Positioning for growth

Amidst the global pandemic and its impacts on office occupation, H121 was robust. A standout feature of the results was the continuing strength of rent collection. As of 10 September 2021, the H121 rent collection rate was 99.0% (comprising 96.8% received, 0.4% of remaining monthly paid rents and 1.8% of agreed deals), supporting strong income returns. Quarterly dividends amounting to 3.2p per share were declared for H121 (lower than the 3.4p declared for H120 because of an FY20 skew towards Q1201) and for the year RGL expects to declare 6.5p of DPS (FY20: 6.4p), fully covered by EPRA earnings. This implies higher earnings in H2 versus H1, which largely reflects the normal seasonal skew of rental and related income to H2. H121 EPRA net tangible assets (NTA) per share increased 1.0% to 99.1p compared with 98.6p at end-FY20 and including dividends paid the six-month EPRA NTA total return was 3.6% or c 7.2% annualised. To end-H121 the cumulative accounting total return2 since IPO was 39.9% or a compound average annual return of 6.1%, all generated by dividends paid. The FTSE EPRA NAREIT UK Index has returned an aggregate 4.7% or 0.8% pa over the same period. RGL’s H121 six-month total return was 3.6% or an annualised 7.3%, 87% of which reflected dividends paid.

Key features of the H121 results included:

Having previously invested in both multi-let regional industrial assets and offices4 RGL decided to further refocus the portfolio towards regional offices. This reflected its view that its industrial assets offered little remaining income upside compared with the opportunities that it could identify in the office sector. Significant transaction activity since the end of H121 has substantially achieved this aim and has added considerable scale, with an attractive initial yield and significant income growth potential. Compared with end-H121, the portfolio value has increased by 24% to c £905m5 and the industrial assets, the focus of sales year to date, have reduced from 11% of the total value to 4%. Regional office assets now represent c 91% of the portfolio and non-core assets, including the rump of the industrial assets, c 9%.

RGL believes strongly in the future for offices within the commercial market universe, especially good quality regional assets with affordable rents. RGL’s asset manager, London & Scottish Property Investment Management, has recently underlined this by acquiring c 1.1m RGL shares, an investment of c £1m. While RGL’s enlarged portfolio is now effectively fully focused on the sector, it retains a high level of diversification to mitigate income risks. It comprises more than 170 properties spread across the regions and let to more than 900 tenants operating in a wide range of sectors that can fairly be said to reflect the broad spread of the UK economy.

Aggregate disposals since H121 of £62.2m include the £45.0m sale of a seven-asset industrial portfolio at a 7.5% premium to the start-year valuation and reflecting a net initial yield of 6.75%. This was followed, on 31 August 2021, by the significant acquisition of a portfolio of 31 predominantly multi-let office assets for £236.0m (before acquisition costs) from Squarestone Growth. The price paid for the assets reflected a net initial yield of 7.8% and reversionary yield of 11.0%. The transaction was settled with a relatively modest new equity outlay and appears well-timed with office valuations appearing to have stabilised. The consideration comprised £83.1m of new shares (issued at 98.6p, representing the EPRA NTA at the time despite the shares trading at a c 15% discount), existing cash resources including the proceeds of recent disposals, and additional borrowing of £76.2m.

RGL was primarily attracted by the quality of the assets acquired, their complementarity with the existing portfolio, and the significant asset management opportunity they provide.

The portfolio assets comprise 27, geographically well-spread regional offices (93.3% by value), two industrial units, a residential asset and a drive-thru restaurant. The initial income is attractive with the £21.9m contracted rent roll reflected in a net initial yield of 7.8% and with EPRA occupancy of 78.8% and reversionary yield of 11.0% there is significant opportunity to increase income over time. The capital value per square foot of c £136 is similar to the average of RGL’s existing office portfolio and the asset manager estimates this represents a c 30% discount to replacement value. Similarly, rents on the portfolio are set at an affordable level, an average £13.4 per square foot (RGL’s existing office assets averaged c £13.8 at end-H121) with potential upside to an estimated market level of c £15.0 per square foot (RGL: £13.9).

By income, 75% of the acquired assets are in locations where RGL is already represented and where it has identified attractive long-term prospects. The balance is in locations where RGL is not currently represented but where it is happy to be so. In addition to enhancing asset and geographical diversification, only 30% of the rent roll is derived from existing RGL tenants, creating a broader spread of income for the enlarged portfolio.

RGL says that it has seen a gradual return to the office, accelerating since the schools re-opened in September, and that most tenants have now re-opened. It is awaiting robust data on the level of physical occupation (how many staff are now back working in those offices) but estimates that is in the range of 40–50%. Most tenants are expected to adopt a hybrid model of working, at least initially, whereby employees spend perhaps three days per week (typically Tuesday, Wednesday, Thursday) in the office and two days at home. Hybrid working is unlikely to materially reduce space requirements as it must cater for peak usage. As an alternative, hot desking is typically unpopular with staff, who value their own space, the certainty of being in proximity to close colleagues and may stifle the collaboration and creativity required by many employers. RGL expects any reduction in the demand for space driven by changes in working practices is likely to be offset by a reduction in office density (the number of employees per square meter), accelerating a trend that was in place prior to the pandemic. This is likely to apply particularly to good quality space at affordable rents. The trend has been driven by a recognition that to retain and attract staff, in many industries it is necessary for employers to offer better facilities (including relaxation areas and space for collaborative working and informal discussion) and quality accommodation. Social distancing, driven by the pandemic, is only likely to reinforce this trend.

RGL is attracted by the relatively high yields that are available on regional offices, a combination of low rents, low capital values, well below new build cost, at a level that has inhibited most new development in recent years. Meanwhile, re-purposing of existing space towards residential, student and hotel accommodation, has worked to reduce supply. Structural demand factors remain in place, such as office migration from (more expensive) London to the regions and the political goal of rebalancing economic activity from South England to the North likely to remain, possibly reinforced by a shift to ‘localism’ (smaller, regional offices located in towns and cities outside the capital).

RGL remains very positive on the outlook for regional offices and has positioned the portfolio for growth. At H121 its office portfolio contained £13.5m of reversionary income potential from current contracted rent to the full occupancy market level estimated rental value (ERV). We estimate that the Squarestone portfolio acquisition has added between £5–7m to this. RGL recognises that in current market conditions, this may take some time to come through and expects occupier demand and earnings to FY22 to be relatively flat the second half of FY21 and into FY22, followed by a strong improvement later in FY22 and through FY23.

Since our last published forecasts, the significant expansion of the portfolio has a material impact on net rental income and EPRA earnings on a full year basis in FY22e. In per share terms (the average number of shares in FY22e increases by c 19%) there is a slight reduction in EPRA EPS, with the accretive impact of the transactions offset by a reduction in our underlying, like-for-like, forecast. Or forecast growth in DPS is also slightly reduced in line with EPRA EPS. The slight reduction in forecast EPRA NTA balances the impact of substantial transaction-related acquisition costs (mostly land transfer tax) with a slightly more positive underlying valuation assumption. We introduce a FY23 forecast for the first time.

The driver of our forecasts is net rental income which includes the net positive impact of the portfolio transactions, assumes a flat portfolio ERV and unchanged EPRA occupancy6 from the H121 level of 85.7% (we previously assumed an increase to 91% by end-FY22). We are now expecting a gentle recovery in leasing activity through FY22 and accelerating through FY23. This includes an impact from property refurbishment (including the soon to be vacated Tay House property with £2.7m gross rent roll from a total of £61.1m at end-H12, since increased by net acquisitions) which reduces near-term income until completed and the property re-let. This is not reflected in the EPRA occupancy rate from which properties under development/ refurbishment are excluded. We anticipate a pick-up in the pace of earnings and dividend growth through FY23.

The weakness in office valuation in FY20 was based more on valuer sentiment, with reduced investment volumes causing a dearth of transactional evidence. RGL says that valuations appear to have bottomed and stabilised but that any material uplift may not occur until 2022 as the occupier market strengthens. We have assumed a modest 0.5% pa positive property revaluation movement. This seeks to balance our flat ERV and EPRA occupancy assumptions with the consensus view that office valuations may increase by c 2% pa during 2022 and 20237. In 2021e this is offset by acquisition costs. We estimate that most of the valuation gains locked in by the significant asset sales since end-H121 were reflected in the H121 balance sheet, but we include H221 realised gains of c £1.5m. We estimate that a 1% increase/decrease in the FY21e value of investment properties increases/decreases EPRA NTA by c 1.8%.

We have not assumed further non-core asset sales. If the proceeds are not reinvested this would likely reduce rental income but also reduce gearing.

Long-term commercial property returns are substantially driven by income, which have historically been relatively consistent compared with more volatile capital values. In this context, RGL aims to provide an attractive total return to shareholders with a strong focus on income. With the exception of FY20, due to the pandemic, total return has been positive in each year since IPO, amounting to 39.9% or a compound average annual return of 6.1%, all generated by dividends paid.

RGL’s high dividend yield continues to be at the very top end of both this narrow peer group and the broad UK property sector (we estimate c 4.0% on a trailing basis), particularly in respect of covered dividends. Quarterly dividend payments were maintained during the worst period of the pandemic, albeit at a reduced level, and RGL targets a 6.5p DPS for FY21, a 1.6% increase on FY20 (6.4p). The FY21e DPS represents a yield of 7.4% while the shares trade at an 11% discount to H121 EPRA NTA per share.

In Exhibit 5 we show a comparison with a narrow group of peers that are similarly focused on regional commercial property. To ease comparison, the data is based on 12-month trailing DPS declared and last published EPTA NTA/NAV. RGL’s c 7% trailing yield is well above the peer group average, reflected in a slightly higher than average P/NAV.