No. of Recommendations: 3
Hello Jim,
You're correct, that type of comparison vs gilt prices is a normal way to estimate the valuation of the REIT sector as a whole.
If you repeat the same exercise using IUKP instead of Unite Group, you should see the correlation is even more clear, especially if you start from 2022.
1. The effect is largely mechanical/mathematical. As gilts yields rise, property yields rise alongside. Thus NAV drops.
And REIT shares are generally priced at a discount to NAV.
Thus, the effect of gilt rate changes passes through quite directly to share price.
However, the average market discount to NAV also changes over time.
But we live in interesting times and so gilt yield movement has dominated the equation in the era 2022-2025.
There are also odd effects at the level of individual REITs, e.g. relating to inflation, other yield improvements, long term or short term fixes on debt etc.
For example, imagine two fictional REIT companies, A and B.
2. Company A, CassandraREIT, wisely locked in 2% rates on all their borrowings for 50 years.
Now, imagine that ordinary 5 year borrowing rates for REITs go to 5%.
Company A effectively has a non-property asset on the books, the cheap debt. It may or may not show up in certain NAV figures.
The debt might be so valuable that it is far more important in their valuation than the actual buildings or property operations.
(Makes me wonder about Google, recently; and in practice, something similar happened to British Telecom with their pension fund).
If the debt somehow isn't included in a measure of the NAV, it will still modify the discount the market applies to that measure.
A real world example of this effect is Social Housing REIT (SOHO).
(I hold SOHO, and this is exactly the reason why I hold it.)
(And one might speculate that managers with the wisdom to lock in cheap debt for the very long term are higher quality managers).
3. Company B, MicroREIT, owns 10 flats and is borrowing from their local town bank with an adjustable rate mortgage rather than using fixed term debt.
When short-term rates rushed up in 2022-2023, their share price was trashed by the market very quickly, as rents cannot rise as fast as interest cost.
Somehow though, they survive, perhaps an injection of new share capital to keep them afloat.
Later, perhaps short rates start dropping, e.g. monthly borrowing costs go to 2%, while 5-year rates have only dropped to 4.5%.
Company B might now be seen as far more attractive than an average REIT. Suddenly, year on year EPS is going to the moon.
Consequently the share price of company B becomes a kind of proxy for bets and beliefs about where short-term rates will go next.
Perhaps moreso than any market beliefs about the value of the flats they rent out.
In this case, company B has a kind of hidden asset, 'their decision not to copy what most REITs do'.
But it is much harder to notice that 'asset' or price it.
MicroREIT is a ficticious example, but e.g. Custodian REIT in the UK intentionally uses short term borrowing facilities as well as long term.
3. About using gilt yields to value the sector. I feel this is best used at sector level. Consider companies C and D.
Company C makes money from small property lots giving a yield of 8%, but with more risk & management skill needed. Gilts move up 0.5%. A repricing from 8% to 8.5% is -6%.
Company D makes money from London offices giving a yield of 4%. Gilts move up 0.5%. A repricing from 4% to 4.5% is -11%.
An example similar to Company C might be Custodian REIT. An example similar to Company D might be Unite Group, or LandSec or British Land.
This situation also applies in reverse as rates drop.
UTG, LAND and BLND generate 'outperformance' over other REITs when the property yield is compressing back down.
4. These effects may combine in surprising ways. Suppose SuperCovid 2.0 comes along. Students are banned from university for 1 year.
Sadly, Company E, TogetherREIT, operates student property.
You might think, "ah well, best frame my Together share certs behind glass and hang them on the wall as a memento to my folly".
But the government responds to the viral economic crisis by dumping rates to 0%, and uses lots of quantitative easing to push the long end to 0% too.
TogetherREIT will probably go up while making brutal losses on their yearly business operations.
Although they will have a nightmare year in terms of earnings (rental income -> 0), having yields at zero sends the NAV of the buildings soaring.
The NAV is calculated from a fair appreciation of the long-term expected rental from the property, adjusted for risk, short/long term occupancy etc.
TogetherREIT can lock in long term debt for the future at an incredible level if they want, which is a kind of 'free asset' as I mentioned above.
A real world example of something like this would be the share price of Unite Group in mid 2020 compared with mid 2021.
5. In summary, individual REIT prices don't always vary reliably with gilt yield moves, but viewed across the sector, it's the way of things.
I think REITs are extremely interesting to study and I hope this post encourages others on Shrewdm to look into them further.
Certainly, I've had more fun studying REITs than any other type of company since Berkshire!
Best wishes and have a nice weekend everyone.
TRS
