Do developments boost REIT returns?

Real estate investment trusts (REITs) can potentially create shareholder value in many ways including generating a portfolio premium through building a collection of highly desirable individual investment assets, or by creating a corporate brand and operating platform in order to maximise rental income, or through establishing a development division focused on perpetually developing or re-developing assets. It is the latter that raises a key question for REIT investors, do developments deliver superior shareholder returns?

First rate academic research* of US REITs and a simple review of UK REIT** performance suggests that, in general, developments do boost REIT shareholder returns. Therefore, it makes sense for investors to engage in fundamental research to identify those REITs that possess both a proven ability to deliver successful developments together with access to an attractive pipeline of future development opportunities.?

“REITs create value through their real estate development projects.”?

Professor David Geltner et al.

The academics (David Geltner, Anil Kumar and Alex M. Van de Minne) found “that super-normal profits do tend to exist in the investment property development projects produced by publicly-traded equity REITs. Specifically, we find that, over the 1998-2018 period, REITs' Tobin's-Q ratios increase significantly as a function of the ratio of development assets to total assets…”?Put simply, “REITs create value through their real estate development projects.”?

The scholars suggest two possible reasons for the existence of super-normal profits, “either that the commercial real estate development industry tends to be broadly characterized by super-normal profits, or that there is a beneficial capital allocational efficiency effect of the stock market in attracting, supporting or cultivating firms that are particularly successful at real estate development of investment properties.”?The challenge for analysts and investors is to identify those REITs that are likely to be “particularly successful” undertaking the development of investment properties.?

Taking embodied carbon into account means that new developments have a high environmental hurdle to jump

Amid the current climate change crisis investing is not just about shareholder returns in isolation. Questions are now being asked about how returns are generated, with returns increasingly viewed in the context of climate change and assessed with regards to what is best for the planet.

With embodied carbon representing a significant proportion of the whole of life greenhouse gas emissions new developments must meet a real need and do so in a low carbon or net zero manner. Taking embodied carbon into account means that new developments have a higher environmental hurdle to jump than refurbishments.?Many REITs recognise this responsibility and are now targeting net zero carbon developments.?These targets combined with measures taken to reduce operational carbon and to generate on-site renewable energy should materially reduce the lifetime carbon footprint of new buildings.?

There are clear financial risks to developments too, any property developer would struggle to deliver a financially viable new development into a saturated market with declining tenant demand.?Shopping centres are a perfect example of the risks faced by REIT investors.?Digitalisation has changed the shopping habits of consumers, shoppers are migrating online, bricks and mortar retailers are failing and in turn their landlords are suffering.?Identifying enduring positive socio-economic mega trends is a key component to successful property development.?

UK REITs have outperformed the liquidity challenged open-ended direct property funds

In the UK REITs have outperformed the liquidity challenged open-ended direct property funds. Part of this outperformance can be explained by the numerous specialist REITs that have been successful in executing development or redevelopment strategies.?

Drilling down into the performance of individual REITs reveals an interesting picture.?Bloomberg-driven analysis of the constituents of the iShares UK Property ETF reveals companies engaged in investment property development are at the top and bottom of the performance tables. Specialist REITs developing in the logistics space have performed extremely well whereas REITs developing in the retail space have performed poorly, with the administration of Intu highlighting the fate faced by those that fail to navigate a safe passage when tenant trends change direction.?Stuck in the middle of the performance table are the externally managed diversified REITs that have far less scope to engage in development activities.?

The rapid growth in e-commerce has led to a supply-side response from certain REITs within the logistics sub-sector.?For example, Segro and Tritax Big Box both own and develop warehouses that are increasingly used as e-commerce fulfilment and distribution centres.?Over the past 5 years these two stocks feature in the top 10 best performing REITs based on the constituents of the iShares UK Property ETF.

Tritax Big Box estimates that it owns and controls the UK’s largest logistics focused land platform capable of delivering approximately 40mn sq ft of logistics space.?Potentially hugely valuable when judged in the context of their current development of the Littlebrook site in Dartford.?This 114 acre site is on track for at least 2.8mn sq ft of technology-packed modern logistics space and, as at the end of 2020, the company estimated that it had already achieved an impressive value creation uplift of ￡149.7mn on ￡184.8mn of costs.

Segro estimates that over the next decade potential gross rental income from new developments could top ï¿¡270mn.?Achieving this would represent a massive 68% increase on the ï¿¡392.9mn of gross rental income that Segro collected in 2020.

Investors are right to spend time identifying mega trends and researching the best stocks

Looking to the future, investors are right to spend time identifying powerful socio-economic mega trends (e.g. ageing for population, digitalisation, and generation rent) and researching the best stocks within these trends to identify REITs that combine the ownership of great investment assets together with the strategic drive to continuously look for profitable and environmentally friendly development or redevelopment opportunities.

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VT Gravis Digital Infrastructure Income Fund film?

VT Gravis UK Listed Property Fund film

* Is there Super-normal Profit in Real Estate Development? MIT Center for Real Estate Research Paper No. 3, David Geltner, Anil Kumar, and Alex Van de Minne

**iShares UK Property UCITS ETF

Disclaimer:?Gravis funds invest in Segro and Tritax Big Box REIT. Past performance is not a guide to future performance. The value of the investment and the income deriving from it can go down as well as up and can't be guaranteed. You may get back less than you invested. For UK readership, not for US distribution.?

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