Value investors are drawn to broken UK REITs

While trade buyers and private equity are grabbing the real estate funds, retail investors are ignoring UK REITs

What's the reason?

Over the past year, UK real estate investment trusts, or REITs, have significantly underperformed the overall market. The largest group in the industry, industrial REITs, have returned only 6.8 percent, primarily from income, compared to the FTSE All-Share index, which excludes investment trusts, and has generated a total return of about 22 percent.

But trade buyers and private equity are clearly interested in the industry, even though investors are not. There were 82 listed REITs five years ago. Since then, more than half have been purchased or liquidated. Blackstone, a massive private equity firm, has been particularly active, first acquiring St. Modwen Industries and Properties REIT. After defeating Tritax Big Box (LSE: BBOX) in a competition for Warehouse REIT, it sold assets to Tritax in return for a 9% share.

It appears that the trend will continue. British Land (LSE: BLND) bought Life Science REIT earlier this year. More recently, Schroder Reit (LSE: SREI) and LondonMetric Property (LSE: LMP), which has completed a number of deals in recent years, joined forces to bid for Picton Property Income (LSE: PICT), though the outcome is still unknown. Some of Picton's shareholders expressed their displeasure with the proposed terms to the Investors' Chronicle last week.

UK REIT discounts that are not justified.

One of the best examples of value in the industry is provided by Derwent London (LSE: DLN). The company trades at a 47 percent discount to net asset value (NAV) with a 4.6 percent yield, and it owns a portfolio of superior offices in central London. Management recently announced a 50 million share buyback in an effort to close the discount, indicating that it feels this is a better use of capital than purchasing more assets. Buying back stock is the same as purchasing a new building at a 50% discount, so you can't blame management for it.

However, given that rents are breaking records and London is expected to run out of high-quality office space in the coming years, it is obvious that something has gone terribly wrong in this market.

Another illustration is Grainger (LSE: GRI). Despite being one of the biggest residential landlords in the nation, they are unable to produce new homes quickly enough to satisfy demand. It has continuously reported occupancy rates in the high 90s, and overall rental income increased by 7.8 percent last year. However, the shares have dropped 29% in the last 12 months and are currently trading at a yield of 5.4% and a nearly 50% discount to NAV. The founder of the retail group Frasers, Mike Ashley, has been purchasing while others are selling. Through derivatives, he owns just under 5% of the business.

Catalyst for value.

Other examples include Great Portland Estates (LSE: GPE), which is trading at 60 percent of NAV and has a lower yield of 2.7 percent due to its emphasis on development rather than income. With yields of about 7%, even reasonably well-known REITs like LondonMetric and Supermarket Income (LSE: SUPR) are trading at about 90% of NAV.

Generally speaking, UK REITs are trading at some of the lowest prices ever recorded. Yes, they might become more affordable, but eventually trade buyers and private equity will find them to be too good to pass up. Value investors should find this appealing because value investing functions best when there is a definite potential catalyst to realize that value. It might not be long before all of the remaining deeply discounted REITs are removed, given the ongoing liquidation of the London equity market.

Investors who purchase at current valuations may see appealing capital gains if and when that happens. While they wait, they can benefit from dividend yields of 5% to 7%, which are frequently the result of long-term agreements with superior tenants.