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Active management for income

Regional REIT 4 October 2016 Update

Regional REIT

Active management for income

Interim results update

Real estate

4 October 2016

Price

105p

Market cap

£288m

Net debt (£m) at 30 June 2016

191.0

Shares in issue

274.2m

Free float

76%

Code

RGL

Primary exchange

LSE

Secondary exchange

N/A

Share price performance

%

1m

3m

12m

Abs

(0.24)

3.97

4.75

Rel (local)

(1.5)

(2.84)

(7.2)

52-week high/low

111.0p

88.0p

Business description

Regional REIT owns a commercial property portfolio of, predominantly, offices and industrial units located in the regional centres of the UK. It is actively managed and targets a total shareholder return of 10-15% pa with a strong focus on income.

Next events

Q3 dividend announcement & trading update

17 November 2016

Analysts

Martyn King

+44 (0)20 3077 5745

Julian Roberts

+44 (0)20 3077 5748

Andrew Mitchell

+44 (0)20 3681 2500

Regional REIT is a research client of Edison Investment Research Limited

Regional REIT (RGL) provides a focused exposure to actively managed UK regional commercial real estate, predominantly secondary office and light industrial assets. The regional property recovery began later than in London and we believe RGL offers the potential for above average late-cycle income and capital growth. While Brexit has increased uncertainty about economic prospects, the asset manager observes that regional demand has so far remained resilient and anticipates higher rental income, with targeted improvements to occupancy through the second half of the year and into 2017. It has an established and diversified high-yielding portfolio that already supports the attractive 7.3% prospective dividend yield with the potential for income and capital growth from property-specific asset management initiatives.

Year
end

Net rental income (£m)

EPRA EPS*
(p)

EPRA NAV
(p)

DPS
(p)

P/EPRA NAV
(x)

Yield
(%)

12/15**

4.6

0.9

107.8

1.0

0.97

1.0

12/16e

37.2

7.7

110.6

7.7

0.95

7.3

12/17e

41.4

8.9

113.7

8.9

0.92

8.5

12/18e

43.3

9.5

115.4

9.5

0.91

9.0

Note: *EPRA EPS is adjusted to include exceptional expenses related to listing and includes estimated performance fees.** 56-day trading period only.

High-yielding assets worked hard

RGL has an active asset management strategy, built on detailed plans for each property and targeting a 10-15% pa return to shareholders, including a 7-8% pa dividend return on the IPO price of 100p. The existing portfolio assets are relatively high yielding (H116 net initial yield 7.1%), capable of supporting a fully covered 2016e dividend yield of 7.3%, and well-diversified by property, region and tenant. The asset manager, LSI, brings a well-resourced and dedicated team, with cross-cycle experience, essential to exploit the opportunity provided by significant lease breaks and expiries over the next three years to grow income and valuation. Driven by the timing of acquisitions and H116 acquisition costs, we have slightly reduced 2016 estimates, offset by expected faster occupancy gains in 2017/18.

Positive market drivers intact

Regional commercial rents have been increasing against a background of improving occupational demand and declining availability. We see the ongoing development of the regions as key for RGL and while Brexit has added to uncertainty about longer term economic prospects, the asset manager observes that regional occupier demand has so far remained resilient and anticipates further gains in occupancy and rental income. Other demand drivers, such as business relocation, are structural and the manager points to an opportunity to benefit from a narrowing of the historically wide gap between secondary regional property yields versus prime as investor flows recover, with the regions taking an increased share.

Valuation: High dividend yield, fully covered

RGL’s prospective dividend yield of 7.3% is fully covered and at the top of the range for the UK REIT sector. The c 5% discount to our 2016e EPRA NAV, which assumes a constant valuation yield, is slightly wider than the sector median.

Investment summary

Regional REIT (RGL) has delivered its first set of interim results since listing on the Main Market of the London Stock Exchange (LSE) in November 2015. It is a UK-based real estate investment trust (REIT) that aims to deliver an attractive return to investors through investments in commercial property (predominantly office and light industrial property) in the main regional centres of the UK, effectively outside the M25 motorway. RGL was formed from the combination of two existing, privately owned, limited life property funds that had previously been created by the investment manager, Toscafund Asset Management (Tosca) and the external asset manager, London & Scottish Investments (LSI), and was thus able to come to market with an established and diversified portfolio of high-yielding properties. H116 has seen the £128.1m acquisition of additional property assets, including two substantial portfolios, and disposals of non-core assets have further progressed portfolio refocusing, both towards office and industrial property and across the regions. Refinancing has lowered the cost of debt.

RGL has an active asset management strategy, built off detailed plans for each property and targeting a 10-15% pa return to shareholders, including a 7-8% pa dividend return on the IPO price of 100p. The prospective dividend is fully covered and offers a sector-leading yield of 7.3%. LSI brings a well-resourced, dedicated team, with cross-cycle experience, and targets occupancy and rent increases to drive income and capital growth from existing assets. Regional commercial rents have been increasing against a background of improving occupational demand (including structural drivers such as business relocation) with declining availability, and are coming from a lower point in the cycle than London offices or the retail sector. The yield spread on secondary assets versus prime assets remains historically wide with the opportunity for RGL to benefit from further narrowing. While Brexit has increased uncertainty about longer-term economic prospects, the asset manager observes that regional demand has so far remained resilient and anticipates higher rental income with targeted improvements to occupancy through the second half of the year and into 2017. We recently wrote at length about RGL, its strategy and the investment opportunity in our initiation note, and provide an update here.

Highlights of the interim results

The gross value of the investment portfolio (externally assessed) increased to £501.3m in the period compared with £403.7m at the end of 2015. The like-for-like increase in value was 1.8%.

£128.1m of properties were acquired, including the Wing portfolio (£37.5m acquisition at 8.5% net initial yield) and Rainbow portfolio (£80.0m/8.2% net initial yield), and £41.2m of mature non-core assets sold (including Blythswood House at £17.4m/5.0% net initial yield).

Since the end of the period, RGL has acquired the Wallace portfolio, an office park of six buildings, for £5.5m. The portfolio is expected to provide an annualised net income of £0.8m, with a net initial yield of 12.0%.

As previously reported, average occupancy was lower at 81.8% (31 December 83.9%), but up from March 2016 (80.9%). The portfolio acquisitions were made at void rates above the portfolio average (Wing 78.2% and Rainbow 77.2% occupied), providing the opportunity to benefit from planned improvements. Both have since seen occupancy improvements and the manager reports significant new lettings in H216.

EPRA NAV per share was relatively flat at 108.0p (31 December 107.8p), but included acquisition and stamp duty costs of 2.5p and 2.8p of dividends paid.

Borrowing increased by £89.2m to £217.8m to finance acquisitions, with LTV at 38.1% (31 December 25.4%). The average all-in borrowing cost declined to 3.8% (31 December: 4.5%).

Focus on regional commercial property recovery

The regional commercial real estate opportunity

RGL’s target of a 10-15% pa return is based on targeting underexploited properties and managing them actively to improve occupancy and rents. Providing context for this, our views on the UK commercial property sector and the regional property opportunity were discussed at length in our initiation note and are briefly summarised here:

The recovery in commercial rents following the financial crisis began later in the regions than in London and rents have continued to increase against a background of improving occupational demand and declining availability.

Brexit has added uncertainty about economic growth, but other drivers of demand (such as business relocation) are structural.

Investment demand, predominantly targeted at stabilised income assets, has slowed from the record level seen in 2015, but there are signs that this has begun to increase, with the regions continuing to take a growing share.

The gap between yields on prime regional office properties and secondary properties remains historically wide and the manager continues to see a particular opportunity from a narrowing of this gap, expecting it to be achieved at least in part by further medium-term yield contraction on secondary property, providing the prospect of capital appreciation.

Exhibit 1: UK commercial real estate investment volumes (£bn)

Source: Cushman & Wakefield research, Regional REIT

Diversified business base manages asset management risks

RGL’s strategy is fundamentally different from peers, which may be more London-focused or targeting long leases. RGL seeks to add additional value by targeting underexploited properties and managing them actively to improve occupancy, rents and capital value over time. The diversification of the portfolio is an important element of balancing the risk of this strategy (whether it be market conditions or operational delivery), with the potential for enhanced rewards. At 30 June 2016, the RGL portfolio comprised 128 properties made of 974 individual units let to 719 tenants. It is also diversified by geography and increasingly focused (91.6% by value) on the targeted sectors of office and light industrial property. An appraisal of the top 15 tenants shows a broad mix across a wide variety of business sectors, and no excessive concentrations, in particular with respect to financial services companies. The largest tenant represents 5.3% of gross rental income and the largest property represents 6.6% of portfolio value. Selective acquisitions and non-core disposals since IPO, and continuing through H116, have contributed towards a rebalancing of the portfolio away from Scotland to more closely match the general regional economy and population (England and Wales now 73.5% by value versus 64.6% at IPO).

Exhibit 2: Segment split by income

Exhibit 3: Regional split by income

Source: Company data as at 30 June 2016

Source: Company data as at 30 June 2016

Exhibit 2: Segment split by income

Source: Company data as at 30 June 2016

Exhibit 3: Regional split by income

Source: Company data as at 30 June 2016

Occupancy at 30 June 2016 was 81.8%, which was lower than at the end of 2015, primarily due to the acquisition of the Wing and Rainbow portfolios at lower occupancy than the portfolio average, so as to be able to benefit from planned active asset management improvements. The manager indicates that leasing activity since the half year has taken occupancy to c 83%, and that at least 85% by year currently appears to be a reasonable objective. Assuming no change in the portfolio, no further acquisition of properties with low occupancy and the active asset management potential, the manager believes that c 90% occupancy is a reasonable level for long-term structural occupancy. The weighted average unexpired lease term to first break is 3.6 years, again a little lower than at year end (3.8% excluding the non-core, fully occupied Blytheswood House where the sale was announced in April, or 4.4 years including it), but not an unreasonable length when compared with current new lease terms. For the office and light industrial properties targeted by RGL, leases at inception tend to be in the region of 10 years with a five-year break clause or a straight five years with no break. Exhibit 4 shows that there is a noticeable pick-up in lease maturities in 2017 and 2018 and this represents both a key challenge for the manager and a key opportunity to benefit from its active asset management strategy.

Exhibit 4: Lease maturity to first break

Source: Regional REIT

Our forecasts assume that all maturing leases are extended or re-let on terms that are similar to the portfolio average expected rental value (ERV). We assume that ERV grows at 2% pa.

Very usefully the interim results contain information about the manager’s asset management and strategy and progress with respect to the Wing and Rainbow portfolios. We review this in the next section.

Asset management of newly acquired portfolios

The Wing portfolio was acquired in March of this year for £37.5m, representing an 8.5% net initial yield. The portfolio includes four office properties (Manchester, Leeds, Leicester and Basingstoke) and a light industrial site in Beverley. The portfolio provides a solid income base immediately, with the potential to add additional value from letting space already refurbished by the previous owner, refurbishing existing unlet space, restructuring existing leases and securing alternative uses. The letting of already refurbished space has increased occupancy from 78.2% at acquisition to 85.2% as of September 2016. Refurbishment has continued and a number of lease extensions are under negotiation.

The Rainbow portfolio was also acquired in March 2016 for £80m, representing a net initial yield of 8.2%. The investment plan looks to create additional value on the five office buildings and seven industrial sites by restructuring existing leases, and refurbishment and lettings of space. The portfolio is split c 45% industrial/55% office by rental income and is spread throughout the UK in major urban areas including Bristol, Manchester, Cardiff, Sheffield and the West Midlands. Occupancy of 77.2% on acquisition is now (as of September 2016) 78.2%. The portfolio includes two office buildings in Aylesbury, one of which is occupied by Lloyds Banking Group until 2021. At the other, RGL has secured a new 10-year lease with the anchor tenant Equitable Life over two floors and has agreed break terms with the tenant (LBG, which had served notice) on the other two. This will allow refurbishment of the vacant two floors and re-letting. The building is modern and attractive in a town centre location and the manager is optimistic of the re-letting potential. At the Aztec 800 office building, seven miles north-west of the Bristol city centre with good links to the M4 and M5, refurbishment is being finalised and potential occupier interest from more than one party seems strong. The manager believes that the go-ahead for the Hinkley Point C nuclear power station provides positive support for stronger local demand.

Estimate changes and valuation

Our medium-term forecasting framework is covered in detail in our initiation note. Following the interim results, we have made the following adjustments:

Although we have increased our estimate of gross contracted rental income for the end of 2016 from £45.8m to £46.7m, our 2016e net rental income actually declines slightly. H116 gross rental income of £43.7m was a little lower than we had allowed for and the further acquisition uplift that we had allowed for comes a little later in the year, feeding through to lower net rental income earned during the year.

However, the investment manager expects a continuing reduction in voids, with occupancy lifting to around 85% by the end of this year, and moving towards the c 90% expected structural void rate on a constant portfolio following asset management initiatives. We have increased our occupancy assumptions with a positive impact on 2017 and 2018 expected net rental income. We would draw attention to the opportunity that is indicated by the relatively low average rents and capital values attached to the current RGL portfolio. The regional office portfolio generates average rents of £12.80 per square foot and is valued at £118.50 per square foot, while the light industrial assets are let at an average rent of £3.70 per square foot with a value per square foot of £34.97. The manager suggests that new build costs for similar office assets is likely to be £140 to £180 per square foot and £60 to £65 per square foot for light industrial.

Exhibit 5: Edison occupancy assumptions

Source: Company data, Edison Investment Research

H1 expenses represented 31.8% of gross rental income and, although lower than the 39.3% reported for the shortened 2015 trading period, were running at a higher rate than the 27.5% that we had been forecasting for 2016 as a whole. 2015 was upwardly distorted by the shortened trading period, while H116 was affected by the higher average void rate (less recoverability of direct property costs), expenses related to the level of acquisition activity and public company status, and non-recoverability of VAT on asset manager fees. The asset manager is guiding to below 30% for the year as a whole and our upwardly revised forecast represents a 28.1% ratio. We continue to expect the ratio to decline over 2016 and 2017 as voids reduce and given the element of operational gearing implied by our NAV forecasts, to which management fees are formulaically linked.

H116 EPRA NAV was slightly lower than we had expected because of the expense impact and the increase in stamp duty introduced in the 2016 budget. The investment manager indicates that costs related to acquisition and the stamp duty change had a combined negative impact of c 2.5p per share.

Exhibit 6: Estimate revisions

Net rental income (£m)

EPRA EPS* (p)

EPRA NAV (p)

DPS (p)

New

Old

% chg.

New

Old

% chg.

New

Old

% chg.

New

Old

% chg.

12/16e

37.2

38.1

-2%

7.7

8.0

-4%

110.6

113.1

-2%

7.7

8.0

-3%

12/17e

41.4

40.9

1%

8.9

8.6

3%

113.7

116.1

-2%

8.9

8.2

9%

12/18e

43.3

42.5

2%

9.5

9.1

4%

115.4

118.4

-3%

9.5

8.6

11%

Source: Edison Investment Research

As discussed above, RGL is targeting a total return of 10-15% pa to shareholders, including a 7-8% pa dividend return on the IPO price of 100p, with additional capital appreciation driven by specific asset management initiatives in the portfolio. The continued strengthening of the regional property market more generally would additionally support overall returns. Our forecasts indicate a dividend yield on the current share price of 105p of 7.3% (7.7% on the IPO price), very much towards the top of the range of prospective dividend yields for the UK REIT sector, while trading at a discount to 2016e of c 5%, slightly wider than the median.

Exhibit 7: Regional REIT prospective yield versus REIT sector peers

Source: Bloomberg. Note: Those companies for which forecasts are available. Data as at 28 September 2016.

As explored in detail in our initiation note, RGL seeks to engage in selective acquisitions to grow the portfolio on terms that are immediately accretive to EPRA EPS and dividend-paying capacity.

Exhibit 8: Regional REIT share price/NAV per share versus REIT sector peers

Source: Bloomberg. Note: Those companies for which forecasts are available. Data as at 28 September 2016.

Exhibit 9: Financial summary

Year end 31 December

2015

2016e

2017e

2018e

PROFIT & LOSS

£'000s

IFRS

IFRS

IFRS

IFRS

Gross rental income

5,361

41,509

45,466

47,574

Non-recoverable property costs

(754)

(4,291)

(4,092)

(4,282)

Revenue

 

 

4,608

37,218

41,374

43,292

Administrative expenses

(1,353)

(7,380)

(7,963)

(8,212)

EBITDA

 

 

3,255

29,839

33,411

35,081

Gain on disposal of investment properties

87

(75)

0

0

Change in fair value of investment properties

23,784

3,623

7,504

5,152

Operating profit before financing costs

 

 

27,126

33,387

40,914

40,233

Performance fees

0

(95)

(974)

(828)

Exceptional items

(5,296)

0

0

0

Finance income

177

97

68

25

Finance expense

(997)

(8,757)

(9,161)

(9,161)

Net movement in the fair value of derivative financial investments

115

(2,024)

0

0

Profit Before Tax

 

 

21,124

22,608

30,847

30,268

Tax

0

0

0

0

Profit After Tax (FRS 3)

 

 

21,124

22,608

30,847

30,268

Adjusted for the following:

Performance fees

0

95

974

828

Exceptional items

5,296

0

0

0

Net gain/(loss) on revaluation

(23,784)

(3,623)

(7,504)

(5,152)

Net movement in the fair value of derivative financial investments

(180)

1,904

0

0

Gain on disposal of investment properties

(87)

75

0

0

Profit before Tax (norm)

 

 

2,370

21,059

24,317

25,944

Period end number of shares (m)

274.2

274.2

274.2

274.2

Average Number of Shares Outstanding (m)

274.2

274.2

274.2

274.2

Fully diluted average number of shares outstanding (m)

274.2

274.2

274.2

274.2

EPS - fully diluted (p)

 

 

7.7

8.2

11.2

11.0

EPS - normalised (p)

 

 

0.9

7.7

8.9

9.5

Dividend per share (p)

 

 

1.0

7.7

8.9

9.5

Dividend cover

N/A

100%

100%

100%

BALANCE SHEET

Fixed Assets

 

 

407,492

512,918

528,421

541,573

Investment properties

403,703

510,132

525,635

538,788

Goodwill

2,786

2,786

2,786

2,786

Non-current receivables

1,004

0

0

0

Current Assets

 

 

35,803

31,284

26,351

19,497

Trade and other receivables

11,848

13,816

13,195

14,527

Cash and equivalents

23,954

17,468

13,157

4,970

Current Liabilities

 

 

(21,485)

(28,622)

(30,693)

(32,362)

Trade and other payables

(12,576)

(15,354)

(16,917)

(18,169)

Deferred income

(5,906)

(9,588)

(10,097)

(10,514)

Taxation

(2,387)

(1,239)

(1,239)

(1,239)

Bank and loan borrowings - current

(200)

0

0

0

Derivative financial instruments

(416)

(2,440)

(2,440)

(2,440)

Long Term Liabilities

 

 

(126,469)

(214,771)

(214,771)

(214,771)

Borrowings

(126,469)

(214,771)

(214,771)

(214,771)

Net Assets

 

 

295,341

300,809

309,308

313,937

Derivative interest rate swaps

416

2,440

2,440

2,440

EPRA net assets

 

 

295,757

303,249

311,748

316,377

IFRS NAV per share (p)

107.7

109.7

112.8

114.5

EPRA NAV per share (p)

107.8

110.6

113.7

115.4

LTV

25.4%

38.7%

38.4%

38.9%

CASH FLOW

Operating Cash Flow

 

 

(2,232)

28,800

35,130

34,589

Net Interest & other financing charges

(411)

(9,244)

(9,093)

(9,136)

Tax

0

0

0

0

Purchase of investment properties

(4,191)

(139,251)

0

0

Sale of investment properties

5,348

40,369

0

0

Capex

(4,000)

(8,000)

(8,000)

Acquisition of subsidiaries, net of cash acquired

26,659

0

0

0

Net proceeds from issue of shares

0

0

0

0

Equity dividends paid

0

(12,340)

(22,349)

(25,639)

Other (including debt assumed on acquisition)

0

1,077

0

0

Net Cash Flow

25,172

(94,588)

(4,312)

(8,187)

Opening net (debt)/cash

 

 

(127,886)

(102,714)

(197,303)

(201,614)

Closing net (debt)/cash

 

 

(102,714)

(197,303)

(201,614)

(209,801)

Source: Company accounts, Edison Investment Research

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Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

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New Zealand

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

US

Sydney +61 (0)2 9258 1161

Level 25, Aurora Place

88 Phillip St, Sydney

NSW 2000, Australia

Wellington +64 (0)48 948 555

Level 15, 171 Featherston St

Wellington 6011

New Zealand

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