UK Edition
Two weeks ago, in the wake of the post‑mini‑Budget crash in gilt prices, we tipped some property funds whose dramatic share price falls looked overdone. Now, as those bonds come under renewed pressure, we’ll look again for bargains.
First let’s restate briefly the investment fundamentals. When cash and gilts generate a yield of more than 4pc, as they do now, markets will demand a higher rate of return from other income‑producing assets in proportion to their perceived riskiness.
At first sight, then, it’s no good if a property fund yields 4pc: why take the risk involved if you can get the same return or better from cash or by lending to the Government?
The answer is that cash and (conventional, non‑index‑linked) gilts pay a fixed rate of return, whereas a property fund will at least aim to increase its dividend from one year to the next. The longer we experience high inflation, the more valuable this income growth becomes.
Apart from a decent yield now and the prospect of dividend growth, there is one other thing we need from property funds at present: a resilient debt profile.
Real estate investment trusts invariably borrow money to boost returns; this has been a sensible strategy in recent years as they have been able to borrow at interest rates far lower than the returns available.
This has now changed: interest rates have risen sharply and are expected to go higher still. What we don’t want is a trust that finds its interest bill rising so far that much of its rental income goes to its lenders rather than to its shareholders.
We asked a specialist real estate investor, Matthew Norris of Gravis Capital Management, to name a trust that passed all these tests. His choice was PRS Reit, a residential property fund tipped here in November last year. It yields 4.8pc, has raised its rents by about 5pc this year and has fixed the interest rate on most of its debt.
Norris first invested in the fund, which describes itself as “the largest portfolio of single‑family rental homes in the UK”, in September last year in the belief that it benefits from what he calls the “generation rent” megatrend: an acceptance among younger people that they are unlikely to be able to buy a property for some time and that they will instead seek high‑quality rental accommodation.
He says PRS Reit’s annual results, published on Tuesday, illustrated the robust performance of generation rent assets. It said its portfolio was performing strongly and rental demand continued to grow.
It added that rising interest rates were expected to reduce mortgage affordability and “drive demand in the rental sector as prospective homeowners turn to rental alternatives”, while “high‑quality, well located homes combined with customer service remain highly attractive to prospective renters”.
While the overall rise in rents during the year was 5.1pc, it achieved 10pc increases on properties let to new tenants, compared with about 4pc on renewals with existing ones. Rent arrears were just £600,000 at the end of the financial year in June, compared with net rental income for the year of £34.3m. The portfolio grew by 20pc from 3,984 homes to 4,786 over the year.
Despite all these promising facts, we must acknowledge the continuing dangers of the wider economic environment. As we wrote above, rising interest rates and bond yields tend to push up yields on other assets – and hence push down their prices.
We don’t know where interest rates will peak so downward pressure on the valuation of the assets of this and other property funds is possible. Equally, markets look ahead so some of the expectation of higher rates will already be “in the price”. We also have the buffer of a 28pc share price discount to the portfolio’s net asset value.
Norris notes that many Reits are currently trading at discounts of nearer 50pc but says his research suggests that buying “quality” Reits at either a more modest discount or even a premium has tended to produce better returns than simply buying those on the widest discounts.
“PRS’s discount of 28pc to the last reported net asset value is not the widest around but the trust is certainly among the highest‑quality portfolios of assets, especially in the private rental sector,” he says.
Questor says: buy
Tickers: PRSR
Share prices at close: 83.3p
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