Delivering income while investing for growth

Against a more uncertain political and economic backdrop, Picton produced a solid performance in H120. The property portfolio performed well, driven by the strong portfolio weighting towards the industrial and office sectors. The like-for-like increase in valuation was 1.2% and the total return of 3.2% in the period was well ahead of the MSCI Quarterly Property Index (‘the Index’) total return of 0.8%. Picton has outperformed the Index in terms of both total return and income return over one, three, five and 10 years. Although recurring income earnings were lower as expected as the company uses scheduled lease expiries and lease surrenders to invest in improving and repositioning assets to enhance longer term income and capital value prospects, the dividend remains well covered and NAV total return in the period was a positive 2.8%.

In its outlook statement Picton anticipates that against the current uncertain economic and political backdrop, interest rates are likely to remain low for the foreseeable future. UK commercial property sector returns are expected to be lower than in recent years, although the broad market consensus is that they will remain positive (Exhibit 6), substantially driven by income, with the industrial and office sectors continuing to lead. Picton’s portfolio positioning continues to look well placed as does its income focus and fully covered dividends, while a diversified tenant base mitigates some of the cyclical income risks. Gearing is deliberately conservative, while flexible undrawn banking facilities provide scope for opportunistic acquisitions should these arise. Meanwhile the significant refurbishment programme is underway to enhance and unlock income and value potential within the portfolio.

The decision of Nicholas Thompson to stand down as chairman, a position he has held since the company was launched in 2005, was announced earlier in the year. After a thorough search he is to be succeeded by Nick Wiles who has been appointed as a non-executive director, effective 1 January 2020, and who will transition to chairman on 1 June 2020 when Nicholas Thompson formally steps down. Nick Wiles was senior independent non-executive director at Primary Health Properties until its merger with MedicX earlier in the year. He is currently chairman of PayPoint Inc and during a long career in investment banking mostly spent at Cazenove & Co, where he was a partner prior to its incorporation; he was also chairman of UK investment banking at Nomura until retiring in 2012.

While Picton’s property portfolio performance continues to benefit from its sector positioning, there is significant potential within the portfolio to enhance income and capital values, in many cases supported by identified asset management initiatives.

The externally appraised fair value of the portfolio at 30 September 2019 (end-H120) was £693m (FY19: £685m) with a balance sheet value, after lease and other adjustments, of £683m. Like-for-like growth in the period was 1.2%. The annualised rental income (or passing rent) was £37.9m with an estimated market rental value at full occupancy (ERV) of £47.3m, both a little ahead of the end of FY19. The valuation reflects a net initial yield of 4.9% and a reversionary yield of 6.3%. The £9.4m gap between passing rent and ERV represents a significant opportunity for Picton to enhance the income and value of the portfolio through future leasing events. Almost two-thirds of this reversionary potential relates to void reduction, with EPRA occupancy of 88% at end-H120 below the historical trend (c 94–95% over the past five years) and significantly reflecting the timing of lease maturities. The weighted average unexpired lease length is just over five years.

Since the end of H120 Picton has disposed of an office building in Croydon for £18.2m. The sale price represented a 7% uplift to the June 2019 valuation, was double the 2005 acquisition price of £9.1m and was reflected in contributed to the H120 unrealised revaluation gains. The property was sold with 10% vacancy and the potential for vacant possession in 2022 following a lease restructuring earlier in the year. Picton has received £0.6m in additional income as a result of the lease restructuring.

The sector and regional positioning of the portfolio highlights its unconstrained approach to asset selection within the overall framework of maintaining a diversified overall portfolio. Compared with the MSCI Quarterly Property Index, the portfolio has around double the weighting to the strongly performing industrial sector (with a high South-East share) and around half the weighting in retail/leisure sectors (no exposure to shopping centres) where returns are currently weak. The regional (rather than central London) nature of Picton’s office exposure also contributed positively to performance. Picton’s six-month portfolio return was 3.2%, outperforming the MSCI UK Quarterly Property Index return of 0.8%, with an income return of 2.4%, 0.1% ahead of the Index.

In H120 Picton’s industrial portfolio saw like-for-like growth in capital values of 3.8% with passing rent up 1.2% and ERV by 2.7%. While office portfolio values increased by 1.9% like-for-like, passing rent was 2.2% lower on the same basis, primarily reflecting a lease expiry (in Chatham) where the property is currently being refurbished. The office portfolio ERV increased by 2.3%. Reflecting market conditions, the retail and leisure portfolio saw a 6.1% like-for-like decline in capital values, although passing rent increased by 3.9% as previously void space was successfully let. The retail & leisure portfolio ERV declined by 4.7%.

Significant leasing activity in H120 included the completion of 14 new lettings adding an aggregate c £1.5m to annualised rent roll, on average at around the estimated rental value (ERV). Additionally, 20 existing lease renewals were completed, covering an aggregate c £1.2m of an annualised rent roll, and an average 9% uplift to ERV, as well as 12 rent reviews that were secured at an average 6% above ERV, producing an uplift of c £0.5m to annualised rent roll.

As a percentage of ERV, 79% of Picton’s vacancy is represented by assets that are currently under refurbishment, with the company taking advantage of lease expiries and the opportunity to take back properties early through lease surrenders (in many cases generating surrender premium income) to actively invest in improving the quality of the assets with the intention of delivering higher occupancy, rental income and capital values over time. Earlier in the year Picton said that it had identified more than 20 projects within the portfolio, representing an aggregate investment of c £15m. We expect this investment to be spread over the current year and next. During H120 £2.8m was invested to refurbish and reposition assets. Projects were completed at Marlow and Manchester, where the space is either under offer or receiving good interest. Work is currently underway at 11 other assets.

Exhibits 5 lists several projects that are currently under way with an aggregate ERV of £3.5m and the potential to meaningfully enhance income and value when completed.

Amid some slowing of UK economic growth and continuing Brexit-related uncertainty, the UK commercial property market as a whole has entered a period of increased uncertainty with sector performance remaining highly polarised. The industrial, warehouse and logistics sectors, and to a lesser extent the office sector, are continuing to deliver positive returns while the retail sector continues to suffer from weak occupational demand and the impact of CVAs and defaults, reflected in softer rental and capital values.

Looking forward, the most recent quarterly market forecasts by the Investment Property Forum (IPF, canvassing a group of fund managers and surveyors under the IPF Research Programme) were published in September and point to a deterioration in expectations for capital growth over the past quarter. This is focused on the retail sector, where the expectation of capital value decline has increased but also includes industrial, where expectations of capital value growth have been tempered. The consensus expectation for overall total property return remains positive despite weakness in retail.

We present the market consensus data as a guide to expected overall market direction and returns but would caution against a direct read across to Picton’s, or any other, portfolio. The market consensus is formed of a wide range of differing expectations and at the individual portfolio level much depends on the performance of individual assets as well as the timing and effectiveness of asset management initiatives.

Our forecasts allow for the completed sale of the Croydon office property in Q320 but otherwise assume an unchanged portfolio. In reality, Picton continues to monitor the market for attractive new investment opportunities and is also likely to continue to divest of mature assets.

As was the case in H120, we expect the current dip in occupancy and rent roll, as the company uses lease expiry and lease surrender opportunities to undertake refurbishment activity, to temporarily reduce FY20 rental income and EPRA earnings until some of the asset management projects complete and the properties re-let. We forecast growth to resume in FY21. Picton embarked on its asset management programme from a very strong dividend cover position (1.21x in FY19) and as a result we forecast dividend cover to remain at a good level in FY20 (1.09x) despite the expected EPRA earnings decline. Although we have not assumed growth in FY21 DPS, we note that our forecasts show cover increasing to 1.20x , a level of cover that may indicate scope for dividend growth, especially as the bulk of the refurbishment investment should by then be complete.

Our key forecasting assumptions include:

A summary of our FY20 and FY21 forecasts is shown in Exhibit 7.

At 30 September 2019 (end-H120) the gross outstanding debt (including unamortised loan arrangement fees) was £187.1m and net debt was £170.0m with a net LTV of 24.5% (FY19: 24.7%). All of the debt is secured against property assets and the majority (90%) of outstanding debt represents long-term fixed-rate borrowing, which is supplemented by lower cost, more flexible, revolving credit facilities. The average cost of debt was 4.1% and the weighted duration was 9.8 years.

At end-H120 the company had undrawn debt capacity of c £30m in addition to cash resources of £17.1m, providing considerable financial flexibility for future investment. The Croydon disposal has since netted c £18m in disposal proceeds and our forecasts assume that the c £19.0m of outstanding revolving debt will be repaid.

Picton has a strong focus on income and pays fully covered quarterly dividends that currently annualise at 3.5p per share (a prospective yield of 3.8% at the current share price), while continuing to invest in the portfolio to support future income growth.

In Exhibit 8 we show Picton’s NAV total return performance (change in NAV plus dividends paid) over the five-year period from IPO to 31 March 2019. Without assuming reinvestment of dividends, the aggregate NAV total return over the period was c 94% or a compound annual average 14.2%. As discussed above, we believe that our forecasts for FY20 and FY21 have been struck cautiously, reflecting a less benign external market environment than has been experienced over the past five years while assuming a relatively modest capture of the upside potential within the Picton portfolio. H120 NAV total return was 2.8% and our forecasts imply a compound annual return of 5.4% for the year and 5.0% over the two-year forecast period FY20–21. Three-quarters of that forecast return comes from well-covered DPS payments. Even on this cautious basis of forecasting there remains a material uplift compared with risk-free returns (the 10-year UK gilt yield is c 0.7%).

In Exhibit 9 we show a summary performance and valuation comparison of Picton and what we consider to be its closest diversified income-oriented peers. Over the past year Picton shares have performed more strongly than the peer group average as well as the broader UK property sector and the FTSE All-Share Index. The valuation comparison is based on last-reported EPRA NAV per share and trailing 12-month DPS declared. On this basis the Picton yield is below the peer average and the P/NAV slightly above. We believe the outperformance of Picton shares and the share price rating reflect the company’s strong track record of property level performance, the future income and valuation growth potential embedded in its portfolio, its good level of dividend cover and relatively modest gearing.