Love Reits? Maybe it's time to try America

The struggles of the UK’s real estate investment trusts (Reits) have been well-documented. Higher interest rates have caused property values to drop and have in turn wiped billions off Reits’ own values.

Seeing this, some UK investors might be tempted by Reits across the Atlantic, whose prices have fared relatively better over recent years (see chart). Such investors should exercise caution. The American Reits have a lot going for them, but they also come with drawbacks that are unique to their market.

US Reits market is more mature

The first thing to note about US Reits is that they are bigger. The £10bn market cap of Segro (SGRO), the UK’s biggest Reit, is dwarfed by the $112bn market cap of Prologis (US:PLD), the biggest Reit in the US. All told, there are 30 US Reits bigger than Segro and many of those have global portfolios that include large holdings in the UK and Europe, compared with the UK Reits which for the most part are smaller and only own UK assets.

The size of the US is not explanation enough alone. Rather, the more mature US Reit market is a reflection of its more mature commercial real estate market, which is 13 times larger than the UK’s by value despite the US economy being only seven times larger. The American Reit structure is also older, having existed since the 1960s in the US, compared with its advent in the UK in 2007.

Mergers are also comparatively easier, allowing big US Reits to get bigger. Although the UK saw LXi Reit (LXI) and Secure Income Reit as well as Shaftesbury (SHB) and Capital & Counties (CAPC) join forces last year, shareholder activism, buyouts and mergers of all stripes are generally much more prevalent in the US due to its looser restrictions.

The more mature US market means there are some subsectors to which US Reits are more exposed – and some to which they are relatively less exposed. Offices are an example of the latter. While the asset class is a key holding for three of the UK’s five largest Reits, Landsec (LAND), British Land (BLND) and Derwent (DLN), none of the 11 biggest US Reits hold offices.

Conversely, one asset class where US Reits have a lot more exposure is infrastructure. American Tower (US:AMT), Crown Castle (US:CCI) and SBA Communications (US:SBAC) are the US’s second, fourth and 11th largest Reits and all three own communication towers across the country let to mobile phone services providers, radio and TV broadcasters, government bodies and other companies. No equivalent Reits exist in the UK.

The other type of infrastructure popular in the US Reit space is data centres. The US’s third and 10th largest Reits, Equinix (US:EQIX) and Digital Realty (US:DLR), both own and let them to tech companies requiring immense amounts of digital storage space. The only equivalent in the UK is Digital 9 Infrastructure (DGI9) and Cordiant Digital Infrastructure (CSRD), which are much smaller and younger companies by comparison, and investment trusts rather than Reits to boot.

The US excitement for data centre Reits is not without its critics, however. Last year, short seller Jim Chanos told the Financial Times he was raising money to bet against such trusts, predicting that the tech companies that currently rent the space would look to develop their own data centres going forward. As he put it in the interview, “although the cloud is growing, the cloud is their enemy, not their business. Value is accruing to the cloud companies, not the bricks-and-mortar legacy data centres”.

Chanos’ short points to a wider issue in the US Reit space: the risk that many are overvalued. According to numbers compiled by FactSet (see table), the average FTSE 350 Reit is priced at 92 per cent of its net asset value (NAV) per share and at 8.72 times earnings per share (EPS). By comparison, the average S&P 1500 Reit is priced at 2.39 times NAV and 40.2 times earnings. The US Reits’ high price/NAV ratio can partly be explained by higher debt bringing down their NAVs. The average S&P 1500 Reit’s net debt is 1.36 times its NAV while the average FTSE 350 Reit’s net debt is only 35 per cent of its NAV.

Defenders of the US Reit market argue that this higher debt/net asset ratio is purely an accounting difference. Generally accepted accounting principles (GAAP) rules mean that US Reits’ NAVs are not as in line with market values as UK Reits are under international financial reporting standards (IFRS). In other words, some US Reit valuations can be quite out of date, which can skew the debt/net asset ratios. This also explains why price/net assets is much higher in the US.

And, even though US Reits’ GAAP debt/NAV is high, debt/earnings before interest, tax, depreciation, and amortisation (Ebitda) is low. One senior source at a large US Reit said this was their preferred metric for measuring the performance of real estate companies, and it’s easy to see why. On this metric, the US performs much better than the UK. While the total debt is 6.9 times Ebitda for the average S&P 1500 Reit, it is 84 times Ebitda for the average FTSE 350 one. The UK figure is heavily skewed by Hammerson’s (HMSO) anomalously high debt to Ebitda ratio, but even if Hammerson is discounted the average FTSE 350 Reit still has total debt of 10.6 times Ebitda.

The fact that US Reit earnings are less dependent on debt does not explain the high price to US Reit earnings, though. Rather, James Crutcher, a portfolio manager at CBRE Investment Management, says the higher multiples on US Reit shares come from the fact that they have much more exposure to subsectors that are seen as high-growth – such as self-storage, healthcare, residential, student accommodation, and, as previously mentioned, infrastructure. In addition, Crutcher notes that it is easier to raise equity in the US than in the UK because of its stronger economy, which also explains the better performance of US Reit shares.

For the canny UK Reit investor, this represents an opportunity. Crutcher says the fact that so many UK Reits are trading at a discount to NAV right now is reflective of where the space is in the cycle. He predicts that, by the end of this year, many of those same Reits will be trading at a premium. So, although UK investors might well be wooed by US Reits’ recent performance, they should be wary of missing out on hidden value at home. US Reits are a nice addition to a portfolio, but UK listed real estate still has plenty of potential.