Strong H122 with good growth potential

Picton Property Income reported strong results for the six months ended 30 September 2021 (H122). Including strong property revaluation gains, the IFRS profit 1of £53.9m was the highest that it has ever recorded for a six-month period. Excluding revaluation gains, operational progress, including an increase in occupancy to 93%, supported growth in recurring EPRA earnings and dividends. At the portfolio level, the total property return (income and capital growth) of 9.0% was above the 7.6% returned by MSCI UK Quarterly Property Index, as it has been over one, three, five and 10 years and since inception.2 Performance has been top quartile in each of the seven years ended 30 September 2021. At the company level, the accounting total return (or NAV total return)3 was 10.2%. The H122 operational momentum and the recent accretive £13.1m acquisition of a multi-let industrial estate, funded with low-cost flexible debt, will support H222. Reversionary income potential embedded in the portfolio remains significant at c £9m, while a low 21.9% loan to value ration and further undrawn debt of £36m leaves Picton well place for further inorganic growth.

We highlight the key features of the H122 results:

Financial results underpinned by strong track record of portfolio performance

At the portfolio level Picton has built a strong and consistent track record of outperformance versus the MSCI UK Quarterly Property Index (‘the index’), generating above index income returns and total property returns on an ungeared basis over the one, three, five, seven and 10 years (to 30 September 2021). Performance has been top quartile compared with the more than 200 portfolios that comprise the benchmark in each of the seven years ended 30 September 2021.

Among the factors supporting this strong performance, we note:

Exhibit 5 shows a summary of Picton’s portfolio at 30 September 2021 (end-H122). The c £745m valuation4 reflected a net initial yield of 4.5% and a reversionary yield of 5.9%. During H122 a non-core retail asset was sold for £0.75m (16% ahead of the end-FY21 valuation) and shortly before the period end the £13.1m (before costs) acquisition of a city centre industrial estate in Gloucester was completed. Adjusted for these transactions and £4.4m of capex the like-for-like gain in valuation was 7.4%, driven by the strength of industrial property combined with leasing and asset management activity. Since end-FY21, occupancy increased from 91% to 93%, the result of strong tenant retention and new lettings. Lease transactions have on average been ahead of the March 2021 ERV5, while ERV has continued to grow. New lettings added £2.2m pa to contracted rent roll at average 2.2% above ERV. Lease renewals/regears retained £0.3m pa of rents with an average 5.4% uplift over ERV. Completed rent reviews secured a £0.1m pa uplift, 10.8% above ERV. Overall, annualised contracted rent roll increased from £36.5m in March 2021 to £38.3m, including a 3.2% like-for-like increase. Total ERV increased from £45.4 to £47.2, including a 1.9% like-for-like increase.

Just before the end of H122, Picton acquired the Madleaze Trading Estate, which is well positioned in central Gloucester, adjacent to the Gloucester Quays Retail Park and the Gloucester and Sharpness canal. It comprises 18 industrial units let to eight occupiers with two units vacant and under refurbishment for re-letting. Rents of £2.74 per sq ft are affordable and the capital value a low £44 per sq ft, well below the estimated reinstatement cost. The rental income of £0.75m pa is included in H122 contracted rent roll (but with no material contribution to H122 income) and reflects a net initial yield of 6.1%. Rental income is expected to increase to £0.86m pa once the estate is fully let, and further still as rents are reset to market levels over the medium term.

On a smaller scale, a non-core retail asset was sold for £0.75m, 16.3% ahead of the March valuation.

Over recent months, the 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 benefitting from the gradual ‘return to the office’ and has shown 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. Leisure assets have benefitted from the removal of lockdown restrictions but within retail, shopping centres and high street locations continue to suffer from excess supply. 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.

Picton’s portfolio remains strongly weighted towards industrial property (c 56% by value compared with c 33% for the index6) and significantly underweight in retail and leisure (the c 11% weighting is less than half the index weight. Picton’s office exposure of c 33% is slightly higher than the index (c 28%). In line with broad market trends, industrials continued to drive H122 performance, although each of the broad sectors showed positive like for like valuation movements. In retail and leisure, Picton benefitted from strong growth in retail warehouse valuations (c 7% of the portfolio and almost two-thirds of its total retail and leisure exposure).

Significant potential within the existing portfolio

The end-H122 ERV of £47.2m was £8.9m, or 24%, ahead of the annualised contracted rent roll of £38.3m. Void reduction represents £3.5m of the potential upside, with the balance comprising the upside from lease incentive run-off (c £2.8m) and the potential to increase existing rents to market levels at lease expiry (c £2.6m).

By sector, the greatest potential is within the industrial and office sectors. With occupancy close to full in the industrial sector, the upside is from reversion to market rents (which continue to increase) while in the office sector there is considerable upside from void reduction. In retail and leisure there is scope to increase occupancy, although on average contracted rents are above ERV. Which is likely to put pressure on average rent levels.

Although occupancy continued to increase during H122, it remains below the longer-term trend. In part this reflects asset management and a deliberate refurbishment in recent years, but the pandemic has slowed letting, particularly in the office sector. The top five voids within the portfolio account for more than 70% of the total, most of which represents current or recently completed office refurbishments.

Financial flexibility for acquisitions

Funding for the recent industrial estate purchase was provided from Picton’s revolving credit facility (RCF) with a cost of 1.5% pa plus Libor (c 1.6% in total). The spread between funding costs and the net initial yield of 6.1% makes the acquisition clearly accretive to earnings. With a low c 22% loan to value (LTV) ratio and a further £36m available under the RCF, Picton is well positioned for further accretive acquisitions. Its approach to acquisitions is typically opportunistic within the goal of maintaining a diversified structure and management indicates that assets from any of the main sectors will be considered based on their attractiveness, especially in areas where rental growth will offset inflationary concerns.

The UK commercial real estate sector saw considerable share price weakness at the start of the pandemic and although the market has substantially recovered since, many UK listed commercial property companies have continued to trade at a material discount NAV (Exhibit 15 below). In combination with well-publicised issues in unlisted property funds,7 Picton identifies an opportunity for the market consolidation, to generate economies of scale through the removal of duplicated management costs, improved liquidity and greater overall efficiency. With its strong track record of property performance and a scalable internalised cost structure, Picton appears well paced to create additional shareholder value by increasing the size of its portfolio. Although it is often difficult for all parties involved to reach agreement on such transactions, we note that Drum Income Fund was recently agreed acquired by Custodian REIT in an agreed transaction and Yew Grove REIT has recently agreed to an acquisition by Slate Office REIT.

We have increased our forecasts for EPRA earnings (particularly for FY22) and NAV/EPRA NTA, with the recovery in occupancy and property values coming through faster than we had assumed. Quarterly DPS has increased once during FY22 but is running below the level we had previously assumed, despite earnings being higher. We continue to forecast further increases in H222 and again in FY23, with the FY23e DPS representing a new high level.

Our forecasts, shown in detail in Exhibit 15, are based on an unchanged portfolio (but include an impact from the late H122 industrial estate acquisition). The company continues to monitor potential accretive acquisition opportunities and with modest gearing and undrawn borrowing facilities is well placed to fund these, a potential uplift to our forecasts.

Forecast growth in gross rent roll is driven by reversionary capture in industrial and void reduction in offices, partly offset by rent pressure in retail, where for some properties, current rents are above market levels. At the group level we look for annualised rent roll to increase from £36.5m at end-FY21 to £38.2m (previously £37.7m) at end-FY22 and £40.5m (previously £39.3m) at end-FY23. We estimate this implies an increase in portfolio occupancy from 93% at H122 to 95% by end-FY23.

We forecast an increase in Q422 DPS from 0.85p per share to 0.9p per share and for this to be maintained throughout FY23. At 3.6p the aggregate FY23e DPS would be above the pre-pandemic level of 3.5p. We forecast FY23 dividend cover of c 1.1x.

For Picton and across the market, to varying degrees, each of the main sectors showed positive capital value movements in the six months to end-September 2021.8 We forecast further growth in capital values for Picton, driven by increased occupancy and contracted rents. The H122 like-for-like gain in values was 7.4% and net of capex and acquisition costs the gain per share was c 8p. Our forecasts include like-for-like gains of 2.3% in H222 (a net 2.5p per share) and 5.1% in FY23 (5.6p).

We estimate that each 1% increase/decrease in the total portfolio value is equivalent to an increase/decrease in EPRA NTA per share of c 1.5p.

Although total-return driven, Picton puts a strong focus on sustainable dividends, fully covered by earnings, at a level that provides the financial flexibility to pursue asset management initiatives. These are aimed at enhancing asset quality, occupancy, rental income and capital values, and medium-term value creation. Quarterly dividend payments were consistently maintained at the height of the pandemic and during lockdown, but at a reduced level. As uncertainty about rent collection eased, increased quarterly DPS payments were declared in Q221 and Q221 and increased again in Q122. The current annualised rate of 3.4p has almost returned to the pre-pandemic level of 3.5p. With 121% cover by EPRA earnings in H122 and improving prospects, we forecast further increases.

Combining growth in EPRA NTA per share with DPS paid over the past five and a half years (to 30 September 2021/end-H122),9 Picton has generated an aggregate NAV/EPRA NTA total return10 of 59.4% or a compound annual average return of 8.8% (without assuming reinvestment of dividends paid). Our forecasts imply a total return of 8.1% in FY22 and 7.4% in FY23.

The current quarterly run rate of DPS (3.4p) represents a 3.5% FY22e yield. While the current P/EPRA NTA per share (H122: 105p) of 0.94x shows a significant recovery from early 2020, as pandemic uncertainty was at a high, and is now in line with the five-year average of c 0.94x, it remains below the high of c 1.1x.

Exhibit 14 shows a summary performance and valuation comparison of Picton and what we consider to be its closest diversified income-oriented peers. Over 12 months, Picton’s share price performance is ahead of the group average, which shows a wide spread of performances, and the broad UK property sector and UK equity market. Picton shares trade on a lower yield than the group average while its P/NTA is above average. The factors that support this valuation include the company’s strong track record of property level performance, the future income and valuation growth potential embedded in its portfolio and its strong balance sheet with relatively modest gearing.