Palace Capital — Confidently reinstating DPS

Palace Capital is an internally managed UK REIT that operates a total return strategy focused on the regions, supported by a diversified portfolio of mainly office and industrial assets (c 60% combined) and balanced between income-producing assets and opportunities for capital growth through refurbishment and development.

Palace has a proven long-term track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. Since its first major post-IPO transaction in H214 until end-FY20 PCA’s total return strategy has generated cumulative EPRA NAV total returns of 113.1% or a compound annual average return of 12.3%.

An active refurbishment and development programme weighed on income in FY20 but will improve the quality of the portfolio and should enhance future income and capital value prospects. The existing portfolio contains strong reversionary potential, while completion of the flagship Hudson Quarter development in York in March 2021 should add meaningfully to portfolio income and capital value.

The COVID-19 pandemic and lockdown has created a challenging and highly uncertain economic and market backdrop. The lockdown’s timing was too late to significantly impact FY20 income earnings, but year-end property valuations and capital returns were negatively affected. In common with peers across the sector, rent collection has slowed although Palace reports a robust performance to date supported by a proactive approach with tenants. As at 7 July 2020 (the date of reporting FY20 results) 93% of rents that had been billed in relation to the March quarter advance billing date had already been collected, with 91% in cash and 2% subject to an agreed near-term collection plan, with the remaining 7% outstanding. For the June quarter advance billing date, 84% of rents that had been billed had been collected in cash (64%) or were subject to agreed near-term collection plans (20%), with 16% outstanding.

A final DPS of 2.5p was declared (bringing the total for the year to 12p) and the company says that this has been set very conservatively and is the minimum level of dividend that it expects to pay in each quarter of FY21; it hopes to lift dividends as the year progresses. We estimate that to fully cover the £4.6m dividend payment after all expenses and financing costs requires £12.3m of net rental income to be generated compared with the £15.9m reported (as adjusted) in FY20 (excluding the one-off lease surrender premium), which would represent a reduction of more than 20%. Upside potential to this base level DPS comes from an improvement in market conditions as the lockdown eases and progress with capturing the significant reversionary potential embedded in the portfolio.

With total drawn debt of £120.8m at 31 March 2020, Palace has undrawn debt resources available of £32.9m, including £21.5m of the Barclays development facility to fully fund the remaining construction cost, in addition to cash resources of £14.9m.

We briefly review the FY20 results below before providing an update on the near-term outlook and potential impact of COVID-19, as well as the medium-term prospects driven by the significant embedded income and capital potential in the portfolio, including Hudson Quarter, providing Palace with a wide range of opportunities despite more challenging markets.

As Palace had previously indicated, FY20 adjusted profit before tax of £8.0m (FY19: £8.9m) was in line with expectations, while COVID-19 contributed to end-year negative unrealised valuation movements. Adjusted profit before tax excludes a one-off £2.9m lease surrender premium which is included in the EPRA definition of earnings. EPRA earnings increased to £10.8m (FY19: £7.6m). Underlying the results was a positive property level total return (income and capital) of 1.1%, driven primarily by sector positioning, outperforming the MSCI UK Quarterly Benchmark return of -0.5%, for the third year in a row.

Lower underlying net rental income (excluding the surrender premium) reflected the ongoing refurbishment and development programme. Increased administrative costs primarily reflected the investment in growing the property management team, partly offset by lower share-based payment expenses. On an underlying basis, excluding refinancing costs and fair value movements in debt hedging instruments, finance expenses were little changed.

With the Q320 DPS of 4.75p cancelled to conserve liquidity going into the pandemic, the 2.5p final DPS took the total to 12p for the year, 1.5x covered by adjusted EPS of 17.5p.

Unrealised revaluation losses of £17.9m in FY20 (5.7% fall in valuation adjusted for disposals) include the year-end impact of COVID-19 and some timing effects that management expects to unwind as newly developed or refurbished assets are completed and let or sold.

EPRA NAV per share reduced to 364p (FY19: 407p), partly offset by the 19.0p of DPS that was actually paid in the year the EPRA NAV total return was -5.8%. DPS declared for the year was 12.0p including Q120 and Q220 DPS of 4.75p each and a final DPS of 2.5p.

End-FY20 gross outstanding debt was c £120.8m (including unamortised debt facility fees) and the cash balance was c £14.9m. Net debt of c £105.8m represented a net loan to value ratio (LTV) of 38.1%. The debt was well spread across lenders with an average cost of 3.1% with no maturities for the next two years. Of the total debt facilities, 56% of the was either fixed rate or hedged to mitigate interest rate risk and 44% was floating rate. The debt facilities shown in Exhibit 2 include the £26.5m Barclays Bank development facility that was arranged to substantially fund the Hudson Quarter construction costs. The £21.5m undrawn from this facility at end-FY20 is sufficient to cover the remaining Hudson Quarter development costs. During FY20 the revolving credit facility (RCF) with NatWest was increased from £30m to £40m and extended for a further five years at lower cost.

Each of the facilities has its own agreed banking covenants in respect of minim levels of LTV and interest cover (ICR) or debt service cover (DSCR, including loan amortisation). Overall, Palace states that rental income would need to fall by more than 40% on average and asset values by 18% on average for all the ICR and LTV covenants to be challenged, respectively. However, two facilities in particular (Scottish Widows and Santander), are under more pressure due to their funding of the leisure assets in the portfolio, where rent receipts have been particularly affected by the pandemic lockdown. Post the year end, the ICR covenants for these two facilities were breached as part of the quarterly April test. Both banks provided temporary covenant waivers in response to this unusual situation and PCA expects to return to compliance this month.

The portfolio was externally valued at £277.8m at the end of FY20, with a contractual rental income of £17.6m reflected in a net initial yield of 6.0%. It comprised 53 assets (51 completed and two development assets) let to more than 200 individual tenants. The weighted average unexpired lease term (WAULT) to first break increased to 4.8 years (6.5 years to expiry) from 4.5 years during FY20 and the EPRA occupancy rate (which excludes development assets) increased to 87.3% (FY19: 86.9%). The estimated rental value (ERV) of the void space is £2.6m), the majority of which relates to completed refurbishment projects or assets that have been identified for strategic refurbishment or development. Total ERV of £20.6m (including lease incentives at expiry and upside reversion to market rents) is £3.0m or 17.6% above current contractual income, representing significant upside potential. Additional to this is the income potential from the Hudson Quarter commercial space when completed which Palace estimates will add c £1.0m to ERV (and generate a pre-tax development gain of at least £10m).

The portfolio is regional (ie not Central London) and 60% (by value) is invested in offices and industrial assets, both sectors that at a market level were performing well going into the pandemic and which are expected to continue to outperform the retail sector. Regional offices account for c 46% of the portfolio by value, including city centre buildings in Liverpool, Manchester, Leeds, Newcastle and York (on completion of Hudson Quarter), all within the domain of the ‘Northern Powerhouse’ and set to benefit from the government’s ‘levelling up’ agenda which aims to drive growth in the north. Business relocations away from London, limited new supply and the past conversion of office space to residential, are all factors that should continue to provide support to the market going forward despite a more uncertain economic environment. With an ERV of £2.1m, office voids represent a significant share of the upside from letting vacant space. Industrial property (14% by value) has similarly been benefitting from firm occupier demand, particularly by retailers requiring ‘last mile’ distribution space to meet increased customer demand from e-commerce, limited new supply and rental growth. Two large leisure assets in Halifax and Northampton account for 13.7% of the portfolio by value. The sector has faced similar challenges to the retail sector and has been significantly affected by the lockdown. However, the properties are substantially let (93%) to solid covenants with an average 9.5-year WAULT and management is confident of collecting all rents outstanding as a result of the lockdown in coming months. The portfolio’s exposure to retail is relatively low with two retail warehouses let to Booker (a subsidiary of Tesco), Wickes (part of Travis Perkins) and Pets at Home, and a supermarket let to Aldi on a long lease. The range of other retail tenants is diverse with no exposure to problem areas like mid-market fashion or department stores.

The upside potential embedded within the portfolio is represented by:

Of the £3.0m (18%) end-FY20 reversionary potential from the completed assets, the single largest opportunity comes from void reduction (£2.5m), the majority of which relates to completed refurbishment projects (£1.8m). Additional potential (£0.7m) comes from assets where vacant possession has been strategically obtained with a view to refurbishment or development activity, some of which could meanwhile be offered on short lets. Including Hudson Quarter, end FY20 potential ERV (£21.6m) was 23% ahead of the end FY20 contracted rent.

Palace has also identified several medium-term asset management opportunities that it plans to phase in over a number of years, potentially providing counter-cyclical opportunities to add value to the portfolio should market-wide rents and capital returns stall.

Hudson Quarter is a key development for Palace and with positive conditions in both the commercial and residential markets in York management has not changed its expectations for rental values or gross development value. Construction activity continued through the lockdown, and although it slowed slightly due to social distancing measures and materials supply chain issues, it has again begun to pick up with completion now expected in March 2021, about two months later than previously expected.

Hudson Quarter occupies a two-acre site in York, within the city walls and just a minute’s walk from York railway station. The scheme comprises three residential buildings and a commercial building. The 127 flats will be sold and the commercial element, comprising 39, 500 sq ft of grade A offices, of which 4,500 sq ft has been pre-let, will be retained for income.

Although the marketing suite was closed during the lockdown contracts have been exchanged on 32 of the 127 apartments with a value of £8.5m; a further five are under offer (value of £1.6m). Palace says that it has detected no weakness in the market as a result of the pandemic lockdown and has had no need to discount prices to maintain sales. In February, 4,500 sq ft of office space, on the ground floor of one of the residential buildings was pre-let to Knights, the quoted law firm, at a record rent for York of £25 per sq ft.

Forecasting in the current environment is highly uncertain, from the perspective of accounting income, cash collected income and capital values. In that context we have opted to consider a range of potential outcomes in respect of the current financial year only while noting that completion of the Hudson Quarter development in March 2021 should, all else being equal, provide a significant uplift to contracted rental income and NAV, as well as releasing c £50m of capital (from completion of residential sales in full) for debt reduction and/or reinvestment in yielding assets.

Palace has yet to provide any guidance in respect of the full year financial performance but has indicated that it sees the payment of quarterly dividends amounting to 10p for the year as a very conservative objective that it hopes to improve upon. We estimate that to fully cover the £4.6m dividend cost after all expenses and financing costs requires £12.3m of net rental income to be generated. Compared with the £15.9m reported in FY20 (excluding the one-off lease surrender premium) this represents a reduction of more than 20%.

For the income statement we have modelled three scenarios in order to indicate a range of potential outcomes. We have deliberately not labelled these as base case, lower case and upper case given the uncertainty and because outcomes that fall outside of our scenarios are entirely possible. A summary is shown in Exhibit 7.

Resulting from the pandemic, lockdown and weakness of economic activity, the key area of uncertainty with regards to the recurring income statement ie before property valuation movements, is in respect of rental income. There are several factors that will contribute to the outcome including:

At present we do not know how these factors will play out, but we expect the position to become clearer as the economy continues to re-open. Our three scenarios each focus on:

Our central scenario assumes that all rents on agreed monthly payment plans are received during FY21 but that only 90% of Q1–Q2 outstanding rents are ultimately collected, reducing rent roll going into H221 by c £0.4m. The resulting accounting gross rental income of £16.8m compares with the opening rent roll of £17.6m (but closing FY21 rent roll of £16.7m). With adjusted EPS of 14.4p we assume aggregate DPS of 13p for the year.

In the upper scenario we assume that 100% of outstanding Q1–Q2 rents are collected during FY21 and that rent roll ends FY21 at £17.1m, with accounting gross rental income of £17.5m reported and slightly lower non-recoverable property costs. With no contribution assumed from the letting of vacant space, this should not be interpreted as a best-case scenario. Adjusted EPS of 16.3p would indicate a higher DPS than for the central scenario.

In the lower scenario we assume that just 80% of Q1–Q2 outstanding rents are collected and that rent roll closes FY21 at £16.3m. Reported accounting gross rental income for the year is £16.1m and non-recoverable property costs are higher at £2.9m. With adjusted EPS of 12.0p the lower scenario has Palace’s base level annual DPS target of 10p well covered, although this should not be interpreted as a worst-case scenario.

As we have assumed that rents are either collected during the year or not paid at all the only difference between accounting rental income and cash received rental income implied by our scenario analysis is in respect of rent-free/lease incentive adjustments which smooth the impact through the income statement with a non-cash adjustment. In our analysis the IFRS smoothing impact is relatively small (c 5%) but would increase if rent deferrals extend beyond the end of FY21 or if there are more rent-free agreements with tenants, deferring near-term income but extending occupancy.

MSCI UK Property Index monthly return data show that across the UK commercial property sector as a whole, positive total returns were recorded until March 2020, with a positive performance from the industrial and office sectors offsetting weakness in retail and leisure. From March through May, due to the pandemic and lockdown, all main sectors experienced weakening capital values and negative total returns, while the weakness of retail and leisure accelerated. Total market capital returns were -2.3% in the month of March 2020, -1.7% in April and -1.1% in May. Data for June from CBRE suggests that industrial and office values may be in the process of stabilising (-0.1% and -0.2% respectively) while the decline in retail values continued (-1.4%).

Office rental value growth was broadly stable through May, but capital values weakened and there is much debate as to whether the pandemic and remote working will have a negative long-term impact on the demand for office space. Home working has probably received an enduring boost but the case for full-time office working is less clear. When in the office, it is likely each worker will require an increased amount of space. Well-appointed offices, with good transport links, good IT infrastructure and environmental credentials are likely to retain a premium. The industrial sector should continue to find support from a general tightness of supply relative to demand and has continued to see rental growth through May. The structural weakness in the retail sector seems set to continue. Based on recent trends, Exhibit 8 shows our best guess at capital value movements across the market for FY21 and applied to the PCA portfolio as at end-FY21. We have allowed for PCA’s leisure assets to do a little better than the market, reflecting the end-FY20 negative valuation adjustment and the recent asset management/lease extension initiatives. We also expect PCA’s retail exposures to outperform the wider retail market, but we have made no allowance for the possibility that letting void space may have a positive valuation impact. Given the level of uncertainty this is best treated as an illustration.

Although we have included none of the development gain that management expects from the completion and letting/sale of Hudson Quarter, with scheduled completion in March 2021 it is possible that some of this may fall into FY21.

Including these property valuation movements into our central scenario for income returns suggests an end-FY21 EPRA NAV per share of 339p (FY20: 364p). Alternatively, each 1% increase/decrease in the total portfolio value (including the development assets) is equivalent to an increase/decrease in EPRA NAV per share of c 6p. For the end-FY20 EPRA NAV (364p) to fall to match the current share price (200p) would require a c 27% reduction in the portfolio value.

With Hudson Quarter construction spending funded by the Barclays development facility, and including £3m of capex in respect of completed assets, our central scenario indicates a broadly stable cash position and an increase in net debt to £125.0m (end-FY20: £105.8m) and an increase in LTV to 43.9%. If capital values are stronger than we allow for the LTV would be lower. For the upper and lower scenarios, the impact on debt and gearing should be smoothed out by higher or lower dividend payments, respectively. If adjusted for the post-completion sales of the Hudson Quarter apartments (c £50m) and including the development gain that management expects (at least £10m), the end-FY21 LTV would be c 30%.

Since its first major post-IPO transaction in H214 until end-FY20 Palace’s total return strategy has generated cumulative EPRA NAV total returns of 125.3% or a compound annual average return of 13.3%. Our central scenario indicates a negative total return in FY21 (-7.6%) driven by the market-driven property valuation movements that we assume, but we note that FY22 (for which we provide no forecast at this stage) should benefit from completion of the Hudson Quarter development (at the end of FY21) with management expecting an increase in rental income of c £1m pa and generating a pre-tax development gain of at least c 20p per share at completion and full letting (or sale). Some of the development gain may be recognised by the independent valuers in FY21 but we assume not at this stage.

The company indicates that it targets quarterly DPS payments for FY21 amounting to at least 10p per share (a 5.0% yield on the current share price), with the potential for this to be higher. Recognising Palace’s REIT status and the requirement that it distribute at least 90% of its rental profits, we have assumed aggregate DPS of 13p (a yield of 6.5%) or c 90% of our ‘central scenario’ adjusted earnings. The shares trade at a significant discount to EPRA NAV, around half the end-FY20 EPRA NAV per share of 364p and a still large discount of c 40% to our central scenario FY21 EPRA NAV per share of 339p.

In Exhibit 10 we show a summary performance and valuation comparison of Palace and a peer group of UK commercial real estate investment companies with a strong regional focus.

Palace shares have declined over 12 months, broadly in line with the peer average. However, the peer group performance is below that of the broad UK property sector where some of the long-income-focused specialist REITs and industrial-focused REITs have been outperformers. In terms of valuation we show the trailing yield based on aggregate declared DPS over the past 12 months as well as the forward-looking yield based on the most recently declared DPS annualised. Neither is entirely satisfactory as the sector remains in a state of flux, with some companies having indicated a reduced DPS payout for the time being and some postponing DPS payments altogether until later in the year. It will take some time before the full-year prospective DPS outlook becomes clearer and a true comparison can be made. With that said, PCA’s annualised yield of more than 5% based on the minimum (10p) annual dividend that management expects is above the peer average and compares favourably to the risk-free yield on offer (10-year UK gilt yields are less than 0.2%). Given the strong track record of total return generation, the prospect of Hudson Quarter completion in FY21, and the potential to drive further returns from the existing portfolio, the Palace valuation appears undemanding with material upside if economic and market prospects become clear in the coming months.