Property has traditionally been a good inflation hedge, with rental uplifts usually coming in line with inflation. With inflation forecast to hit around 8% next month (and who knows what later in the year) it seems clear that this will not be the case this time.
Leases with inflation protection built-in typically come with a cap and collar (an upper and lower limit to annual uplifts), which at most would be 4% or 5%. However, income return is just one facet of property investment and when combined with capital value returns, total property return could well beat inflation.
Property companies with index-linked leases, operating in structurally strong sectors (where added valuation gains from asset management initiatives and investment yield compression could boost total property return) should do well in this high inflation environment. Logistics springs to mind here, which make the discounts that both abrdn European Logistics Income and Tritax EuroBox are trading on seem perverse.
It’s not logistics I wanted to focus on here, though. It is the UK’s long indexed-linked income property specialist Secure Income REIT that I wanted to get under the bonnet of. The group announced impressive results this week in which net asset value (NAV) increased 11.8%, helped by a 9.3% rise in the value of its property portfolio. How is it shaping up this year and are its assets in structurally strong sectors likely to see capital value growth as well as rental growth?
Summary of portfolio
The group’s portfolio is invested in three sectors – leisure (43% – mainly through Merlin Entertainments theme parks), healthcare (37% – mainly hospitals), and budget hotels (20% – Travelodge).
At first look, the portfolio appears to have a high exposure to assets that could suffer in a cost-of-living squeeze (hotels and leisure). But the manager says that the portfolio was put together to be less cyclical and more recession-proof (before the pandemic came along!). The manager argues that, in a cost-of-living squeeze, discretionary spend on big ticket items such as holidays goes and staycations increase, with theme parks and hotels seeing a boost.
Merlin is the largest visitor attractions business in Europe and second only to Disney worldwide. Secure Income REIT’s manager says that Merlin’s UK and German theme parks traded strongly in 2021 outside of COVID restrictions (a confidentiality clause prevents it from going into too much detail but the fact that it is opening five new Legoland attractions in the next two years signals that it is in good health).
The second half of last year saw Travelodge revenues surpass that of 2019. In the third quarter, revenue was up around 10% on the same period in 2019 and in the fourth quarter revenue was up 2% on 2019.
Lease profile
Secure Income REIT’s lease profile is in good shape. A total of 58% of its income is inflation-linked, with 27% uncapped to RPI. The other index-linked leases are CPI and have a cap in place of 3.5%, 4% or 5%. The other 42% of income has upward only rent reviews in place – with 30% the higher of 2.75% per annum or five-yearly open market rent reviews.
Using the RPI curve and assuming no yield compression, the group forecasts that the value of its portfolio will increase 4.7% in 2022 from index-linked rental growth alone. This would see NAV increase 6.8% and with dividends (targeted to increase by 15% in July) a NAV total return of around 11%.
Yield compression?
So, can added yield compression be eked out from within its portfolio? The portfolio yield is still 16 basis points (0.16%) higher than pre-pandemic, despite more favourable characteristics within the portfolio such as a WAULT nine years longer. This is due to its budget hotels portfolio where yields are 128 basis points (1.28%) higher than pre-pandemic. A very lean investment market exists for Travelodge hotels, following the antics of its private equity owners during the height of the pandemic (click here to read about this), but Secure Income REIT’s manager says that the investment market for Travelodge assets is beginning to recover and could result in yield compression this year.
Asset management initiatives (beyond the built-in inflation-linked lease regears) could be few and far between. Last year the group struck a deal with Merlin to extend its lease lengths to 55 years unbroken (almost unheard of in property), with annual CPI+0.5% uplifts with a cap at 4%, in return for a payment of £33.5m. This was more than made up for in valuation gains due to the longer leases. The likelihood of striking a similar deal in other parts of the portfolio this year seems doubtful.
The rarity of transactions in the sectors that the group invests in (aside from budget hotels) means that comparable transaction evidence is hard to come by, and so valuers will be hard pushed to be persuaded to move values too much.
The manager’s estimate of 11% NAV total return this year, along with any added yield compression that does materialise (and assuming there are no more COVID restrictions), should be enough to beat the most recent inflation forecasts. Whether the inflation rate rages further remains to be seen, however.
QD view – Cushion the inflation blow