Is property built on a strong platform?

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If US private equity giant Blackstone was a social media influencer, then we’d have to say its move to acquire UK-listed Industrials Reit went viral earlier this month.

Pundits and fund managers emerged in droves to cheer the deal, seeing the swoop as an endorsement of value in the beaten-up commercial property sector.

And investors metaphorically smashed the like button, too. UK real estate investment trusts and ETFs are trading well above the lows of March.

Though perhaps that isn’t saying much.

In many cases, the prices of commercial property related shares are still down year-to-date – and this after 2022 had already put the boot in.

Still, in property you make your money when you buy, not when you sell. A low purchase price implies higher rental yields and bigger capital gains in the future.

So, is this the time to look for other bricks-and-mortar bargains before they are all bid up by the big boys?

Playing property fast and loose

Blackstone agreed to pay 168p per share for Industrials Reit, valuing the target at £511m.

More excitingly, that 168p was a 42% premium to Industrials’ price before Blackstone showed its hand.

Nice gains if you can get them. Apply such an uplift across the UK’s depressed property sector, and there would appear to be abundant upside for buyers today.

However, I’d suggest Industrials Reit is in some ways a special case. It owns unusual assets compared to other listed funds invested in the UK real estate.

Typically, UK REITs that offer exposure to ‘industrial’ assets – think warehouses and factories rather than iron foundries – are ‘big box’ players. Their portfolios heave with big logistics hubs rented out to the likes of Amazon and Tesco.

Picture all those huge warehouses you see by the sides of motorways these days.

Whereas, Industrials Reit owns Multi-Let Industrial estates (hence its ticker ‘MLI’). These estates are a hodgepodge, let across several dozen tenants, each of whom rents a usually fairly modest-sized space as a workshop, warehouse, garage, or similar, and sometimes coming with their own kitchens and toilets.

The economics of this business is very different to that of the big box REITs.

Crucially, Industrials signs fairly short leases. According to its 2022 annual report, Industrials’ average lease is around four years – and it turns over about 25% of its existing leases every year.

In contrast, deals signed by the logistics giants often run for over a decade.

Now, shorter leases mean Industrials needs to work harder to keep its estates occupied. Tenants are freer to shop around, or to up and leave.

But the upside in inflationary times like today is that Industrials can raise rents more rapidly as new tenants come in, which keeps its rent roll growing nicely.

Fast turnover also makes Industrials more responsive to market conditions.

For example, Amazon threw cold water on the logistics sector last year when it admitted it had taken on too much warehouse space. That began a de-rating for the likes of Tritax Big Box, which had expanded rapidly during the pandemic.

In contrast, Industrials’ tenant mix is more diverse to begin with – and it is also less vulnerable to shifts in demand. Online retail retrenching? No worries, it can sign-up more niche engineers benefiting from post-Brexit ‘re-shoring’, for instance.

For property – hardly the fastest-moving sector – this makes Industrials positively racy.

A platform for growth

The secret sauce for Industrials, therefore, is in managing the comings and goings of hundreds of tenants while collecting rent from the incumbents – and doing everything else a landlord usually does – to keep vacancies low and the cash flowing in.

Industrials Reit calls its operations a ‘platform’, accordingly.

The platform label has been trendy in recent years. To over-simplify, it implies the business is a sort of operating system that can be copied-and-pasted across an expanding asset base, where profits are mostly driven by how well the assets are managed by the platform – rather than by fine-tuning the assets themselves.

Compare that with, say, British Land, the illustrious old-line REIT that makes a big fuss about the quality of its prime mixed-use campuses in places like Paddington Basin in London. No doubt British Land sometimes drops the word ‘platform’ into presentations to analysts. But its earnings power is really about how attractive the office and retail spaces it develops subsequently prove with its blue-chip clients.

It’s easy to see why for a firm like Blackstone, the platform operations offered by Industrials are more attractive than buying up a traditional Reit like British Land.

In theory, Blackstone has acquired a system that can consolidate and manage more industrial estates in a relatively predictable fashion – with Blackstone putting extra capital in at the top and enjoying a rising rental cashflow as its output. As long as Industrials Reit can continue what it’s doing, it should be a matter of step-and-repeat to expand the business, without the development risk of traditional real estate – nor the existential risks confronting the sector thanks to the shift to home working and online retail.

Still a buyer’s market

All very compelling – but of course, the smart thing would have been to identify the appeal of Industrials Reit before Blackstone made its move.

That’s especially true because I don’t think there’s anything else quite like it that you can invest in now to gain pure exposure to the MLI space.

For sure, some of the large REITs and other funds own mixed-use industrial estates. But even a company like the fairly diverse £10bn industrials bellwether Segro is mostly a bet on big box logistics and warehouses for retail.

For this reason, I don’t believe Blackstone’s move really offers much of a read across to sector as a whole – or at least not in the obvious sense. The near-term outlook for real estate writ large still depends mostly on the direction of interest rates, and on how post-Covid working and shopping habits finally settle.

However, a contrarian might say this tells us it is actually the time to dig for value in those big box and/or office-heavy REITs.

Because such real estate really does look cheap. Sticking with Segro, the firm just put out a very encouraging trading update that implied property valuations have begun to stabilise – even as it sees plenty of potential for growth in rental income.

Segro trades at around a 20% discount to net assets. Yet the same inflationary forces that have proved a headwind to real estate for the past 18 months should ultimately bolster property valuations – not least because inflation makes it more expensive to build or replace warehouses and other physical assets.

Blackstone has bought what is working today with Industrials Reit. But another key to winning with property investment is to buy what will be popular tomorrow.

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