Behind the Trust: Schroder Real Estate Investment Trust
By formalising its investment policy to focus on sustainability and capitalise on mispricing, Schroder Real Estate Investment Trust is seeking to be the first mover within its sector to proactively respond to the UK’s Net Zero Carbon objectives to the potential benefit of both shareholder returns and the planet.
Investors intent on embracing ESG commitments tend to focus on investing in the shares or bonds of companies whose management share their mindset, but there is one asset class which is often overlooked that could help them achieve their dual aims: property.
Real estate has one of the highest carbon footprints of any sector. According to the International Energy Agency, the built environment generates 40% of global carbon emissions annually. Building operations are responsible for 27%, while building, infrastructure materials and construction – typically referred to as ‘embodied carbon’ – are responsible for the remaining 13%. In addition, the majority of today’s UK stock will still be in use in 2050.
As a result, the real estate sector is critical to the widespread objective of reaching net zero carbon emissions by 2050 and achieving the Paris Agreement’s target of limiting global warming to 1.5°C above pre-industrial levels.
Schroders Capital, the private markets division of Schroders, recognises the importance of incorporating sustainability at the heart of its investment proposition, leveraging its proven sustainable real estate platform to enable Schroder Real Estate Investment Trust to capture the ‘green premium’.
“The ‘green premium’ in real estate markets has been evident for some time, where environmentally efficient buildings can command a higher valuation than property in the same location and of a similar age with a larger carbon footprint,” says Bradley Biggins, who co-manages the Trust alongside Nick Montgomery.
“Investors are prepared to pay higher prices for buildings with strong sustainability credentials because they tend to let more quickly and at higher rents, suffer lower vacancy rates, require less capital expenditure in the long term and are more protected from the risk of obsolescence with tightening environmental regulation. By investing in and adapting existing assets to improve their environmental performance, we can enable our shareholders to capture this green premium which has the potential to drive a consistent, attractive level of income whilst positioning the portfolio to potentially deliver long-term capital growth.”
The Trust’s ‘brown-to-green’ investment strategy, a first in the UK’s listed real estate sector, aims to meet the growing investor and occupier demand for more sustainable buildings by continuing to transform the environmental performance of the portfolio’s assets over time.
“We’re not giving up performance for sustainability – far from it,” says Biggins. “This is a decarbonisation strategy that delivers modern buildings which are fit for purpose, at the same time as seeking to increase returns for shareholders.”
What does the Trust do?
The Trust aims to provide shareholders with an attractive level of income together with the potential for income and capital growth through investing in a diversified portfolio of UK commercial real estate. The focus is on delivering consistent dividend growth by improving the quality of the underlying portfolio through a disciplined, research-led approach to transactions, capital investment, active asset management and operational excellence.
Amendments to the Trust’s investment policy, supported by shareholders in December 2023, extended this to achieving meaningful and measurable improvements in the sustainability profile of the majority of the portfolio's assets, considered against a range of objective environmental, social and governance metrics.
Consequently, the management fee has been aligned to this strategic evolution through the introduction of a unique 0.05% performance-related fee adjustment. From 1 April 2024, the fee is adjusted up or down based on performance against two conditions. Firstly, the Board is satisfied that the managers have delivered measurable improvements in the sustainability profile of portfolio assets. Secondly, the Trust has generated an income return that is ahead of the MSCI benchmark because the new strategy is designed to deliver more consistent long-term income. If both conditions are met, the base fee is adjusted upwards by 0.05%. However, the adjustment works in the opposite direction too, as failure to deliver on both requirements will lead to a 0.05% reduction in the base fee paid by shareholders.
The changes represent an evolution of the Trust’s strategy rather than a revolution, and build on the team’s experience in investing with an ESG mindset while leveraging the broader sustainability resources within Schroders.
How does the Trust do it?
The Schroder Real Estate Investment Trust is managed by Schroders Capital, a highly experienced global real estate investor with a strong sustainability track record.
It boasts a deep understanding of UK commercial real estate and a data-led ESG framework through which fund managers can drive demonstrable improvements in the sustainability profile of their portfolios.
Its proprietary and independently validated scorecard methodology for monitoring and reporting on environmental performance allows investors to monitor the portfolio’s progress against clear, asset-specific sustainability targets and gives the portfolio managers the opportunity to lead the way on sustainability reporting.
In order to spread investment risk and maximise the stability of the income generated by the Trust, the assets are diversified by location, sector, size, tenant and lease expiry. The value of any individual asset at the date of its acquisition must not exceed 15% of gross assets and the proportion of rental income derived from a single tenant must not exceed 10%.
1. Early mover advantage
The managers believe that Schroders Capital has the relevant expertise and experience to navigate this challenge and identity a specific opportunity for the Company to leverage an early mover advantage, clearly declaring its focus on decarbonisation strategies that adapt existing buildings to achieve the ‘green premium’ with the potential to capitalise on mispricing.
2. Future-proofed portfolio
The Trust is delivering tomorrow’s real estate strategy, today. Over time, stringent regulation is likely to compel the real estate sector to move further in this direction.
By formalising its sustainability proposition, the Trust is pre-empting future regulation with a strategy that will remain relevant in the longer term, as well as further improving the resilience and liquidity of the portfolio.
3. Consistent returns
The enhanced strategy aims to provide shareholders with sustainable income both from an environmental perspective and a long-term growth perspective.
Through improvements in the portfolio’s environmental performance, investors can capture the rental and valuation premium that buildings with genuine green credentials command. This should build on the strong relative outperformance compared with the MSCI Benchmark over all time periods to date, underpinned by a consistently higher income return generated by the underlying portfolio.
4. Attractive income
The Trust’s attractive dividend is fully covered by earnings (as at 30 September 2023) and the board remains committed to a progressive dividend policy. This is well supported by the team’s focus on actively managing the assets to drive further improvements.
“We don’t want to just buy the most sustainable assets today and hold them” says Biggins. “We are looking for assets that aren’t meeting their full sustainability potential, and where we see a route to enhance that performance to deliver rental growth and a valuation uplift.”
“The fundamentals have to work, too. The location and sector have to be right and the current rents have to be at a level where we see scope for raising those rents once we have invested in the assets.”
5. Active management
The Trust has a proven process and a significant active management pipeline to improve the performance and valuation of assets over time.
Stanley Green Trading Estate, an operationally net zero carbon warehouse scheme in Cheadle, Manchester, is just one example within the portfolio where significant ESG improvements have been delivered through active asset management. Having acquired the site in December 2020, SREIT oversaw a transformation completed in May 2023 to deliver the region’s first operationally net zero carbon industrial scheme, providing 80,000 square feet of best-in-class warehouse and trade counter space.
Improvements which led to carbon neutral status include the installation of air source heating systems, extensive photovoltaic (solar panel) systems, energy efficient LED light fittings and electric car charging points, as well as enhanced cladding and window materials to optimise thermal efficiency and provide natural light. Other sustainability measures put in place included covered cycle storage, communal drinking taps, a wildflower meadow, and bird and bat boxes.
Watch our Stanley Green case study video.
A circa 4,000 square feet unit on the existing estate with an EPC rating of ‘C’ was recently let at £14.50 per square foot, whereas the new operationally net zero carbon units of a similar size have been let at £17.50 per square foot, reflecting a 21% premium (data as at 30 September 2023).
Tenants are more discerning than ever when it comes to space and that extends beyond sustainability. For office tenants, for example, extensive refurbishments undertaken by the team have created welcoming receptions, ‘end of journey’ facilities (changing rooms, showers, bike storage and lockers), wellness facilities and collaboration spaces.
“Each sector and tenant have different requirements,” says Biggins. “We have teams of people who are specialists in their sectors with a track record of delivering redevelopments and putting together comprehensive and well-conceived plans to drive improvements for tenants – and ultimately returns for our investors.”
6. Deep and proven expertise
Shareholders benefit from access to a highly experienced team and global estate platform. Schroders manages around £13 billion of real estate assets in the UK.
“We have an experienced team and close relationships with the agents and tenants. This enables us to tap into good, on-the-ground intel, so we know who is looking for what space to attract the best tenants for our assets. We’re also able to understand the current dynamics in any particular market to inform where we should be deploying our investors’ money,” says Biggins.
Schroders Capital, and the wider Schroders Group, is a global leader in sustainability and contributes to shaping regulation and best practice. Schroders Capital Real Estate became a signatory to the Better Buildings Partnership Climate Commitment in 2019, committing to net zero no later than 2050 for its assets under management.
The team’s proven, proprietary, independently validated scorecard methodology for monitoring and reporting on asset level environmental performance provides the transparency to allow investors to closely follow the portfolio’s positive progress.
The Trust has achieved a gold level award from the European Public Real Estate Association for six successive years in recognition of its ‘exceptional’ adherence to the Sustainability Best Practices Recommendations, which promote quality sustainability reporting within annual reports and consolidated financial statements.
8. Growth potential
The portfolio is well diversified by sector, location, and tenant with a focus on higher growth areas, low vacancy rates and creditworthy tenants. Although the Trust holds a wide spread of around 40 investments, the top 15 account for around 80% of the portfolio valuation.
“Our largest assets are where we see the greatest potential for improvement. When we do improve them, we’re going to move the needle for the Fund,” says Biggins.
This focus on larger assets with significant growth potential has led the managers in recent years to dynamically allocate to the industrials sector, with a preference for multi-let estates over the ‘big box’ warehouse market due to tighter supply and the potential for alternative uses over the longer term. Consequently, the team believe multi-let industrial assets will continue to outperform in the medium to long term.
“In addition, there’s more varied demand for multi-let industrial estates,” says Biggins. “Big boxes are more dependent on online retail, whereas multi-let industrials have much more diverse tenant bases with uses ranging from manufacturing and storage to gyms and trade counters.”
9. Focus on winning regions
The managers are focused on higher growth cities and regions across the UK – including London sub-markets, and larger regional cities such as the 'Big 6’ where the Company owns assets in Manchester, Leeds and Edinburgh.
The locations favoured are benefiting from higher economic growth due to structural changes such as urbanisation, technological advancements and changing demographics. These cities boast diversified local economies, sustainable occupational demand as well as favourable supply and demand dynamics.
10. Balance sheet strength
The Trust has a robust balance sheet with low-cost, long-term debt. At 30 September 2023, the average interest rate for total drawn debt was 3.5% and the average maturity was 10.2 years. 91% of the debt was fixed rate or hedged against movements in interest rates. This puts the Trust in a strong position in a higher interest rate environment and is a competitive advantage versus peers. The Company is unique in the recognised peer group (AIC sector, UK – commercial) in that it is paying a dividend higher than the pre-pandemic level, and visibility on costs has been a factor in that.
“In the next few years, many of our peers will be refinancing, and given the current interest rate environment it is possible their costs are going to go up,” adds Biggins.
Fund risk disclosures
- Credit risk - A decline in the financial health of an issuer could cause the value of its bonds, loans or other debt instruments to fall or become worthless
- Currency risk - The fund may lose value as a result of movements in foreign exchange rates
- Interest rate risk - The fund may lose value as a direct result of interest rate changes
- Liquidity risk - The fund is investing in illiquid instruments Illiquidity increases the risks that the fund will be unable to sell its holdings in a timely manner in order to meet his financial obligations at a given point in time It may also mean that there could be delays in investing committed capital into the asset class
- Market risk - The value of investments can go up and down and an investor may not get back the amount initially invested
- Operational risk - Operational processes, including those related to the safekeeping of assets, may fail This may result in losses to the fund
- Performance risk - Investment objectives express an intended result but there is no guarantee that such a result will be achieved Depending on market conditions and the macro economic environment, investment objectives may become more difficult to achieve
- Property development risk - The Fund may invest in property development which may be subject to risks including, risks relating to planning and other regulatory approvals, the cost and timely completion of construction, general market and letting risk, and the availability of both construction and permanent financing on favourable terms
- Real estate and property risk - Real estate investments are subject to a variety of risk conditions such as economic conditions, changes in laws (e g environmental and zoning) and other influences on the market
This communication is marketing material. The views and opinions contained herein are those of the named author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy.
The data has been sourced by Schroders and should be independently verified before further publication or use. No responsibility can be accepted for error of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions.
Past Performance is not a guide to future performance. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall.
Any sectors, securities, regions or countries shown above are for illustrative purposes only and are not to be considered a recommendation to buy or sell.
The forecasts included should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. Forecasts and assumptions may be affected by external economic or other factors.
Issued by Schroder Unit Trusts Limited, 1 London Wall Place, London EC2Y 5AU. Registered Number 4191730 England. Authorised and regulated by the Financial Conduct Authority.