An investor has numerous ways of accessing a property return. Often early thinking is confined to investing in residential, then commercial property and in many cases limited to bricks and mortar buildings.
However, as we witnessed with Britain’s vote to leave the EU, it doesn’t always deliver the income and diversification that investors normally think of when first thinking of investing in property; with a number of direct property funds swinging fund prices and suspending redemptions.
Property exposure can be gained via equity markets through Real Estate Investment Trusts (REITs) in the UK and internationally (US, Europe, Asia) via debt (mortgages) and property futures. More sophisticated investors can also seek to risk manage their property allocation by buying and selling exposure. Indeed, our own approach coming into the EU referendum was to hold a large international REIT allocation (ex. UK) and post the result to selldown our international REIT position to invest in UK REITs. This was a time when direct property funds were suspending redemptions.
What we have seen since is direct property funds reopening as the selling pressure of investors redeeming has reduced / been eliminated. Similarly, the fear of property values didn’t crash as some had expected or as was feared in mainstream media. Yet, as seen around the EU referendum, there are times when the different property market exposures are priced differently; as is the case today.
Since the start of 2016 both REITs and property funds have underperformed the UK FTSE 100 Index (FTSE). Indeed the FTSE rallied post EU referendum due to the large number of multinational companies listed. However, in terms of property, there is visible disconnect between UK REITs and UK physical property price movements.
At time of writing, large diversified REITs are trading at a 30-35 per cent discount to net asset value (NAV) – the difference between the REIT share price and the net value of the underlying assets which they hold. This discount suggests that physical UK property prices may be overvalued by 10-15 per cent.
There are a number of reasons as to why this pricing discrepancy exists. It could be due to the mix of assets that the majority of REITs hold. Predominantly, REITs tend to be invested in prime property with a bias towards offices and more high-end commercial space. As a result, REITs were, and are, more exposed to the negative impact of the Brexit vote. A key knock-on effect of a negative impact on this industry is a fall in demand for prime office space, such as in the City of London.
In our view, REITs are more likely the subject of a liquidity driven selloff. As investors’ view on UK property has softened, they have decided to sell down the REITs that they hold in their portfolios as their most liquid property assets. Whatever the cause, there is now a large disconnect between the positive forecasts on the UK property market and the negativity reflected in heavily discounted REIT valuations. As a result, we believe that REITs have been oversold by investors and are currently mispriced.
This undervaluation of REITs presents a potential arbitrage opportunity as the difference between the discount to NAV of REITs and market forecasts is unusually large. Even if the property market is overvalued, REITs are so undervalued that a correction would still most likely lead to an increase in their value and hence a positive return for investors.
We believe investors, when considering a property investment, should assess the routes to gaining and maintaining exposure. Capital markets are efficient but at times there are opportunities for an investor to benefit from market dislocation. Today this is one example.
Source: What Investment, 2017, Full Article Here