Palace Capital — A wealth of asset management opportunities

Palace Capital is an internally managed property investment company, with plans to convert to a real estate investment trust (REIT) with effect from 1 August 2019, focused on commercial property in major cities and university towns in the UK, outside London. It has a sector-agnostic, entrepreneurial approach to investment and operates a total return model, with a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. This strategy provides attractive income returns, as well as exposure to capital growth from the repositioning of value-add properties. We calculate an average annual compound EPRA NAV total return of 15.8% since its first significant acquisition in H114. The existing portfolio contains strong reversionary potential and offers significant refurbishment and development opportunities. We expect the Hudson Quarter development in York to materially drive returns in the next two years

Financials: Hudson Quarter to drive near-term returns

Our underlying forecasts for FY20 and FY21 are little changed but benefit from anticipated tax benefits as a result of planned REIT conversion. We assume continuing rental growth and modest underlying occupancy gains throughout the forecast period, although we expect recurring earnings (adjusted PBT excluding non-recurring surrender premium) to be lower in FY20 as a result of the FY19 letting deferrals to pursue medium-term asset management plans by refurbishing and redeveloping. Completion of the Hudson Quarter in late FY21 should generate development gains, benefitting NAV by more than 20p per share. In FY22 we expect annual rental income from the Hudson Quarter commercial assets to add c £0.9m to recurring income, and for the completion of the sale of the residential development to materially lower gearing, with the net LTV reducing by c 10pp to below 28%. Without assuming any further investment activity, we forecast an end-FY22 EPRA NAV per share of 435p and for dividends to be more than covered by recurring EPS of 19.7p.

The dividend yield is attractive, approaching 7%, and with a liquid balance sheet and moderate gearing the current level of DPS has been maintained in anticipation of recurring income growth. Compared with a peer group of similar regionally focused commercial property investors, Palace shares trade a yield premium with a higher than average discount to EPRA NAV of c 30%. REIT conversion may underline the strong income element in current returns while asset management initiatives to capture reversionary potential and progress with Hudson Quarter are also potential triggers for a re-rating.

We review the main sensitivities on page 13. We consider these to be related mainly to the broader macroeconomic background and the cyclical nature of the commercial property market. Commercial property has historically exhibited substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. We would also highlight the increased risks and uncertainties that attach to development activity, although in respect of Hudson Quarter we note that a fixed price construction contract and development funding are in place while planned pre-letting of commercial space and pre-sales of residential space will mitigate post-construction risks.

Palace Capital is an internally managed property investment company that has announced plans to convert to a REIT with effect from 1 August 2019. It focuses on commercial property in major cities and university towns in the UK, outside London and at 31 March 2019 had a property portfolio externally valued at £286.3m. Palace operates a total return model and will continue to do so post-REIT conversion. Palace is sector-agnostic in its approach to investment and seeks to be entrepreneurial and opportunistic in its acquisitions, looking for opportunities to enhance sustainable recurring income through asset management and generating capital growth through refurbishment and development opportunities. This strategy provides attractive income returns from a core portfolio of income-producing assets as well as exposure to capital growth from the repositioning of value-add properties.

History

The company was given its current form in July 2010 when Stanley Davis (the current non-executive chairman) and Neil Sinclair (the current CEO) acquired board control of an AIM-listed vehicle for the purpose of property investment. The current portfolio has been built by acquisition since late 2011, mostly off-market corporate acquisitions that are tax efficient and have minimal purchase costs to absorb. Reflecting the strong growth of the company, it transferred to the Main Market of the London Stock Exchange in March 2018.

The first transformational acquisition came in October 2013 when a portfolio of 24 properties from around the UK, known as the Sequel portfolio, was acquired from Quintain and Buckingham Properties. Palace paid £39.25m for the properties which were valued individually at the time at £44.2m with a net rent receivable of £5.25m pa. The August 2014 acquisition of the PIH portfolio, comprising 17 properties, for £32.0m was a further significant step. In terms of scale, the £67.9m October 2017 acquisition of RT Warren (Investments) represents the most significant move to date, albeit off a larger base. RT Warren brought a portfolio, externally valued at £71.8m, comprising 21 commercial properties, mostly located in the Home Counties that surround London, and a number of non-core residential assets, the majority of which have since been sold, freeing capital to recycle into higher-yielding commercial assets. Outside of these notable portfolio acquisitions, Palace has been active with numerous smaller acquisitions, investing more than £100m in a number of transactions. Most recently it acquired One Derby Square in the centre of Liverpool for £14.0m (before costs), reflecting a 6.75% net initial yield.

Palace seeks opportunities for further growth in the portfolio where it can identify assets that meet its selective investment criteria. This has been demonstrated in the past year where it has held back from acquisitions at prices that it believes are unrealistic in current market conditions despite having a significantly positive cash position.

Palace has built a strong track record of value creation over several years, generating an aggregate EPRA NAV total return of 123.8%, or a compound annual average return of 15.8%, between the end of H114 and end-FY19. We have begun the analysis at H114 because this corresponds to the acquisition of the Sequel portfolio, Palace’s first transformational acquisition. The negative total return in FY18 resulted from the share issuance to fund the RT Warren portfolio and captures none of the future asset management-driven value creation that management hopes to achieve from this, its largest portfolio acquisition to date. Capital returns contributed more than two-thirds of the total (86.7%) return over the period and income returns through dividend payments the balance (37.2%).

Palace plans to convert to a REIT with effect from 1 August 2019 having received shareholder approval for the necessary amendments to the company’s articles of association at the AGM on 12 July 2019. We expect conversion to enhance future returns by reducing potential tax liabilities but anticipate no change in the company’s total return strategy.

Income returns will benefit from the elimination of the tax charge on rental profits and IFRS net assets will benefit from the elimination of deferred tax liabilities in respect of unrealised valuation gains. EPRA net asset value is not immediately affected by REIT conversion because it adjusts for deferred tax, but REIT conversion will provide more flexibility to dispose of assets without crystallising a tax liability. The company will continue to pay dividends on a quarterly basis but following conversion these will comprise a property income distribution (PID) from the net profits of the tax-exempt rental business and a normal dividend.

As an internationally recognised property investment vehicle, Palace anticipates that REIT conversion will increase liquidity in its shares by providing access to pools of capital that are specifically designated for REIT investment.

At the end of FY19, deferred tax liabilities amounted to £5.6m. Of this, £1.6m became payable on completion of the second tranche of the non-core residential property disposal and c £1m will become payable as the Hudson House residential assets are eventually disposed of. The balance of c £3m will be eliminated on REIT conversion and appears in our FY20 forecasts as a tax credit.

The board comprises seven members, three executive and four non-executive, led by non-executive chairman, Stanley Davis, who was closely involved with the formation of the group’s business and has been an important supporter of its early fundraisings. Stanley Davis owns 3.6% of Palace shares. The three other non-executive directors, Anthony Dove, Kim Taylor-Smith and Mickola Wilson are all considered independent and have broad commercial and property experience: the senior independent non-executive director, Anthony Dove was a partner at law firm Simmons & Simmons; Kim Taylor-Smith was chief executive at Birkby and, following its takeover, at Mentmore; and Mickola Wilson, who joined the board on 1 February 2019, is a joint owner and director of Seven Dials Fund Management responsible for providing consultancy, research and investment management advice to the property fund management industry in the UK and worldwide.

The three executive directors, Neil Sinclair, Stephen Silvester and Richard Starr, collectively have more than 100 years of experience in the real estate market, as well as having management experience in public property companies. Brief biographies of the chairman and executive directors are provided on page 16, and further details for the other board members are available on the company’s website.

Excluding non-executive directors, Palace had 12 employees at end-FY19 (11 at end-FY18), focused on asset management, with day-to-day project and property management outsourced.

The Palace property portfolio was externally valued at £286.3m at 31 March 2019. This included an income-generating investment portfolio of 59 commercial assets (plus two car park assets), the remaining RT Warren residential assets held for sale and the Hudson Quarter development asset, split on the balance sheet between investment properties under development (the office and other commercial) and trading properties (the residential space that will be sold). The balance sheet value differs slightly from the external valuation, primarily due to lease incentive and other adjustments. The standing commercial assets had a gross annualised contracted rental income of £17.7m, and after non-recoverable property costs that mostly relate to voids, the net contracted rental income was £15.8m. The weighted average unexpired lease term was 4.5 years to first break and on an EPRA basis, occupancy was 87%. The estimated rental value (ERV) of the portfolio of £22.4m represents a significant income opportunity, discussed below, and is expected to increase to c £23.3m upon completion of the Hudson Quarter commercial space.

Although Palace is sector-agnostic in terms of its approach to asset selection, it nevertheless maintains a diversified portfolio by both sector and location. The portfolio is regional (ie not Central London) and 60% (by value) is invested in offices and industrial assets, which continue to drive overall returns. The tenant base is also diversified in number and industry exposure, with the largest (Vue) accounting for 5.2% of contracted rents and the top 20 tenants accounting for c 44% of passing rent.

The largest sector exposure is to regional offices (47% by value) where growing tenant demand, including relocations away from London, limited new supply and conversion of office space to residential have all contributed to a generally positive demand-supply balance and continuing rental growth. Industrial property (13% by value) has similarly benefitted from firm occupier demand, limited new supply, and rental growth. There are two large leisure assets in Halifax and in Northampton which account for 16% of the portfolio by value. The leisure sector has faced similar challenges to the retail sector which has slowed the letting of vacant space, but management is confident that its active approach to the management of these assets will show positive results in coming months with lease negotiations underway. In retail (10% by value) the largest tenant exposure is to Aldi on a secure and recently extended long lease. The range of other retail tenants is diverse with no exposure to problem areas like mid-market fashion or department stores.

Four commercial property asset disposals were completed during FY19 for a total of £2.1m, all relatively small properties that were vacant or due to become vacant. Two further properties (Rathbone and Old House) have since been sold for an aggregate £1.5m.

More significantly, the year saw significant progress with the sale of non-core residential assets acquired with the RT Warren portfolio, freeing up capital for recycling into higher-yielding assets. Sales were agreed and/or completed on 53 of the 65 properties including a block of 50 sold to the London Borough of Barnet for £18.2m, a modest 3% discount to book value. Two of the properties are to be retained for strategic purposes and the remaining 10 assets have now all been sold.

Throughout the last year Palace was on the lookout for further investment opportunities but its strategy of buying only when it is confident of meeting its targeted returns has seen it decline many of these. In December it was able to acquire the freehold of the recently refurbished One Derby Square in Liverpool for £14.0m (before costs), reflecting a 6.75% net initial yield. The property was 96% let at acquisition to a range of tenants including Prêt a Manger, Tesco, Medicash, Reed Specialist Recruitment and Brook Street. The acquisition is in line with Palace’s strategy to focus on city centre locations in university towns and regional cities with a positive supply-demand position and the company sees a significant further opportunity for active management to capture reversionary potential and enhance the future capital value.

Significant opportunities exist in the current portfolio. The ERV of £21.5m is c 25% or £3.8m ahead of the end-FY19 passing rent of £17.7m. More than £3.0m of the reversionary potential is within the regional office portfolio and £1.9m of this represents the upside from reducing voids.

The company has indicated that reducing voids will be a focus for the current year alongside the programme of refurbishment and development opportunities that have been identified in the asset management plans of each individual property. These will be phased in over a number of years providing counter-cyclical opportunities to add value to the portfolio. Exhibit 8 provides a summary of the main upside opportunities. It is not possible to model all of these on an individual basis although given its significance we have detailed forecasts for Hudson Quarter, reviewed in the following section.

We expect the Hudson Quarter development to be a key driver of income growth and value creation during the forecast period. We expect the fully let income benefit from the retained commercial assets at completion to increase gross rental income by more than 5%, and recurring income by more, and our forecast development gain of c £10m or a 22p addition to NAV, could prove conservative based on management’s expectations.

After many years of negotiation, PCA received optimal planning consent in August 2017 for the redevelopment of its two-acre site in York, within the city walls and just a minute’s walk from the York railway station. The scheme comprises three residential buildings and an office building, and will provide 127 flats, 35,000 sq ft of grade A offices and 5,000 sq ft of other commercial space and car parking.

Following the agreement with Barclays Bank for £26.5m in development funding and the signing of a £35m construction contract, building work commenced in February 2019. It is expected to take around two years and is scheduled for completion in early 2021 (late FY21), with construction currently on time and on budget. The York office market is strong and with the Hudson Quarter office development being the first within the city walls for more than a decade the company anticipates strong interest strong interest from potential tenants with a view to pre-letting ahead of completion. The residential apartments will be sold and Palace expects to enter pre-sale agreements on many of these ahead of practical completion. Marketing officially commenced on 20 June 2019 with an initial tranche of 20 apartments offered for sale. Reflecting the attractions of the development and the strength of the local market (York was recently voted by The Sunday Times as the best place in the UK to live - 2018), interest in the apartments has exceeded management expectations. In the first three weeks since launch, 22 apartments with an aggregate sale value of £5.8m have been reserved and deposits paid and the launch of a second tranche is being considered.

Now that management has entered a fixed price construction contract, agreed the development funding terms, and has additionally guided on its expectations for the likely value of the development at completion, we have included the project within our base case assumptions rather than providing a supplementary sensitivity analysis.

Including the pre-development site value of £16.8m, the construction costs of £35.0m (as per the announced construction contract), and our estimates for professional fees (£2.5m) and capitalised interest costs (£1.5m) we estimate a total development cost of £55.8m. This is slightly higher than our previous estimate (£54.4m) which excluded professional fees but higher capitalised interest expenses. The cost of the Barclays development loan facility is lower than we had allowed for, with a borrowing margin of 3.25% over Libor and a non-utilisation rate of 1.3% applied to undrawn funds.

Management has indicated that it expects the gross development value (GDV) at completion to be c £69m, although it has not given a precise breakdown of its assumptions, with a development profit of at least £10m. Our own revised assumptions are similar, giving a GDV of £65.8m. Using our estimate of total construction costs the implied gross development gain is between £13.2m using management’s estimate of GDV and £10.0m (22p per share) using our estimated GDV.

Exhibit 10 summarises our estimate for GDV which we believe is consistent with management’s own expectations given that it differs by only c 5%.

We have included the forecast development gain within our FY21 estimates in line with the expected completion date. Compared with the 31 March 2019 book value this represents a further uplift in value of £9.4m or 21p per share.

We assume that the office space and other commercial space will be pre-let in line with our assumptions and will contribute to rental income from the beginning of FY22, providing a significant uplift to recurring income.

For the residential space we assume that the majority (80% by GDV) of the apartments will have been pre-sold by the time of completion, generating up to £4.2m in cash flow from pre-sales deposits, with a full sale of the assets completed in early FY22. The full sales proceeds on completion have a strong positive impact on net cash after repayment of the development loan facility and are the main contributor to our forecast for a 10pp reduction in the FY22 net LTV to below 28%.

The recently published FY19 results showed further growth in recurring earnings driven by underlying rental values and modest like-for-like growth in property valuations despite a more uncertain market backdrop.

Adjusted PBT of £8.9m was c £0.3m ahead of the revised forecast that we published following the trading update on 2 May, which highlighted the deliberate deferral of some potential letting activity so as to be able to undertake refurbishment and redevelopment activity in order to enhance medium-term returns. Compared with our expectations, net rental income was c £0.5m higher, partly offset by c £0.2m higher administrative expenses.

The key highlights of the FY19 results were:

We have made only modest underlying changes to our forecasts for recurring earnings in FY20 and FY21 however:

For both FY20 and FY21, the underlying adjustments to recurring income that we have made include a modest uplift in forecast net rental income (modest occupancy gains assumed compared with previously) offset by higher assumed administrative costs. In addition, we expect the Hudson Quarter development to contribute significantly to FY21 NAV growth as it nears completion.

We have also extended our forecasting horizon out to FY22 when we expect a first-time income contribution from the retained Hudson Quarter commercial assets to significantly lift recurring income and restore dividend cover. Although not included in Exhibit 12, we also assume a significant reduction in net debt in FY22 as a result of the completion of the sale of the Hudson Quarter residential assets following practical completion in late FY21. Our forecast end-FY22 net LTV of 28% suggests that the company will have significant capacity for additional investment activity during the period.

As it embarks on the development phase of the significant Hudson Quarter development, Palace has a robust funding position. End-FY19 gross outstanding debt was £119.3m (including unamortised debt facility fees) and the cash balance was £22.9m. Net debt of £96.5m represented a net loan to value ratio (LTV) of 34%. The debt was well spread across lenders with an average cost of 3.3% with an average maturity of 3.6 years. 59% of the debt was either fixed rate or hedged to mitigate interest rate risk. The £26.5m Barclays Bank development facility arranged to substantially fund the Hudson Quarter construction costs was undrawn and a small £3.6m facility with Lloyds has been repaid since year end.

In our forecasts we do anticipate the need for further debt facilities but expect the development facility to be fully drawn during FY21, ahead of completion. Ahead of the completion of the sale of the Hudson Quarter residential assets (we expect in early FY22) we forecast debt to peak at £142.3m and net debt at just under £124m, with the LTV at 37.8%. Upon completion of the residential sales and repayment of the development facility we expect gross debt to fall below £120m, net debt to fall below £80m and the LTV to fall below 28%.

This analysis suggests that there is scope for Palace to bring forward acquisitions and/or other asset management and development projects during the period (not in our forecasts), especially as Hudson Quarter construction progress and as the residential pre-sales and commercial pre-letting position becomes clearer.

As we show in Exhibit 3 above, Palace’s total return strategy has generated cumulative EPRA NAV total returns of 123.8% measured since the end of H114, or a compound annual average return of 15.8%. Our forecast indicate total returns of c 7% pa through to the end of FY22, although this could be enhanced by faster void reduction than we have assumed or accretive acquisitions.

Reflecting the balance sheet liquidity and moderate gearing, and the expectation of future recurring income growth, Palace has maintained its attractive dividend payout which represents a yield of approaching 7%, well above the average for the peer group of UK commercial real estate investment companies with a strong regional focus shown in Exhibit 14. Many of these are REITs and correspondingly focus on recurring income returns compared with Palace’s total return strategy. Due to the continuing search for sustainable income, and perhaps due to concerns about the maturity of the economic and commercial property cycle, those companies with an income focus have seen stronger share price performance. As a result, Palace is now trading at a considerable P/NAV discount to the peer group as well as a yield premium.

REIT conversion may well underline Palace’s strong commitment to attractive dividends, while investing to grow the portfolio and enhance capital values. Given the strong track record of total return generation and the potential to drive further returns from the existing portfolio, the Palace valuation continues to appear undemanding.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. We would also highlight the increased risks and uncertainties that attach to development activity, including planning consents, timing, construction risks and the long lead times to completion and eventual occupation. For Palace we consider the main sensitivities to include: