Schroder Real Estate Investment Trust: Moving from stabilisation to recovery

After a challenging 2022, the UK real estate market demonstrated renewed resilience in 2023 and there are encouraging signs that this stabilisation may mark the start of a recovery as we move through 2024 and into 2025. Following the publication of Schroder Real Estate Investment Trust’s (SREI) annual results earlier this month, we explore the outlook for the UK real estate asset class and the SREI portfolio in particular.

The drivers of SREI’s recent outperformance

Following the market’s recent peak in June 2022, average UK real estate values have fallen by approximately 25%, with SREI’s underlying portfolio value falling by 18% over the same period1. Though significant, this correction is less severe than the declines seen in previous downturns, such as the 44% average market peak-to-trough decline experienced during the 2007-2009 global financial crisis and the equivalent 27% decline seen during the recession of the early 1990s.

As the chart below illustrates, the majority of the correction occurred in 2022, with signs of resilience emerging in 2023, particularly in sectors such as industrial property, where capital values have already started to modestly recover in the first half of 2024.

UK real estate values are starting to stabilise

Source: MSCI UK Monthly Index May 2024, Schroders. June 2024.
Past performance is not a guide to future performance and may not be repeated.

Turning to SREI specifically, a favourable sector allocation and stronger income return contributed to a positive net asset value total return of 1.1% in the year to 31 March 2024. In particular, the Company’s overweight exposure to the industrial sector, which is almost entirely multi-let industrial estates, was a key driver of outperformance. Active asset management also made a positive contribution to performance across all sectors, including our ongoing efforts to improve the sustainability performance of assets to benefit from the growing demand for green buildings and the higher rental income that accompany it.

For example, the investment to improve the sustainability characteristics of the Stanley Green Trading Estate in Cheadle, Manchester has added value for shareholders, and we are now embarking on similar “brown-to-green” projects for assets such as the University of Law Campus in Bloomsbury, London and the Churchill Way West Retail Warehouse in Salisbury.

The strong income performance and continued rental growth allowed a 4% increase in SREI’s dividend for the year. Importantly, this dividend is fully covered by earnings. A further increase of 2% has been announced for the quarter ended 31 March 2024, and the dividend now stands 10% above its pre-pandemic level.

Encouraging signs

An unusual characteristic of this cycle has been the presence of continued rental growth. In previous downturns, rents have tended to decline, as evidenced on the left-hand chart below. In this cycle, however, rental values have continued to increase. This has been most noticeable in structurally supported sectors such as industrial, retail warehousing, rental housing, prime offices, and operational assets such as self-storage and hotels, where there have been relatively low levels of new supply coming on to the market, and where demand has remained relatively resilient. This is evidenced for industrial on the right-hand chart below.

Past performance is not a guide to future performance and may not be repeated

Overall, we view the presence of rental growth as an encouraging sign that the UK real estate market is better placed now than in other recent cyclical recoveries. Together with the potential for future beneficial yield adjustment, UK commercial property looks well placed to deliver above average long-term total returns, which should in turn encourage capital flows back to the sector. Indeed, there are already signs of renewed private equity interest in the asset class, and banking markets are starting to open up, which could stimulate increased activity from a broader range of investors.

How important are interest rates to the outlook for UK real estate?

Interest rates have a direct influence on the cost of borrowing, so they are always relevant to real estate investors. When interest rates are rising, as they were in 2022 and 2023, the higher cost of borrowing inevitably impacts activity in the sector, which in turn can weigh on capital values. Conversely, if interest rates are being cut, this should stimulate more activity and lead to a more attractive environment for real estate investors.

Importantly, most market commentators now believe that we are at the peak of the rate cycle, and there are widespread expectations that interest rates can be cut now that inflation looks under better control. This would imply a more favourable environment for real estate markets in the period ahead.

Nevertheless, we should point out that inflation has remained more stubborn than many had predicted, and it might therefore be too early to start predicting an imminent turn in the interest rate cycle. Further increases in interest rates look unlikely, however, and stability in the cost of borrowing could be enough to drive improved sentiment towards real estate. In other words, we don’t necessarily need to see lower interest rates for the asset class to deliver positive performance. The absence of further rate hikes should be enough to support a gradual recovery in the coming years.

Conclusion

The UK real estate market has undergone a substantial correction and now appears to be stabilising, with capital values in some sectors such as industrials, already starting to recover. While uncertainties around inflation and interest rates persist, the market is well-positioned for a gradual, but sustainable, recovery. As the chart below demonstrates, we believe UK real estate can deliver attractive returns in the years ahead, driven by supportive fundamentals such as rental growth, a lack of supply in large parts of the market and an expectation that capital will start to return to the sector.

In the meantime, the SREI portfolio is performing well, particularly when compared to its peers. The portfolio is well placed to continue to benefit in this environment due to its exposure to higher growth sectors, the presence of low-cost long-term debt and our ability to add value through positive active asset management. Indeed, the strategic evolution that we announced in December 2023, which places sustainability at the centre of our investment proposition, will involve significant investment and active management, and should enhance the trust’s long-term total returns.

We are confident that, in combination, these factors should allow SREI to outperform a rising market in the years ahead.

Source: MSCI, Schroders, January 2024

¹ Source: Schroders to 31 March 2024. Past performance is not a guide to future performance and may not be repeated.

Fund Risk Disclosures: Schroder Real Estate Investment Trust

Credit risk - A decline in the financial health of an issuer could cause the value of its bonds, loans or other debt instruments to fall or become worthless.

Currency risk - The fund may lose value as a result of movements in foreign exchange rates.

Interest rate risk - The fund may lose value as a direct result of interest rate changes.

Liquidity risk - The fund is investing in illiquid instruments. Illiquidity increases the risks that the fund will be unable to sell its holdings in a timely manner in order to meet his financial obligations at a given point in time. It may also mean that there could be delays in investing committed capital into the asset class.

Market risk - The value of investments can go up and down and an investor may not get back the amount initially invested.

Operational risk - Operational processes, including those related to the safekeeping of assets, may fail. This may result in losses to the fund.

Performance Risk - Investment objectives express an intended result but there is no guarantee that such a result will be achieved. Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve.

Property development risk - The Fund may invest in property development which may be subject to risks including, risks relating to planning and other regulatory approvals, the cost and timely completion of construction, general market and letting risk, and the availability of both construction and permanent financing on favourable terms.

Real estate and property risk - Real estate investments are subject to a variety of risk conditions such as economic conditions, changes in laws (e.g. environmental and zoning) and other influences on the market.

Concentration risk - The company may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the company, both up or down, which may adversely impact the performance of the company.

Gearing risk - The company may borrow money to make further investments, this is known as gearing. Gearing will increase returns if the value of the investments purchased increase by more than the cost of borrowing, or reduce returns if they fail to do so. In falling markets, the whole of the value in that investment could be lost, which would result in losses to the fund.

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