Schroder Real Estate 09 December 2022
This is a non-independent marketing communication commissioned by Schroder Investment Management. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.
Schroder Real Estate (LON:SREI) invests in UK commercial property with a focus on active asset management, in particular with a sustainability angle. This strategy helps generate a high portfolio yield versus the benchmark and peers, while it has also led to SREI generating good relative total returns in recent years (see Performance). Significant uplifts in value have been achieved in recent years thanks to improving the ESG credentials of properties, and some major projects in this vein are currently under way (see Portfolio).
The property sector, like many others, has been under pressure in recent months, as interest rates have risen from their historical low base. SREI’s results for the half year ending 30/09/2022 showed relative resilience against the backdrop of declining valuations. Manager Nick Montgomery’s strategy means the portfolio tends to avoid the lowest-yielding segments of the individual subsectors that make up the portfolio, and it is these that have led the market down – particularly prime South East industrials and logistics.
Nonetheless the discount has widened to 39% at the time of writing, which means the dividend yield is a highly attractive 7%. While the manager acknowledges the immediate outlook for property values is negative, we note SREI’s dividend is 110% covered by EPRA earnings for the six months to 30 September, while rent collection is extremely strong (99% for the September quarter).
Importantly, the balance sheet looks solid. The trust arranged cheap fixed-rate debt at the end of 2019 which now has an average maturity of over 13 years, and on which the trust pays just 2.5%. There is also a smaller revolving credit facility with rates fixed until July 2023 (see Gearing). The trust’s net LTV is 31.4% (45.8% on a debt-to-NAV basis).
SREI’s high dividend yield looks attractive versus both peers and other asset classes, including equities, cash and gilts – particularly given how well covered it is. Investors buying now should receive a dividend yield of 7% on an ongoing basis. In addition, the reversionary potential of the portfolio is attractive at 6.6% (versus the benchmark’s 4.8%) and there is a pipeline of asset management opportunities to further grow income.
SREI trades on a very wide discount of 39% at the time of writing, meaning the valuation of the portfolio could fall by c. 25% and the shares would still be on a discount. We think this should give comfort to investors concerned that further falls to the capital value of the portfolio are likely in the coming quarters, given that property valuations come in with a lag. Of course, if interest rates peak lower and sooner than expected, then some of the pressure on pricing will be relieved, although there will still be the impact of a recession to assess.
Additionally, we think the balance sheet looks strong. The decision to fix long-term debt in late 2019 was well timed, and the low rate agreed of 2.5% is extremely attractive in the current environment. We note there is some refinancing risk through the RCF, the hedges on which have to be rolled in July 2023, although this is only 26% of the drawn-down debt. The cheap gearing could provide a tailwind behind the NAV when the recovery comes, and importantly there are very significant cushions over the covenants on the debt, as described in the Gearing section.
- High income yield, with dividend fully covered by cash and EPRA earnings
- Manager is well resourced, with good track record of adding alpha
- Strong balance sheet should help in a troubled economic period and protect earnings
- Property’s economic sensitivity could see it suffer in a recession
- Gearing increases NAV volatility
- High portfolio concentration increases importance of single investments to returns