Real Estate Investment Trusts (REITs) were introduced in the UK in 2007. Since then, most of the UK’s largest property companies have converted to REIT status, including big names such as British Land and Land Securities.

Here we take a look at what REIT status means and why REITs could be of particular interest to income investors. We then take a closer look at two individual REITs, one specialist and one generalist.

What is a REIT?

A REIT is essentially a company devoted to property investment. This means that, unlike many other property investments, it can be easily traded on the stock exchange – exactly the same as any other share. This can make it an attractive way for retail investors to access property investments at reasonable prices.

In order to qualify for REIT status, at least 75% of a company’s profits must come from property rental, and 75% of the company’s assets must be involved in the property rental business. REITs must also distribute 90% of their property rental income to investors.

In exchange for operating within these relatively strict parameters, and to encourage investment in UK real estate, REITs do not pay any corporation or capital gains tax on their property investments.

What are the advantages for income investors?

Having to pay out 90% of rental income as dividends can make REITs an attractive option for investors looking for income. The special tax arrangements also mean that the dividends are only assessed for tax once, rather than twice as would otherwise be the case.

Many REITs have long-term lease agreements with their tenants, which helps to make rental income relatively reliable, though of course there are no guarantees. Those who are able to impose regular rent reviews on occupiers should also enjoy steady, if usually unexceptional, income growth.

These traits led us to include Tritax Big Box, a logistics-focused REIT discussed in detail later in this article, in our five higher yielding shares for a low interest rate environment.

Evaluating REITs

REIT returns to investors are made up of two components – dividends and changes in Net Asset Value (NAV).

NAV represents the value of all the assets owned by the REIT. For example, if the assets owned by the REIT, less any debt, are worth £1m and there are two million shares in issue, the NAV per share is 50p. If the value of the properties increases, either through market movements or development activity, the REIT’s NAV will grow.

If a REIT, or the sector in which it invests, is particularly popular, demand might push the share price to a premium over the NAV. The same process in reverse might push the REIT to a discount. However, as a general rule, REIT share prices will tend to move in line with the NAV.

Since REITs are required to pay out 90% of their income to investors, it is hard for them to build up enough capital to reinvest in new properties from their own earnings. For companies looking to expand, that leaves two main means of funding growth – selling new shares or taking on debt.

Using debt prevents investors’ holdings from being diluted, as they would be if the trust chose to raise more equity, but the level of debt in a REIT is something investors should keep a close eye on. REIT debt is usually measured in relation to the NAV through what is called loan-to-value (LTV), the proportion of the property portfolio that is funded by borrowings.

Because property prices are cyclical, property values can change quickly. That means that a REIT with a high level of debt can quickly find itself in trouble as LTV shoots up – especially if a downturn also hits rental income, hampering the ability to service or repay debt.

Specialist vs. general REITs

REITs are not all alike. As well as larger companies, such as British Land, which operate in a variety of different real estate types, there are a number of specialist REITs that focus on particular segments of the market – including healthcare, logistics and retail. Below we take a look at an example of both.

British Land

British Land is one of the UK’s largest diversified REITs.

Although it is best known for its prime London office blocks, including the Leadenhall Building (aka the Cheesegrater), its portfolio is far broader, including London retail and residential buildings as well as some of the largest shopping centres across the UK.

The company has a good track record of developing and managing its assets, which has historically helped it grow NAV. Current projects include the £2bn re-development of Canada Water in South-East London, just one tube stop from Canary Wharf.

Despite a diversified portfolio, the group remains heavily weighted towards London and the South East, accounting for approximately 65% of total assets. Moreover many of those assets are super-prime offices in the heart of the City of London. If Brexit does hit London’s financial services industry this is where the hammer blow will fall hardest, as banks move abroad.

However, the company is currently enjoying 99% occupancy, with an average lease term of nine years. Recent disposals have helped to bring the LTV down to 29.7%, with average interest rate charges of 3.5%. That low debt and long-lease portfolio should hopefully make for reliable rental income, and thus dividends, going forward.

The stock currently trades on a prospective yield of 4.5% (variable, not guaranteed and not an indicator of future performance), and has only cut the dividend once in the last 15 years – in 2010, the heart of the financial crisis, the dividend fell by 13%.

British Land share price, charts and research

Tritax Big Box REIT

Tritax is one of Steve Clayton’s five shares to watch for 2016. It has a £1bn+ portfolio of Big Box logistics buildings (the vast, looming distribution centres that line major trunk roads).

Retailers are a strong source of demand, filling the buildings with automated goods handling equipment to drive down costs. Once a tenant is fully installed, they tend to stay, because the capital they invest inside the building tends to be many times the value of the building itself.

That makes for assets where the tenants are so keen to have the best-located and most flexible buildings that they commit to sometimes decades long leases, with upward-only rental renewals. This keeps revenue visibility high while tenants like M&S, Amazon and Sainsbury are unlikely to miss the rent.

With a target LTV of 40% and an average lease with 16 years left to run, the company has good visibility on future revenues, while the ability to buy assets well has helped to boost NAV. The shares offer a prospective yield of around 4.8% (variable, not guaranteed and not an indicator of future performance).

Tritax Big Box share price, charts and research

The information in this article is not intended to be advice or a recommendation to buy, sell or hold any investment mentioned, nor is it a research recommendation. No view is given as to the present or future value or price of any investment, and investors should form their own view in relation to any proposed investment. If you are at all unsure of the suitability of an investment for your circumstances please seek advice. The value of investments, and any income from them, can rise and fall, so you could get back less than you invest.

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Source: Hargreaves Lansdown