Custodian REIT — Reinstating forecasts with improved DPS outlook

In the three months that ended 30 June 2020 (Q121) NAV per share reduced by 5.9p to 95.7p, driven by unrealised valuation losses on the investment portfolio, and including the 1.6625p DPS paid in respect of Q420, the NAV total return was -4.2%.

From listing in March 2014 to March 2020 (end-FY20), CREI generated an aggregate EPRA NAV total return of 40.1% (without assuming reinvestment of dividends) or a compound annual average return of 5.8% pa. Of the total return, the vast majority (91%) has been generated by dividend payments and the balance by growth in EPRA NAV per share. With market conditions recently more uncertain, the contribution of income to returns is increasingly important.

Income remained robust during Q121 (£9.8m compared with £10.0m in Q420 and an average quarterly rate of £10.2m through FY20), but expenses, including precautionary provisioning against rents owed (we estimate c £0.9m) increased. Q120 income net of expenses of c £6.1m did not fully cover payment of the Q420 DPS during the period, however the c £4.0m cost of the Q121 DPS was c 1.4x covered by EPRA earnings in the period and was fully covered by net cash receipts (allowing for rents accrued but yet received). The 0.95p DPS declared was 27% ahead of the minimum 0.75p that the company had previously indicated, for each of the first two quarters of FY21, reflecting better than expected rental collection (see below), and was fully covered by net cash receipts. With the lockdown easing we expect quarterly dividends throughout FY21 to be at least at the same level. For details of Custodian’s tenant base, see our last note.

During the quarter all sectors across Custodian’s diversified portfolio experienced unrealised valuation decreases; reflecting market-wide trends industrial assets (including logistics) remained more robust while high street retail assets were the weakest. Amidst low transactional activity in the market (investment volumes during the period to 30 June were only 20% of the previous quarter’s levels) the Royal Institute of Chartered Surveyors (RICS) continues to recommend the imposition of a ‘material uncertainty’ caveat against the valuations of all but industrial and logistics properties. Valuations meanwhile are seeking to reflect the change in market conditions resulting from the pandemic, and particularly the risks to deferred and overdue rents. Custodian’s investment manager comments that while this may be inevitable in the short term it does not necessarily represent an irrecoverable shift, expecting demand from occupiers to remain firm as infection management improves. As well as the easing of the lockdown, sentiment around rent collection should also benefit from a reinstatement by the government (after September) of the ability of landlords to formally pursue non-paying tenants.

The valuation movement during the period continued to be tempered by asset management initiatives and this has continued into the current (Q221) quarter with a positive underlying impact on valuation.

Custodian’s investment manager invoices and collects rents directly and, in some cases, this has provided an opportunity to negotiate a positive asset management outcome where tenants have struggled to meet near-term rental payments due to the lockdown. This may typically include an extension to the lease term in return for rent concessions, providing short-term cash flow relief for occupiers and longer-term income security for the company.

The process of collecting rent arrears has continued and as of the date of the Q121 NAV announcement (30 July) 92% of rent relating to Q121, net of agreed rent deferrals (11% of rents), had been collected. Applied to the total invoiced rents this implies 82% collection, 11% deferral and 7% outstanding/due.

With collections continuing, at 30 July, 80% of rents expected for Q221 had been collected, net of amounts deferred by contractual agreement to be recovered over the next 12–18 months. The rents expected to be collected in Q221 include rents due relating to the quarter, net of agreed deferrals of 5% of Q221 rents, and collections of some part of rents deferred in Q121. This implies 82% collection of the rents expected in Q221, 5% deferral and 19% still outstanding/due.

Custodian remains in discussion with tenants in respect of the Q121 and Q221 outstanding rents due and we expect the Q221 collection to increase although a proportion of arrears are potentially at risk of non-recovery from company voluntary arrangements (CVAs) or pre-pack administrations accounting for c 3.6% of rent roll.

As previously reported, the pandemic came too late to significantly impact FY20 recurring income, with the increased DPS target for the year met and fully covered by EPRA earnings, although year-end valuations and NAV were negatively affected. Our forecasts for FY21 were withdrawn at the start of the pandemic due to the heightened uncertainty about the extent and duration of its impact on accounting income, cash rent collection and capital values. Although a good deal of uncertainty remains, we believe it is now reasonable to make tentative forecasts, supported by published cash rental collection data, the Q120 performance and recent trends in market valuations. However, we note that our confidence in these forecasts is lower than normal and that the actual results could be materially higher or lower in several respects.

The factors that will determine future rental income include:

For FY21 we have assumed that:

FY21 IFRS rental income is thus assumed to be £37.8m, before the £1.6m of assumed provisioning against rent receivables (included in expenses) compared with £40.0m in FY20.

In some instances, the assumed aggregate £1.6m provisions taken against rents receivable may represent concessions with occupancy and rent income continuing, but in most cases we would expect a reduction in contracted income and a decrease in occupancy until such time as re-letting occurs. This implies an end-FY21 annualised rent roll of £36.9m compared with £40.5m at the start of the year.

Our FY22 forecast assumes an improvement in contracted passing rent to £38.4m by end-FY22 driven by a recovery in occupancy.

Taking account of recent market trends and the unusually wide range of market forecasts, Exhibit 5 shows our best guess at capital value movements across the market for FY21 and applied to the Custodian portfolio as at end-FY21. Our assumptions imply a relative stabilisation in valuation movements throughout the balance of FY21 following sharp declines in Q420 and Q121 (Exhibit 4 above) but given the level of uncertainty are best treated as an illustration. For FY22 we see the possibility for some improvement in valuations if market conditions return to a more normal situation; however, given the uncertainty that remains we have for now assumed flat capital values in FY22.

Based on these assumptions our forecast end-FY21 EPRA NAV per share is 94p (FY20: 102p and Q121: 95p). Alternatively, each 1% increase/decrease in the total portfolio value is equivalent to an increase/decrease in EPRA NAV per share of c 1.3p. For the end-Q121 EPRA NAV (95p) to fall to match the current share price (86p) would require a c 8% reduction in the end-Q121 portfolio value.

Based on our income assumptions we expect Custodian to increase the level of quarterly DPS payments in the second half of the year and our 4.2p aggregate FY21 DPS forecast assumes quarterly declarations of 1.15p per share in Q321 and Q421 after 0.95p per share in both Q221 and Q221. At 4.2p the aggregate DPS is 1.3x covered by our forecast EPRA earnings; for DPS to be covered by net cash receipts requires 82% of IFRS rental income to be collected.

Our income assumptions for FY22 imply further scope for DPS to increase and we assume a return to aggregate DPS of 5.6p for the year. At this level DPS is 1.10x covered by EPRA EPS and with collection of a part of the FY21 deferred rents continuing into FY22, the cash cover of DPS should be higher.

Our forecasts are shown in detail in Exhibit 8 and a summary is shown in Exhibit 6. For FY21 we show a comparison with our pre-pandemic forecasts, withdrawn in March 2020. We provide FY22 forecasts for the first time.

Our forecast 4.2p FY21 DPS represents a 4.9% prospective FY21 yield (or 4.4% based on the current quarterly rate of DPS of 0.95p or 3.8p annualised). If DPS further increases to 5.6p in FY22 as our forecasts indicate, the prospective FY22 yield is 6.5%. Meanwhile, the c 10% discount to the Q121 NAV compares with an average c 8% premium since IPO in March 2014.

In Exhibit 6 we show a summary performance and valuation comparison of Custodian and what we consider to be its closest diversified income-oriented peers. 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; most companies have reduced DPS payouts for the time being and it will take some time before the full-year prospective DPS outlook becomes clearer and a true comparison can be made. We also note that the historical data does not reflect our expectation that Custodian’s quarterly DPS will increase later in the year. We believe the slight outperformance of CREI shares versus the peer group over the past 12 months and its higher P/NAV in part reflects its focus on smaller lot size properties with a yield premium that supports income returns and dividend paying capacity without additional risk/costs, as well as low gearing, and the company’s track record of income generation.