Palace Capital — Significant potential for income and capital growth

The six months ending 30 September 2018 (H119) may be viewed as a period of consolidation, following a year of significant developments that have prepared PCA for its next stage of growth. Last October, PCA completed the £68m acquisition of RT Warren, its largest portfolio acquisition to date, and management says the most attractive portfolio available to it in several years. Funding was provided by a £70m equity issue, and with the share capital enlarged, a move to the Main Market of the London Stock Exchange followed in March 2018. In June 2018, the shares joined the FTSE Small Cap Index and the FTSE All Share Index. H119 income grew strongly compared with H118, driven by the RT Warren acquisition, and capital values continued to increase during the period. EPS and dividend cover were depressed as a result of cash drag from the capital raise midway through H218, with only modest transaction activity as management maintained a disciplined approach towards acquisitions. The company has signalled no change to dividend policy, expecting income growth to restore cover as a result of ongoing asset management initiatives, leasing events providing the opportunity to capture some of the strong reversionary potential in the portfolio, and accretive acquisitions, potentially made easier by the recent heightening of Brexit uncertainties.

In a positive outlook statement, management points to the strong potential within the current portfolio to continue to extract value through income and capital growth. ERV is more than 20% above the current contracted rent roll. Heightened Brexit uncertainty may create additional opportunities to reinvest by cooling the investment markets, and meanwhile occupational demand appears robust. The regional office and industrial markets continue to benefit from supply and demand imbalances. The office sector (c 50% of the portfolio) is benefiting in many areas from continuing take-up, a lack of new development and the conversion of office space to residential use.

After many years of negotiation, PCA received optimal planning consent in August 2017 for the redevelopment of its two-acre site in York, within the city walls and just a minute’s walk from the York railway station. The scheme comprises three residential buildings and an office building, and will provide 127 flats, 5,000 sq ft of retail/restaurant space, 34,500 sq ft of offices, and car parking. Demolition of the site is nearing completion with a view to commencing construction in February 2019. Construction is expected to take around two years, with marketing commencing around the middle of 2019 and a website for the project has recently been launched (www.hudsonquarteryork.com). The York office market is strong and the city was recently voted by The Sunday Times as the best place in the UK to live (2018).

PCA has agreed heads of terms with a leading bank to finance the construction element.

Our base-case forecasts (extended out to end-FY21) capture the balance sheet impact of our estimate of the costs of development. For now, our base case estimates capture none of the capital or income uplift potential, although we provide a sensitivity analysis below.

Although PCA is yet to provide any firm guidance on the financial impact of the Hudson Quarter development, we feel it prudent to allow for our estimate of the costs of development that will be incurred over the next two years in our financial forecasts. Our assumptions for these costs, based on discussion with management, are shown in Exhibit 2 below. The existing site value, included within the current portfolio valuation, is c £16.8m, and we have allowed for construction costs of £35m. To fund the construction costs, we have assumed a development loan facility of similar size, to which we have applied a 4% margin over Libor to drawn amounts, and a 2% cost to undrawn amounts (to cover arrangement fees, facility fees, etc). We have assumed that development funding is drawn steadily over the two year construction period, with the interest costs capitalised.

The impact of our Hudson Quarter development assumptions on our base-case forecasts is to steadily increase the investment portfolio value (as development spending and capitalised interest are incurred) and the group LTV ratio including the development funding drawn. There is no impact on our income statement forecasts.

PCA is yet to disclose the development profit that it is targeting from the Hudson Quarter development, representing the gap between the expected post-completion market value (the gross development value, or GDV) and the total development costs (our estimate £54.4m). However, the potential positive impact on net asset value is significant. We expect PCA to retain the commercial building, and possibly some the residential assets, for the rental portfolio, with a positive impact on income earnings. The assets disposed of would crystallise any capital uplift and reduce gearing.

The potential value creation is very material in the context of the group, but due to the options for post-completion hold/sell strategies, and the uncertainties about GDV and rental value, it remains too early to build this into our base forecasts.

In Exhibit 3, we show the impact on our FY21e EPRA NAV per share from a range of assumed development profit margins, applied to our estimated costs.

In Exhibit 4, we illustrate our thoughts on the income and valuation potential for the Hudson Quarter commercial space in current market conditions. We believe that PCA is likely to retain this post-completion, and we estimate a rent potential of c £963k pa and a potential GDV of £15.6m (a blended yield of 6.2%). Based on this estimate, the commercial space has the potential to lift our base case FY21e rental and other income of £19.3m by c 5% on an annualised basis.

Notwithstanding the fact that PCA may choose to retain a part of the residential space, based on our estimates for the commercial GDV, and assuming a 20% overall development profit margin for the scheme (GDV £65.3m), a sale of all of the residential assets would reduce the base-case LTV for FY21 from 40.6% to c 29%. The proceeds from sale would allow for repayment of the development loan and an additional c £12m of bank debt. Exhibit 5 brings the impact of all of these assumptions on the base-case FY21e earnings and balance sheet together:

Clearly, there are risks attached to our analysis and to development activity in general. We have been explicit about the assumptions that we have made, but the actual outcome could differ materially from what we have assumed, especially at planned completion in 2021, when market conditions may have shifted. Development activity runs risks of cost overrun or delay, and the development activity is being undertaken on a ‘speculative’ basis, although we expect PCA to target pre-sales of residential space and pre-letting of commercial space well ahead of completion.

Our revised estimates are shown in Exhibit 6. The reduction in H119 rent roll to £17.4m has a negative impact on our forecast gross rental income, which, together with slightly higher non-recoverable property operating costs, reduces our forecast net rental income for the current year (FY19). This is the main driver of the reduction in forecast FY19 adjusted PBT, although much of the impact on adjusted EPS is offset by lower expected effective tax rate. Forecast EPRA NAV per share is slightly increased as a result of the H119 performance. Management has signalled an unchanged dividend policy, which we interpret to mean an unchanged DPS for the current year, and is confident of future income growth that will restore cover. As noted below, our base-case forecasts conservatively reflect only a part of this potential and we show a flat DPS progression accordingly.

Our key forecasting assumptions are as follows:

Palace is not a REIT and while it seeks to generate returns by growing recurring income it also has a parallel focus on increasing capital values. It has built a strong track record of value creation over a number of years, primarily driven by corporate acquisitions that additionally benefit from lower stamp duty and provide the potential to benefit from acquired tax losses and capital allowances. NAV total return in the five years from September 2013 (H114) to end-H119 is 126.1% or a compound 17.7% pa. We have begun the analysis at H114 because this corresponds to the acquisition of the Sequel portfolio, Palace’s first transformational acquisition. The negative total return in FY18 resulted from the share issuance to fund the RT Warren portfolio and captures none of the future asset management-driven value creation that management hopes to achieve from this, its largest portfolio acquisition to date.

Exhibit 8 shows summary valuation and performance data for PCA and a peer group of UK commercial real-estate investment companies with a strong regional focus. There has been a tendency for the share prices of those companies with a strong focus on income returns to show greater resilience over the past 12 months, particularly where dividend cover is also above average. The market’s valuation of capital-based returns has shown a tendency to weaken. PCA shares now yield more than 6%, among the highest in the group, and the P/NAV discount is also well above the peer group average. Given the strong track record of total return generation and the potential to drive further strong returns from the existing portfolio and through accretive acquisitions, the valuation appears particularly undemanding. Increasing investor awareness of PCA’s plans for the Hudson Quarter, its ability to fund the required investment and the scale of potential upside may serve as a catalyst for a re-rating of the shares.