A story of two Reits: the importance of performance in determining valuation

Although they both focus on properties outside of London, AEW UK and Regional are two Reits with very different values

With net assets of 174 million, AEW UK Reit (LSE: AEWU) invests in "UK commercial property assets in strong locations" almost entirely outside of London. Why do two seemingly similar real estate investment trusts (Reits) trade at such disparate valuations? Its shares yield close to 8% and are traded at a 4% discount to net asset value (NAV).

On the other hand, Regional Reit (LSE: RGL), which has 362 million in net assets, makes investments in "high quality commercial properties outside of the M25 motorway." Even though its shares should be more liquid because it is a larger trust, they yield 7.3 percent but trade at a 44 percent discount.

It comes down to performance in part. Utilizing "active management," AEW aims to "grow income, lengthen and improve tenant leases, add value using the planning system, and refurbish, where needed" in addition to purchasing "mispriced assets." Its success is demonstrated by the 70% five-year investment return, which is higher than the 5% property sector index. RGL's NAV, meanwhile, has decreased by 70% over the last three years and 74% over the last five.

This illustrates the disparities between the assets held by the two trusts. Thirteen percent are retail warehouses, eleven percent are offices, eighteen percent are "other," thirty-six percent are industrial properties, and twenty-one percent are high-street retail. The weakest segment of the market, offices, is where RGL holds 91 percent. What's more significant is that AEW has limited borrowings to 25% of portfolio value. With a fixed rate through May 2027, its cost of debt is currently less than 3 percent.

RGL has lacked caution. Its net debt is 260 million, or 42% of the value of the portfolio. That percentage would drop to 29% with a disposal program of 40 properties with a book value of 106 million, partially offset by capital expenditures of 24 million. This, however, comes after a distressed share offering at 10p in the middle of 2024 that raised 110 million but significantly reduced the NAV.

The proceeds, which amounted to 57% of the portfolio value, allowed RGL to pay back a bond worth £50 million that was about to mature. There was a one-for-ten share consolidation after this. Steve Morgan, the creator of the home building company Redrow, underwrote the issue. As a result, Morgans companies now own 22% of the shares in circulation.

What Reit should I pick?

"Challenging" is how RGL's CEO, Steve Inglis, has characterized the operating environment since COVID-19. Even though year-over-year rental income fell by 5% in May of this year, he was still able to report stable property values, a rise in occupancy, and 14 new rentals. Therefore, RGL seems to have turned around, as evidenced by declining debt and rising rental income, which makes the discount very alluring. Rent increases as existing agreements expire are indicated by RGL's external valuer, who estimates that the open-market rent of the portfolio's 126 properties, comprising 1,271 individual units and 780 tenants, is 27% higher than the current rent roll. Investors aren't paying attention right now, but Inglis doesn't believe the local market is in terrible shape and is annoyed by the discount.

Although AEW's portfolio has only 9% rental upside, management anticipates that plans for asset management initiatives and recent acquisitions will "lead to stronger returns in the future." Despite being smaller than RGL, it is more focused and has a more diversified portfolio with 34 properties and 129 tenants.

According to Laura Elkin, lead manager at AEW, the current market is "the greatest buying opportunity we have seen in the ten-year life cycle of the company but, perhaps, a less good time to be selling." More mispricing in the market allows us to purchase properties that don't align with their long-term fundamentals and then actively manage them, which is exactly what we want to see.

The option available to investors is a Reit with a strong track record and promising future at a price that reflects those attributes, or one that is essentially a recovery bet with lots of potential but greater risk.