Custodian REIT — Strong H122 returns and further DPS growth

CREI’s investment strategy is differentiated from most of its peers by a principal focus on properties with smaller individual values (‘lot sizes’) of less than £10m at the point of investment. On average, properties of this size provide a yield premium over larger assets, in part the result of a broader range of potential occupiers while attracting less competition from larger institutional investors.

The portfolio has grown from c £95m at IPO in 2014 to c £565m at end-Q222 and, we estimate currently c £605m on a pro forma basis including subsequent activity, primarily the completed acquisition of Drum Income REIT portfolio. Growth has been achieved through selective individual property acquisitions, which remain CREI’s preferred route, but also strategic portfolio acquisitions, like Drum. CREI seeks further accretive acquisitions to take advantage of opportunities that have arisen due to the pandemic and build additional scale efficiencies. The latter arise from spreading fixed costs (under upwards pressure across the sector from regulatory and ESG requirements) over a wider income producing asset base. As Exhibit 1 demonstrates, in the three years up to the pandemic, market conditions had made it increasingly difficult for CREI to identify attractive acquisition opportunities that met its investment criteria, but this has now begun to change.

Including Drum, year to date purchases have been substantially matched by disposals and with low gearing we expect further acquisitions (our estimates allow for c £30m). Activity has been broadly spread across sectors with disposals primarily directed at mature assets, freeing capital for recycling. CREI booked £4.2m of disposal gains in H122 and we estimate additional gains of c £2.4m have been generated in Q322.

CREI’s agreed acquisition of Drum Income REIT’s portfolio (Drum1) became effective on 3 November 2021. Consideration for the acquisition was settled by the issue of c 20.2m new CREI shares, calculated on an ‘adjusted NAV-for-NAV basis’ with each company’s 30 June 2021 net asset value (NAV) being adjusted for respective acquisition costs. Drum shareholders received 0.53 new CREI shares for each Drum share, representing an agreed purchase price of £43.5m (before adjustment for lease incentives) or, we estimate, £42.0m after lease incentive costs. This compares with a 30 June valuation of £47.5m (after lease incentive costs) or £47.8m including subsequent revaluation.

As a result of the agreed acquisition discount to Drum’s portfolio value, we expect CREI to report a Q322 valuation uplift in respect of the assets acquired of c £5.8m. Net of costs we expect a c 1p per share uplift in CREI’s EPRA NAV per share.

Custodian REIT shareholders represent c 95% of the enlarged share count and Drum shareholders c 5%. The new CREI shares issued to Drum shareholders are entitled to the CREI DPS for the three months to 31 December 2021 (Q322), yet to be declared but targeted by CREI at 1.375p.

CREI and Drum are a good fit, with both companies focusing on smaller lot size regional commercial property assets, and both aiming to provide shareholders with an attractive level of dividend, fully covered by earnings.

Drum had struggled to grow since it was launched in 2015 by Seven Investment Management (7IM). With a market capitalisation of c £20m in early August 2021, before the possibility of an offer by CREI was first announced, it was sub-scale while a significant discount to NAV precluded share issuance. Share dealing liquidity for shareholders was limited by c 69% of its shares being controlled by 7IM on a discretionary basis on behalf of retail investors. As a result of acquisition by CREI, former Drum shareholders benefit from improved liquidity, greater portfolio diversification and increased scale, reflected in lower ongoing charges.

With the acquisition structured as a corporate transaction no Stamp Duty Land Tax was payable, representing a saving of c £2.1m compared with an equivalent property transaction. CREI anticipates it will retain the vast majority of the Drum assets acquired given their complementarity to its existing portfolio. There are no integration risks to the transaction as CREI has effectively acquired the Drum portfolio, with no employees and the old management contract terminated.

The Drum portfolio comprises 10 regional properties. Of these, five are offices and three are retail parks, along with an industrial estate and a shopping centre, for which 40% of rents are accounted for by Sainsbury’s. Of the 78 tenants, the largest is Skills Development Scotland, accounting for c 14% of rents. EPRA occupancy at acquisition of 86.1% (CREI at end-Q222: 91.6%) demonstrates the income potential from asset management initiatives, also reflected in annual rents of £3.6m compared with an estimated rental value (ERV) of £4.4m.

Although UK commercial property market returns have historically shown significant cyclicality, the income component has been much less volatile than capital values. CREI’s income-focused strategy has consistently generated positive annual total returns. Quarterly returns have been positive in all periods other than the first half of calendar 2020 (fiscal Q420 and Q121) when pandemic uncertainty was at its height. Even during these quarters, dividends continued to be paid (income returns were positive) albeit at a reduced rate. From listing in March 2014 to September 2021 (H222), CREI generated an EPRA NAV total return (without assuming reinvestment of dividends paid) of 52.7%, or a compound annual average return of 5.8% pa. The income return (dividends paid) was 44.7% over the period, c 85% of the total return.

Returns have been strongly positive in the first two quarters of FY22, driven by increasing property valuations and higher dividends paid. Exhibit 6 shows the development of H122 NAV, which increased by 8.3% to 106.0p. Including DPS paid the H122 NAV total return was 11.7%, an annualised rate of well over 20%. Realised and unrealised property revaluation gains (net of acquisition costs) generated the NAV increase while EPRA earnings of 3.0p covered DPS paid. DPS paid during H122 included both the fourth interim DPS for FY21 (1.25p) and the fifth ‘top up’ interim DPS declared at year-end (0.5p) as well as the Q122 DPS of 1.25p.

With rental income and EPRA earnings robust, increasing DPS since the second half of calendar 2020 has been the result of improving rent collection. In H122, 95% of expected cash rental income (net of contractual rent deferrals) was collected. Within this, the collection of rent deferrals from prior periods significantly exceeded deferrals agreed in the period. Outstanding rental income remains the subject of discussion with various tenants. Although some arrears are potentially at risk of non-recovery from CVAs2 or pre-pack administrations, we would expect a partial recovery of outstanding rents over time.

Balance sheet provisions for outstanding rent receivables reduced by £90k to c £2.9m. Net of write-offs, the income statement charge was £77k, well down on £2.9m in H121 and £0.7m in H221.

Over recent months, UK commercial property market returns have continued to be driven by the industrial sector. With limited supply and strong demand, encouraged by the accelerated shift to online purchasing and supply chain concerns, capital values and rents continue to grow strongly. The office sector has shown signs of benefiting from the gradual ‘return to the office’ and has delivered modest rental growth and relatively flat capital values. The retail and leisure sector has shown a significantly slower decline in rental values, while capital values have begun to improve from the previous steep decline, but performance varies markedly across sub-sectors. Retail warehouse assets have seen good growth in capital values, benefiting from restricted supply, generally free parking and the convenience that is complementary to growth in online sales, both for click-and-collect and customer returns, while high street locations continue to suffer from excess supply.

CREI’s portfolio valuation movements reflect these market trends, with its strong weighting of industrials and retail warehouses being particularly beneficial. Asset management initiatives (such as lettings, lease renewals, and regears) added £2.3m.

Exhibit 9 shows the H122 results in detail. In particular we highlight:

Our last forecasts were published in our June Outlook note, and these are revised for CREI’s upwardly revised DPS guidance, continued growth in portfolio valuations and NAV, and property transaction activity, most notably the Drum acquisition.

There are no material changes to our FY22 and FY23 EPRA earnings and EPS forecasts. We continue to forecast a faster increase in FY22 and FY23 DPS than the minimum guidance given by CREI (at least 5.25p in respect of FY22 and at least 5.5p in respect of FY23). Property valuations have increased at a much stronger rate in H122 than we had allowed for, and we expect further gains, including from the Drum portfolio, acquired at a discount to fair value. We have introduced tentative FY24 forecasts.

Our forecasts for net rental income include the portfolio activity discussed above, including the Drum acquisition, but also assume an additional £30m of acquisitions (at a 6.5% net initial yield) as CREI re-gears its expanded equity base closer towards its 25% medium-term loan to value (LTV) target (with a maximum 35%). The assumed acquisitions add c £2.0m of annualised gross rents, with a full impact in our FY23 forecasts.

The company’s minimum aggregate DPS target for FY22 of 5.25p represents a prospective yield of 5.4% while our forecast represents a yield of 5.7%. For FY23, our forecast DPS of 6.0p is ahead of the minimum set by the board of 5.5p and represents an FY23 yield of 6.2%. We forecast further DPS growth in FY24.

Recent share price performance has not kept pace with the growth in NAV and the c 8% discount to Q222 EPRA NTA is well below the average c 5% premium since IPO in March 2014. Until the pandemic, CREI shares had traded consistently above NAV, and regained this level in mid-2021, allowing the company to respond to investor demand with the issue of 550,000 shares at a 5.9% premium to the prevailing adjusted net asset value under its tap facility. More recently a discount has re-emerged that in part follows the wider sector trend. It may also reflect CREI’s inability to market its shares during the Drum offer period due to the Takeover Code and perhaps some former Drum shareholders taking advantage of the enhanced liquidity that CREI shares provide. CREI is now free to market its shares once again while we would expect most former Drum shareholders to welcome the increased diversification and lower cost ratio that CREI shares offer, in addition to enhanced liquidity.

In Exhibit 13, we show a summary performance and valuation comparison of CREI and what we consider to be its closest diversified income-oriented peers. CREI’s share price performance is below the peer group average over 12 months, in part reflecting the fact that it had been more stable during the pandemic sell-off. For comparative purposes, the valuation data are shown on a trailing basis so do not capture the prospective increase in CREI’s DPS. Factors supporting CREI’s valuation include its strong commitment to dividend payments (quarterly dividend payments were maintained during the pandemic, albeit at a reduced level), moderate gearing and a focus on smaller lot size properties with a yield premium that has historically supported risk-adjusted income returns.