can solve the lack of care homes without private capital somewhere in the mix, providing purpose-built new properties with all the right facilities.

This will not implicitly stop operators, who have already hit this bottom. One, called Silverline, defaulted on rent to Impact Healthcare for seven houses in January 2023, but the fund replaced it.

Residential Secure Income is a much smaller fund with a market capitalization of just £99.2m on a portfolio of, you guessed it, £141m of residential properties. This fund owns a portfolio of shared ownership homes (mainly flats) and independent rental homes for older people – the fund says it is the largest provider of independent rental management services for pensioners in the UK. The share price at 53p boasts a yield of 7.8% at a discount of around 30%.

Given the weak growth in UK house prices in recent years, the fund has reported some recent declines in NAV, although earnings look set to grow solidly as rent inflation is still very high. One of the concerns of this fund, apart from the size of the subscale and worries about the housing market, was the level of debt, with an LTV of about 53%. These worries are valid as I think anything much above 45% is a concern. The fund also needs to repay some debt later this year, which it hopes can be financed by selling a portfolio of leased assets to a local authority.

However, these concerns are mostly about timing and are undercooked in my view, as the underlying cash flows are strong and the dividends well covered. Note that the dividend was recently cut to secure the fund’s cash flow, and the manager also stepped in with a fee cut. Another positive is that while lower inflation could undermine rent growth, lower inflation will also reduce much of the inflation-linked debt.

Speaking of “challenges”, I think it’s fair to say that Regional Reit has had its share in recent months. It has a number of regional offices, 135 in total, with 1,344 office units and 906 tenants, spread across the UK.

80%Office occupancy rates

Some of its difficulties you can probably guess. WFH saw occupancy rates reaching around 80%, while many regional cities also faced fragile office space markets. There is also the sustainability challenge of new tenants insisting on high sustainability ratings – 18% of the portfolio has an EPC rating of ‘D’ or below, with a further 25.9% at a ‘C’ rating. You can increase the rating by renovating it, but this is expensive.

Another problem was the debt, with the LTV running well above 50 percent at one point, which the fairly frequent haircuts in the valuation over the last year or so didn’t help. And to make matters worse, it had to repay a £50m retail bond in August.

Add it all up and investors have run a mile, with a chronic discount of more than 50%. All of this prompted an emergency fundraising that massively diluted the investor base and brought in well-known housing developer Steve Morgan as its largest shareholder. The LTV is now down much closer to 40%, although this could go up again if there are more downgrades, which I think is possible.

It’s not easy to fathom the likely rebased dividend next year – some, like analysts at Numis, are quoting over 20 percent, but I’d guess it’ll be in the double digits. So troubled yes, but Regional Reit is well placed if there is growth in the UK economy and interest rates fall, stabilizing property prices. A lot could still go wrong, but for the properly adventurous there could be the possibility of a full mid-teens return here.

David Stevenson is an active private investor. He owns shares in Impact Healthcare and previously held Regional Reit retail bonds. E-mail: [email protected]. X: @advinvestor.