A wealth of asset management opportunities

Palace Capital 15 July 2019 Outlook
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Palace Capital

A wealth of asset management opportunities

FY19 results/outlook

Real estate

15 July 2019

Price

285p

Market cap

£131m

Net debt (£m) at 31 March 2019

93.8

Net LTV at 31 March 2019

33.7%

Shares in issue

45.9m

Free float

95%

Code

PCA

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(0.5)

1.8

(18.8)

Rel (local)

(2.2)

1.2

(16.6)

52-week high/low

354p

270p

Business description

Palace Capital is a UK property investment company listed on the Main Market of the LSE. It is not sector-specific and looks for opportunities where it can enhance the long-term income and capital value through asset management and strategic capital development in locations outside London.

Next events

Q1 dividend

October 2019

Interim results

November 2019

Analysts

Martyn King

+44 (0)20 3077 5745

Andrew Mitchell

+44 (0)20 3681 2500

Palace Capital is a research client of Edison Investment Research Limited

Palace Capital recently reported FY19 results and announced plans to convert to REIT status, approved by shareholders at the AGM. The results showed further growth in recurring earnings and positive like-for-like valuation growth but they also reflected the deferral of some letting activity to pursue refurbishment and redevelopment opportunities. Our revised forecasts now include the impact of the Hudson Quarter development in York, which we expect to be a key driver of returns over the next two years.

Year end

Net rental income (£m)

Adj. PBT*
(£m)

Adj. EPS*
(p)

EPRA NAV/
share (p)**

P/NAV
(x)

DPS
(p)

Yield
(%)

03/19

16.4

8.9

17.3

407

0.70

19.0

6.7

03/20e

18.6

8.2

17.1

411

0.69

19.0

6.7

03/21e

16.1

8.4

18.2

432

0.66

19.0

6.7

03/22e

17.0

9.0

19.7

435

0.65

19.0

6.7

Note: *Adjusted earnings: in addition to EPRA adjustments for revaluation gains, profits or losses on disposals of investment properties and surrender gains on early lease terminations, this adjusts for share-based payments and Main Market listing costs. **EPRA NAV is fully diluted.

REIT conversion positive for earnings

Adjusted PBT increased by 5.5% in FY19 to £8.9m or 17.3p per share. DPS was maintained at 19p reflecting the liquid balance sheet and moderate gearing (LTV 34%) and anticipating income growth. EPRA NAV was 407p. Conversion to REIT status from 1 August 2019 will reduce future tax liabilities. Otherwise our FY21 and FY22 recurring earnings forecasts are little changed. Our FY21 NAV now benefits from c £10m of development profits on the Hudson Quarter (HQ) development and FY22 recurring income from letting of the retained commercial space. Interest in the initial marketing of the HQ residential development has been strong with 22 apartments, valued at £5.8m, reserved and deposits paid since launch on 20 June. We expect sales completions to significantly reduce gearing in FY22, with the LTV falling c 10 pp to less than 28%.

Significant income potential

End-FY19 estimated rental value (ERV) of £21.5m, or £22.4m including the £0.9m rent potential from the HQ commercial assets, is significantly ahead of passing rent of £17.7m and represents a significant opportunity to increase recurring income and underpins the continuation of attractive dividend distributions. Significant refurbishment and redevelopment opportunities in the portfolio have the potential to create additional value, counter-cyclically, on a phased basis over several years. The reduction in LTV that we expect post-HQ completion points to headroom for accretive investment, including potential acquisitions, not captured in our forecasts.

Valuation: Attractive yield and discount to NAV

The dividend yield is attractive, approaching 7%, and management has committed to the current level of DPS despite a near-term earnings cover shortfall. The discount to EPRA NAV is c 30%. Asset management initiatives to capture reversionary potential and progress with Hudson Quarter are potential triggers for a re-rating.

Investment summary

Regional investor targeting total returns

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.

Valuation: Dividend yield premium and NAV discount

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.

Sensitivities: Macro and sector

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.


Total return strategy with an income focus

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.

Exhibit 1: Strong growth in DPS (p)

Exhibit 2: Fast-growing property portfolio (£m)

Source: Palace Capital data

Source: Palace Capital data. Note: Property portfolio at fair value.

Exhibit 1: Strong growth in DPS (p)

Source: Palace Capital data

Exhibit 2: Fast-growing property portfolio (£m)

Source: Palace Capital data. Note: Property portfolio at fair value.

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.

Strong track record of value creation

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%).

Exhibit 3: EPRA NAV total return history

H214

FY15

FY16

FY17

FY18

FY19

Cumulative return H214-FY19

Opening EPRA NAV (p/share)

218

341

388

414

443

414

218

Closing NAV (p/share)

341

388

414

443

414

407

407

Dividend paid (p/share)

2.5

8.50

14.00

18.00

19.00

19.00

81

Income return (%)

1.1%

2.5%

3.6%

4.3%

4.3%

4.6%

37.2%

Capital return (%)

56.6%

13.5%

6.9%

6.9%

-6.4%

-1.8%

86.7%

NAV total return (%)

57.8%

16.0%

10.5%

11.2%

-2.1%

2.8%

123.8%

Average annual compound return

15.8%

Source: Palace Capital data, Edison Investment Research

REIT conversion

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.

Management and governance

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.

Portfolio overview and performance

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.

Exhibit 4: Portfolio summary

£m unless otherwise stated

Property valuation

286.3

Number of commercial properties*

59

Commercial GLA**(million square feet)

1.7

Contractual rental income

17.7

Net rental income

15.8

ERV (excluding Hudson Quarter)***

22.4

WAULT (to first break)****

4.5

EPRA occupancy rate

87%

£m unless otherwise stated

Property valuation

Number of commercial properties*

Commercial GLA**(million square feet)

Contractual rental income

Net rental income

ERV (excluding Hudson Quarter)***

WAULT (to first break)****

EPRA occupancy rate

286.3

59

1.7

17.7

15.8

22.4

4.5

87%

Source: Palace Capital. Note: *In addition there two car parks. **GLA is gross lettable area. ***ERV is expected rental value. ****WAULT is weighted average unexpired lease term.

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.

Exhibit 5: Portfolio sector analysis by value

Exhibit 6: Portfolio location analysis by value

Source: Palace Capital, as at 31 March 2019

Exhibit 5: Portfolio sector analysis by value

Exhibit 6: Portfolio location analysis by value

Source: Palace Capital, as at 31 March 2019

Portfolio activity

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 asset management opportunities

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.

Exhibit 7: Estimated rental value

Source: Palace Capital

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.

Exhibit 8: Value-add opportunities within the portfolio

Source: Palace Capital. FY19 results presentation

The Hudson Quarter development

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.

We forecast a significant impact on recurring income and NAV

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.

Exhibit 9: Hudson Quarter development cost assumptions

£000's

Pre-development site value

16,800

Build cost

35,000

Professional fees

2,500

Capitalised interest costs

1,464

Total cost

55,764

£000's

Pre-development site value

Build cost

Professional fees

Capitalised interest costs

Total cost

16,800

35,000

2,500

1,464

55,764

Source: Palace Capital, Edison Investment Research

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%.

Exhibit 10: Edison GDV estimate summary

Residential

Office

Other commercial

Net floor area (000 sq ft)

95.0

GLA (000 sq ft)

34.5

GLA (000 sq ft)

5.0

Number of apartments

127

Headline rent (£ per sq ft)

25

Headline rent (£ per sq ft)

20

Average sales price (£ per sq ft)

550

Lease incentive

10%

Lease incentive

10.0%

Annualised rental income (£000s)

776

Annualised rental income (£'000s)

90

Yield

6.25%

Yield

8.00%

GDV (£m)

52.3

GDV (£m)

12.4

GDV (£m)

1.1

Source: Palace Capital data, Edison Investment Research

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%.

FY19 results

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.

Exhibit 11: Summary of FY19 financials

FY19

FY18

FY19/FY18

IFRS

Adj.

Adj. earnings

IFRS

Adj.

Adj. earnings

Adj. earnings

Rental and other income

18.8

18.8

16.7

16.7

Non-recoverable property costs

(2.3)

(2.3)

(1.8)

(1.8)

Net rental income

16.4

0.0

16.4

14.9

0.0

14.9

10.2%

Dividend on listed equity investment

0.0

0.0

0.0

0.0

Share based payments

(0.3)

0.3

0.0

(0.2)

0.2

0.0

Costs of moving to main market

0.0

0.0

(0.7)

0.7

0.0

Other administrative expenses

(3.8)

(3.8)

(3.3)

(3.3)

14.4%

Operating profit before gains/(losses) on property assets

12.4

0.3

12.7

10.7

0.9

11.6

9.4%

Unrealised gains/(loss) on revaluation of investment properties

(0.4)

0.4

0.0

5.7

(5.7)

0.0

Profit/(loss) on disposal of investment properties

(0.7)

0.7

0.0

0.3

(0.3)

0.0

Unrealised gain/(loss) on listed investments

(0.2)

0.2

0.0

0.0

0.0

0.0

Operating profit

11.1

1.6

12.7

16.7

(5.1)

11.6

9.4%

Net finance costs

(3.7)

(3.7)

(3.3)

0.1

(3.1)

19.8%

Change in value of interest rate derivatives

(0.9)

0.9

0.0

(0.2)

0.2

0.0

Profit before tax

6.4

2.5

8.9

13.3

(4.8)

8.5

5.5%

Taxation

(1.3)

0.2

(1.0)

(0.8)

(0.3)

(1.1)

Profit after tax

5.2

2.8

7.9

12.5

(5.1)

7.4

7.1%

Other data

Basic EPS (p)

11.3

35.9

Fully diluted EPRA EPS (p)*

16.5

18.7

Fully diluted adjusted EPS (p)

17.3

21.2

DPS (p)

19.0

19.0

EPRA NAV per share (p)

407

414

-2.9%

EPRA NAV total return

2.8%

-2.1%

Fair value of investment properties

286.3

276.7

3.5%

Net debt

96.5

82.4

Net LTV

33.7%

29.8%

Source: Palace Capital data, Edison Investment Research. Note: Unlike adjusted earnings, EPRA earnings includes the impact of share based payment charges and does not adjust for the FY18 Main Market listing costs.

The key highlights of the FY19 results were:

Net rental income increased by 10.2% to £16.4m and included full year contributions from RT Warren (acquired for £53.4m in October 2017 and contributing for slightly less than six months in FY18) and SM Newcastle (acquired for £20m in August 2017 and contributing for approximately eight months in FY18).

Underlying administrative expenses (excluding share-based payments charges and the FY18 costs of moving to the main market) increased by 14.4% which mainly reflects the growth in the business and additions to the property management team over the past two years.

Net finance costs (excluding changes in the fair value of interest rate derivatives used for hedging interest rate exposure) increased by 19.8%, which largely reflects higher average borrowings during the year, again a function of business and portfolio growth. The average cost of debt was 3.3% at end-FY19 (end-FY18: 3.4%).

Adjusted PBT increased 5.5% to £8.9m; this would have been higher but for the decision to defer lettings and income in order to pursue asset management opportunities. Adjusted profit after tax was 7.1% higher but EPS was lower at 17.3p, reflecting the higher average number of shares in issue. In October 2017 Palace issued 20.6m new shares 340p to finance the RT Warren acquisition.

The externally assessed fair value of the property portfolio increased by 3.5% to £286.3m with a balance sheet value of £284.5m comprising investment properties (£258.3m), assets held for sale (£11.7m), and trading property (£14.4m). The assets held for sale represent the RT Warren residential assets, the sale of which has now completed, and the trading property represents the residential part of the Hudson Quarter development that will be sold on completion. Investment property values increased 0.5% on an underlying basis although for the portfolio as a whole acquisition costs and realised and unrealised valuation movements had a negative impact of c £1.0m on IFRS earnings.

The IFRS result also included a small £0.2m unrealised revaluation loss on Palace’s 5% stake in Circle Properties, partly offset by dividend income received.

DPS was maintained at 19.0p, ahead of adjusted EPS and IFRS EPS (11.3p), reflecting the strength of the balance sheet position (LTV 34%) and management’s confidence in future income growth. As a result, net assets reduced slightly with EPRA NAV per share at 407p (FY18: 414p). The EPRA NAV total return was 2.8%.

Financial forecasts

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

We have chosen to present FY20 adjusted PBT/EPS excluding the £2.85m surrender premium received in respect of Priory House in Birmingham on the basis that this is non-recurring.

Net earnings and EPS benefit from the expected elimination of any current tax burden following REIT conversion, FY20 for part of the year and FY21 for a full year.

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.

Exhibit 12: Estimate revisions

Net rental income (£m)

Adjusted PBT (£m)*

Adjusted EPS (p)**

EPRA NAV (p)**

DPS (p)

Old

New

Chge (%)

Old*

New

Chge (%)

Old

New

Chge (%)

Old

New

Chge (%)

Old

New

Chge (%)

03/20e*

18.6

18.6

0.1

8.4

8.2

(2.0)

15.5

17.1

10.5

415

411

(1.1)

19.0

19.0

0.0

03/21e

16.0

16.1

0.4

8.5

8.4

(1.4)

15.7

18.2

15.9

419

431

2.8

19.0

19.0

0.0

03/22e

N/A

17.0

N/A

N/A

9.0

N/A

N/A

19.7

N/A

N/A

435

N/A

N/A

19.0

N/A

Source: Edison Investment Research. Note: *For FY20 we had previously included £2.85m of surrender premium within adjusted earnings but we have now excluded this on the basis that it will not be recurring. Including the surrender premium, FY20 adjusted PBT was previously shown as £11.2m and adjusted EPS as 20.8p. **Adjusted EPS and EPRA NAV are both fully diluted.

Key forecasting assumptions

The increase in recurring earnings that we forecast is driven by our expectation of growth in passing rent from £17.7m at end-FY19 to £19.2m by end-FY22. This includes reversionary rental growth of c 0.5% pa, adding c £0.3m pa to annualised passing rent over the period, void reduction of c £0.3m (net of the Birmingham lease surrender), and a contribution of c £0.9m pa from FY22 in respect of the Hudson Quarter commercial assets. Given management’s focus on void reduction and continuing rental growth in regional offices, our assumptions may prove conservative. Net acquisition activity is also likely, adding further to rental income, although our assumptions are based on a constant portfolio. Rental income in FY20 includes non-recurring lease surrender of c £2.9m. Non-recoverable property costs are assumed to drop modestly with void reduction.

We expect accounting earnings and NAV to benefit from modest underlying revaluation gains, in line with achieved rental growth, adding an aggregate c £3.9m over the period (c 8p per share) with a more significant impact from the development profits that we forecast in respect of Hudson Quarter. These are detailed on page 9, but amount to c £9.4m or 21p per share and are included in our FY22 forecast.

Funding and debt

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.

Exhibit 13: Debt portfolio as at 31 March 2019

Lender

Facility (£m)

Drawn (£m)

Maturity date

Hedging

Barclays

39.1

39.1

Jan-23

£35.5m fixed

Nat West (revolving credit facility)

29.4

29.4

Mar-21

100% floating

Santander

26.3

26.3

Aug-22

£19.7m fixed

Lloyds (repaid post the year end)

3.6

3.6

May-19

100% floating

Lloyds

6.8

6.8

Mar-23

100% floating

Scottish Widows

14.2

14.2

Jul-26

100% floating

Barclays (development facility)

26.5

0.0

Oct-21

100% floating

Total

145.9

119.4

Source: Palace Capital

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.

Valuation

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.

Exhibit 14: Peer comparison

Price (p)

Market cap. (£m)

P/NAV (x)

Yield (%)

Share price performance

1 month

3 months

12 months

From 12M high

Circle Property

196

55

0.71

3.2

-4%

-1%

-15%

-15%

Custodian

119

486

1.11

5.5

1%

3%

-3%

-3%

Picton

94

516

1.02

3.7

-1%

3%

1%

-6%

Real Est Inv

57

105

0.82

6.4

4%

5%

5%

-9%

Regional REIT

107

399

0.93

7.5

-2%

1%

13%

-3%

Schroder REIT

57

297

0.83

4.5

2%

-3%

-8%

-15%

UK Commercial Property Trust

89

1155

0.95

4.1

-1%

0%

0%

-4%

BMO Commercial Property Trust

119

948

0.86

5.1

6%

0%

-22%

-22%

BMO Real Estate Investments

84

202

0.79

6.0

-1%

-10%

-14%

-16%

Average

0.89

5.1

0%

0%

-5%

-10%

Palace Capital

285

131

0.68

6.7

-3%

0%

-18%

-21%

UK property index

1,691

4.0

1%

-2%

-8%

-8%

FTSE All-Share Index

4,098

4.5

2%

1%

-3%

-4%

Source: Company data, Refinitiv. Note: Prices at 15 July 2019. *Last reported EPRA NAV per share and trailing 12-month DPS declared

Sensitivities

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:

Sector risk: some of the inherent cyclical risk to vacancy in commercial property can be mitigated by portfolio diversification. As noted above, Palace has a diversified portfolio across property types, locations and tenants, and its sector-agnostic approach to asset selection provides scope to adjust the portfolio to evolving market conditions. The portfolio contains significant reversionary potential and a significant stream of asset management opportunities, providing scope for counter-cyclical income growth and value creation.

Development risk: although we expect asset management projects to continue to be an important contributor to property income growth and capital returns, active projects normally represent a relatively low share of the overall portfolio at any point in time. The Hudson Quarter development is significant in relation to the overall group, although we note that construction is already underway, on a fixed price contract, with a development loan in place to fund the majority of the construction cost, and that management is seeking to manage post-construction risks by securing pre-lets for the commercial space and pre-selling the residential space.

Macro risk:

The UK economy has lost momentum in recent months, in line with the global trend. In March 2019 the Office of Budget Responsibility (OBR) revised down its 2019 GDP forecast to 1.2% from 1.6%, in part reflecting heightened Brexit uncertainty. It expects the unemployment rate to edge up slightly to 4.1%, albeit from very low levels.

Consumer price inflation has moderated and is in line with the Bank of England target indicating little near-term pressure for interest rate increases. On a longer-term basis, real interest rates are low and seem likely to increase. 59% of Palace’s debt is covered by interest rate swaps, significantly mitigating future interest rate risk. An increase in longer-term rates is likely to have a knock-on effect on NAV over time, through increased property yields.

Exhibit 15: Financial summary

Year end 31 March (£000's)

2017

2018

2019

2020e

2021e

2022e

PROFIT & LOSS

Rental & other income

14,266

16,733

18,750

20,939

18,260

19,250

Non-recoverable property costs

(2,055)

(1,824)

(2,318)

(2,300)

(2,200)

(2,200)

Net rental income

12,211

14,909

16,432

18,639

16,060

17,050

Dividend income from listed equity investments

43

0

0

0

Administrative expenses before share based payments

(2,678)

(4,011)

(3,790)

(3,400)

(3,474)

(3,549)

Share-based payments

(237)

(174)

(332)

(300)

(300)

(300)

Operating Profit (before capital items)

9,296

10,724

12,353

14,939

12,286

13,200

Revaluation of investment properties

3,101

5,738

(382)

1,276

10,740

1,319

Gains/(losses) on disposals

3,191

274

(652)

0

0

0

Loss on revaluation of listed equity investments

(214)

0

0

0

Operating Profit

15,588

16,736

11,105

16,215

23,026

14,520

Net finance expense

(3,011)

(3,432)

(4,672)

(4,191)

(4,232)

(4,472)

Profit Before Tax

12,577

13,304

6,433

12,024

18,794

10,048

Taxation

(3,191)

(773)

(1,263)

2,640

0

0

Profit After Tax (FRS 3)

9,386

12,531

5,170

14,665

18,794

10,048

EPRA adjustments:

Revaluation of investment properties

(3,101)

(5,738)

382

(1,276)

(10,740)

(1,319)

Gains/(losses) on disposals

(3,191)

(274)

652

0

0

0

Deferred tax charge

2,200

(299)

243

0

0

0

Other adjustments

155

308

1,143

0

0

0

EPRA earnings

5,449

6,528

7,590

13,388

8,053

8,729

Adjusted for:

Non-recurring items

0

698

0

(2,850)

0

0

Share-based payments

237

174

332

300

300

300

Adjusted earnings

5,686

7,400

7,922

10,838

8,353

9,029

Company adjusted PBT

6,677

8,472

8,942

8,198

8,353

9,029

Average fully diluted number of shares outstanding (000s)

25,738

34,980

45,898

45,947

45,947

45,947

Basic EPS - FRS 3 (p)

36.5

35.8

11.3

31.9

40.9

21.9

Fully diluted EPRA EPS (p)

21.2

18.7

16.5

22.7

17.5

19.0

Fully diluted adjusted EPS (p)

22.2

21.2

17.3

17.1

18.2

19.7

Dividend per share declared (p)

18.5

19.0

19.0

19.0

19.0

19.0

EPRA dividend cover (x)

1.14

0.98

0.87

1.19

0.92

1.00

BALANCE SHEET

Fixed Assets

183,959

253,984

261,064

269,090

279,061

283,380

Investment properties

183,916

253,863

258,331

266,357

276,328

280,647

Goodwill

0

0

0

0

0

0

Other non-current assets

43

121

2,733

2,733

2,733

2,733

Current Assets

13,692

46,292

55,256

65,784

78,956

46,763

Trading properties

0

0

14,367

29,913

52,250

0

Assets held for sale

0

21,708

11,756

0

0

0

Cash

11,181

19,033

22,890

28,361

21,043

40,694

Other current assets

2,511

5,551

6,243

7,510

5,663

6,069

Current Liabilities

(8,197)

(11,520)

(16,000)

(18,322)

(19,079)

(15,536)

Creditors

(6,161)

(8,834)

(10,001)

(12,323)

(13,080)

(9,537)

Short term borrowings

(2,036)

(2,686)

(5,999)

(5,999)

(5,999)

(5,999)

Long Term Liabilities

(79,895)

(105,457)

(119,997)

(129,844)

(141,717)

(115,617)

Long term borrowings

(75,758)

(97,157)

(112,017)

(126,444)

(139,317)

(113,217)

Deferred tax

(2,187)

(6,531)

(5,580)

(1,000)

0

0

Other long term liabilities

(1,950)

(1,769)

(2,400)

(2,400)

(2,400)

(2,400)

Net Assets

109,559

183,299

180,323

186,708

197,222

198,990

EPRA net assets

111,759

190,011

186,968

188,773

198,287

200,055

Basic NAV/share (p)

436

400

393

407

430

434

Diluted EPRA NAV/share (p)

443

414

407

411

432

435

CASH FLOW

Operating Cash Flow

10,294

9,899

11,920

16,433

15,326

9,690

Net Interest

(2,516)

(2,704)

(3,385)

(4,337)

(4,750)

(4,072)

Tax

(1,047)

(395)

(1,639)

(1,940)

(1,000)

0

Net cash from investing activities

(3,352)

(67,725)

(11,560)

(9,994)

(20,650)

49,250

Ordinary dividends paid

(4,617)

(6,744)

(8,718)

(8,718)

(8,718)

(8,718)

Debt drawn/(repaid)

6,467

8,151

17,954

10,464

12,473

(26,500)

Proceeds from shares issued

29

70,000

0

0

0

0

Other cash flow from financing activities

(2,897)

(3,434)

(162)

0

0

0

Net Cash Flow

2,361

7,048

4,410

1,908

(7,318)

19,651

Opening balance sheet cash

8,576

10,937

17,985

22,395

24,304

16,985

Restricted cash

244

1,048

495

495

495

495

Closing balance sheet cash

11,181

19,033

22,890

24,799

17,480

37,131

Closing balance sheet debt

77,794

99,843

118,016

128,880

141,753

115,653

Unamortised debt costs

936

1,552

1,334

934

534

134

Closing net debt/(cash)

65,677

79,258

93,792

103,148

123,739

78,388

Net LTV (exc restricted cash & adjusted for unamortised debt costs)

36.9%

29.8%

33.7%

35.2%

37.8%

27.8%

Source: Company accounts, Edison Investment Research

Contact details

Revenue by geography

4th Floor, 25 Bury Street
St James’s
London
SW1Y 6AL
Phone: 0203 301 8330
Website: www.palacecapital.com

Contact details

4th Floor, 25 Bury Street
St James’s
London
SW1Y 6AL
Phone: 0203 301 8330
Website: www.palacecapital.com

Revenue by geography

Leadership team

Non-executive chairman: Stanley Davis

CEO: Neil Sinclair

Stanley Davis is a successful entrepreneur who has been involved in the City of London since 1977. He founded company registration agents, Stanley Davis Company Services, which he sold in 1988. In 1990 he became chief executive of a small share registration company which became known as IRG and acquired a number of businesses including Barclays Bank Registrars and was sold for a substantial sum to The Capita Group. He is chairman of Stanley Davis Group specialising in company formations, property and company searches.

Neil Sinclair has over 50 years’ experience in the property sector. He was a founder of Sinclair Goldsmith, chartered surveyors, which was admitted to the Official List in 1987 and subsequently merged with Conrad Ritblat in 1993, when he became executive deputy chairman. Neil was appointed non-executive chairman of Baker Lorenz, surveyors in 1999, which was sold to Hercules Property Services in 2001. He was appointed a non-executive director of Tops Estates, a fully listed company, in 2003 and remained so until Tops Estates was sold to Land Securities in 2005. He was one of the founders of Mission Capital, now Watchstone Group, which was admitted to AIM in 2005, and was executive chairman until February 2008.

Executive director: Richard Starr

CFO: Stephen Silvester

Richard has extensive experience of sourcing and managing commercial investments throughout the UK. After qualifying as a chartered surveyor in 2000, he developed his experience working as a fundamental team member of four Central London property firms including the corporate real estate division of what is now CBRE Global Investors. In 2011, Richard established his own boutique property consultancy, successfully negotiating sales and acquisitions on behalf of a wide variety of institutional and private clients before joining the board of Palace Capital in October 2013.

Stephen Silvester, a chartered accountant, joined Palace Capital in 2015 and brings over 15 years’ experience as a finance professional, of which 10 years was in property finance, including capital raising from both debt and equity markets, hedging, securing credit facilities from major institutions for both investment and development finance. Prior to joining Palace Capital he served for three years as group financial controller at NewRiver REIT and before that was financial controller at St Hilliers, a large private real estate company based in Australia with construction, fund management and property development operations.

Principal shareholders

(%)

Axa Investment Managers

7.73

Miton Group

7.41

JO Hambro

7.32

Stanley Davis (Non-executive chairman)

3.63

Companies named in this report

Circle Property (CRC),; Custodian REIT (CREI); Mucklow (MKLW); Picton (PCTN); Real Estate Investors (RLE); Regional REIT (RGL); Schroder REIT (SREI); UK Commercial Property Trust (UKCM); BMO Commercial Property Trust (BCPT); BMO real Estate Investments (BREI)


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