Over the last eight months, FTSE 250 stocks have been on an upward trajectory, increasing by just shy of 16%. This isn’t exactly surprising given the steadily improving outlook for the UK economy in the short term. However, not every stock in the index has been so fortunate.
With interest rates rising to combat inflation, real estate moguls like Warehouse REIT (LSE:WHR) have seen their valuations plummet. In fact, the stock is down by around 18% over the same period. Yet despite what the share price would suggest, the firm is actually performing admirably. Let’s take a closer look at what’s going on.
Interest rates vs real estate
As the name suggests, Warehouse REIT owns a portfolio of urban warehouses across the UK, generating revenue through rent. While there is some diversity, the bulk of its tenants use these logistics facilities for online order fulfilment.
The FTSE 250 stock’s business model involves acquiring well-positioned dilapidated warehouses for refurbishment and then renting. However, buying commercial property isn’t exactly cheap. And since REITs are required to pay out 90% of net earnings to shareholders as dividends, the group is highly dependent on debt financing.
Today, the firm has roughly £306m of loan obligations on its books, all at floating rates. That means when interest rates go up, so does Warehouse REIT’s financing bill. In fact, looking at the latest results, financing expenses for its 2023 fiscal year ending in March doubled from £8.2m in 2022 to £16.7m.
That’s obviously concerning. And it places additional pressure on net profit margins, squeezing the amount of available capital to fund dividends. With that in mind, it’s not too surprising to see income investors jump ship.
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What now?
Taken at face value, the group’s property portfolio appears to be diminishing. After all, it was worth an estimated £1bn in March 2022, versus £829m a year later. But the real estate sector moves in cycles much like the stock market. And for income investors, what ultimately matters is cash flow.
As it turns out, despite the uncertain economic environment, cash flows are on track to increase this year. Management has disposed of a few underperforming non-core properties while signing new and renewed rental agreements. As such, contracted rent grew by a modest 3% to £45.3m, with occupancy now standing at 95.8%.
A low single-digit growth rate is nothing to get overly excited about. But that may soon change. New macroeconomic data from the IMF reveals that the UK is on track to avoid a recession. And it may even return to growth this year.
With inflation also steadily dropping, household budgets potentially are becoming less tight. If true, then e-commerce order volumes may be set to recover, elevating demand for this FTSE 250 stock’s prime warehousing space.
In other words, we might be near the bottom of the commercial real estate cycle. And as history has proven countless times, buying near the bottom is a recipe for building substantial long-term wealth.
