If you want to know how the office market works, follow the money. And nobody has more money than the Real Estate Investment Trusts. But, as David Thame reports, REITs are cautious players, keeping a lid on the office market
Obviously not all office developers are the same. But the REITs, responsible for some of the biggest ticket office schemes in the UK, are the ‘differentest’ of the lot.
REIT stands for Real Estate Investment Trust, a concept imported into the UK from the United States in 2007 after years of campaigning by the property industry. The overwhelming majority of property companies that qualify to become REITs have converted because REITs are tax-efficient in a way that a normal PLC could never be.
Simply put, REITs do not have to pay corporation tax on the profits they make on renting properties, in return for a promise to distribute 90% of that rental income to shareholders. They pay out in the form of dividends, which are then judged by the tax authorities as property income.
This is the solution to a problem that dogged property companies with big portfolios: dividends from property companies tended to be low and therefore relatively unattractive to investors. That in turn was connected to the problem that, for big property businesses, the value of their portfolio (net asset value) is almost inevitably greater than their market capitalisation (eg. share price multiplied by number of shares). The gap between how investors value the company (market capitalisation) and how the economy values the company (net asset value) opens up a world of potential headaches.
REITs also overcome one of the big disadvantages of open-ended property funds, a problem the aftermath of the 2016 Brexit vote revealed. At its simplest, this is the difficulty that faces any fund when investors want their money back quickly, a mighty headache for a fund based on the very illiquid asset of bricks-and-mortar. REITs don’t have that kind of problem because you can sell your shares easily, whenever you like.
The one golden rule is that REITs must be mainly property investors, not developers, but in practise that doesn’t make much difference: REITs happily buy newly-built offices – and developers know this.
So their influence is felt – even if REITs are not themselves the developer.
Today, most REITs are heavily focused on the industrial sector, where the keenest returns are to be made and the competition to buy assets is correspondingly fierce. Meanwhile REITs focused on the retail sector (Hammerson and British Land are cases in point, hurt by the recent Debenhams debacle) are having a torrid time as high street woes continue. For the modest crop of REITs with a strong interest in the office sector, 2019 is turning out to be sweet.
“REITs don’t have that kind of problem because you can sell your shares easily, whenever you like”
British Land is the owner of London’s Broadgate campus, and has recently signed 303,000 sq ft of deals, including 21,000 sq ft to global advertising giant, McCann Worldgroup.
British Land is seeing demand from a wider mix of occupiers at Broadgate as the momentum behind the campus’ evolution accelerates ahead of the arrival of the Elizabeth Line at Liverpool Street in 2019. Typical of a REIT, they are thinking long-term.
But a REIT is not in the market for glory. Rather, it is there for income. Aberdeen Standard’s UK Commercial Property REIT makes the point nicely, because they invest in everything. Their £1.45 billion portfolio is slightly over-weighted to warehouses (46%), while retail accounts for 35% and offices around 25%, of which around half is in London offices and the other half is divided between South East offices and regional offices. The balance of their portfolio is hotels and cinemas.
Will Fulton, Lead Manager of UKCM, explains: ‘We have talked for some time about the importance of income to drive returns, both from earnings and by growing or improving income to feed into capital appreciation.’
But how to generate the reliable income their shareholders demand? Partly they are trading existing assets (like the £73 million sale of the Soho office block at 15 Great Marlborough Street) in order to buy into higher income areas like warehousing. Partly by re-letting offices at new hot rents (like the new NatWest in Swindon, let at a rent 8% ahead of expectations).
For REITs like this, offices are a modest and fairly conservative bet, without the massive upside gains of investing in warehousing, and without the frightening downside loss of buying the wrong shop on the wrong high street. But they are not an exciting bet – logistics or hotels offer much more – and that explains why the surge of speculative office development we might have seen since 2016 has, largely, failed to happen. REITs are just not the kind of organisations to go racing after mid-rank returns.
A blessing or a curse to the office market? Hard to say. But they introduce a very steady-as-she-goes element into a sector that has sometimes had a buccaneering swagger – and that can’t be a bad thing.