SHARES in real estate investment trusts, or REITs, have been extremely attractive for income hungry retail investors during the past seven years. However, the property market moves in cycles and there are an increasing number of signs that we have reached the top of the latest one, and that means investors chasing income could suffer painful losses of capital.
The cycle turns
REITs own huge portfolios of commercial property, such as shopping centres and offices, and then list shares on the London stock exchange, which allows investors exposure to the sector. The value of shares in companies such as British Land and Land Securities have enjoyed a strong run since 2009.
Shares in REITs are driven by two factors. Firstly rental income from property has steadily risen as the UK economy recovered and companies need more space. Secondly UK property has become increasingly attractive for overseas investors to store their wealth, and this increase in demand has driven up property prices. However, there are a number of issues undermining this strong run.
Calling the top
Mike Prew, managing director at broker Jefferies, is a real estate expert who has been in the vanguard after calling the top of the market in August last year. His case is compelling.
First up is that demand is drying up. The buying power of petrodollar rich sovereign wealth funds has been seriously undermined by the collapse in oil prices. Closer to home the UK-listed REITs have also had their wings clipped as investors pulled money from the sector in February at the fastest rate since 2008.
In a classic economic perfect storm just as demand fades there is a tsunami of supply that is about to hit the market. In the London market there is 26m sq ft of new office space due for completion within the next four years. That is the staggering equivalent of 40 new Gherkins in four years.
The UK economic recovery that has been behind steadily rising rents is also running out of steam. The unemployment level is now rising and city bonuses are falling according to the latest figures from the Office for National Statistics. The technology sector has grown rapidly during the past seven years, but that growth is now begining to slow, and the financial service sector has been hit hard by the downturn at the banks.
Political risks rise
Political risk to the property market is also on the rise. The Brexit vote on June 23 could still go either way, and leaving the EU would undoubtedly be bad for UK property prices. The listed REITs also have the majority of their property in London and the Mayoral elections pose a threat if Labour candidate Sadiq Khan is elected. He has set out a range of policies to curb foreign investment into the London market at the expense of residents.
The dividend income from commercial property has been a major attraction for retail investors. The reliable rental income from property assets allows REITS to pay healthy dividends. However, Mr Prew is concerned about the source of some of those rents. British Land in particular generates rents from Tesco supermarkets, and if the UK grocery sector comes under further pressure it could place dividends under pressure.
Dividend cover is one of the easiest ways to check whether income is vulnerable. A score of two times cover is usually considered safe, but the average for the commercial property sector is currently 1.3 times.
Shares in British Land and Land Securities have fallen 20pc during the past six months but this is not a buying opportunity as they still trade on more than 20 times forecast earnings. Time to sell.