Regional REIT — Well positioned for an office recovery

RGL performed well in FY21 despite a challenging backdrop for the office sector caused by the pandemic. Rent collection remained strong throughout the year and currently stands at 99.2%,1 underpinning income performance and uninterrupted quarterly dividends. The year saw substantial property transaction activity,2 reflecting RGL’s view that its industrial assets offered little remaining income upside compared with the opportunities that it could identify in the office sector. Regional offices offer relatively high yields, a combination of low rents and low capital values. The latter are well below new build costs and this 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).

The £236m acquisition of the Squarestone portfolio of primarily regional office assets and the sale of most of the remaining industrial assets achieved this aim and has added considerable scale, with an attractive initial yield and significant income growth potential. Regional office assets now represent c 90% of the portfolio and non-core assets, including the rump of the industrial assets, c 9%.

With the return to the office underway, RGL is optimistic about a recovery in letting activity that would enable it to capture some of the significant reversionary income in the portfolio and drive capital values higher.

Although now focused on the office sector, RGL’s rental stream remains highly diversified across a broad range of properties, tenants and industries, mitigating income risk in a still uncertain environment. All RGL’s debt is fixed or hedged, while over time commercial property sector rents have broadly tracked inflation

The Squarestone portfolio acquisition was covered in detail in our October update note. 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% at acquisition and reversionary yield of 11.0% there is significant opportunity to increase income over time.

With pandemic restrictions lifted, the return to the office is underway. A legacy of the pandemic will likely be a permanent acceleration in some of the trends that were already in place. 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 and Thursday) in the office and two days at home. RGL does not expect hybrid working 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. Hot desking 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 to be offset by a reduction in office density (the number of employees per square metre), 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. The experience of social distancing, driven by the pandemic, is only likely to reinforce this trend.

Leasing activity was challenging through FY21 but RGL is expecting a recovery that will enable it to benefit from strong reversionary income potential in its office portfolio.

Coming into FY21, 12-month lease expiries to first break were £16.2m or 26% of the rent roll. During the year, new lettings added £2.5m to contracted rents and c 59% of expiring income was retained, although on a like-for-like basis EPRA occupancy reduced from 89.5% at end-FY20 to 82.4% at end-FY21. The decline was magnified by some identified significant maturities towards year-end where it had previously been identified that the tenants would vacate to new premises. Coming into FY22, 12-month lease maturities to first break were £14.1m or c 20% of rent roll. An improvement in retention, back towards a more normal 70%, and/or an increase in new letting activity would see occupancy rebuild.

The externally estimated rental value (ERV) of the RGL’s office portfolio was £86.3m at end-FY21, £22.4m or 35% above contracted rents3 (EPRA occupancy 80.8%). The majority of this reversionary income potential (c £17m) relates to occupancy improvement and the balance relates to the gap between existing rents and ERV as well as lease incentive run-off.

RGL came to market in November 2015 targeting a higher yield portfolio that would provide progressive, regular dividends with the potential for capital growth. Active asset management and capital recycling are key elements in sustaining asset yields. RGL’s dividend yield has been consistently one of the highest in the sector and although DPS was reduced in FY20 as a result of the pandemic, quarterly dividends were maintained and have again begun to increase. Aggregate FY21 DPS of 6.5p was up 1.6% on FY20 (6.4p) and we forecast further growth in DPS in FY22 and FY23, fully covered by EPRA earnings.

With the exception of FY20 again, the accounting total return has been positive in each year since the initial public offering, amounting to 41.2% or a compound average annual return of 5.8%, all generated by dividends paid.

RGL’s secured debt portfolio is diversified across a range of lenders and is well spread by maturity with a weighted average of 5.5 years. RGL also has £50m of unsecured retail eligible bonds due to expire in August 2024. During FY21 RGL increased its borrowings to part fund the Squarestone portfolio acquisition, the majority of which was funded by a new club facility provided by the Royal Bank of Scotland, Bank of Scotland and Barclays.

It is RGL’s target to hedge at least 90% of the total debt portfolio using interest derivatives or fixed rate facilities and this currently applies to all debt, eliminating most interest rate risk, with a weighted average effective interest rate, including hedging costs, of 3.3% at end-FY21.

Exhibit 6 provides a summary of the FY21 financial performance.

Key features of the FY21 results included:

As Exhibit 7 shows, the FY21 results were very much as we had expected. There is a slight reduction to our FY22 and FY23 EPRA earnings forecasts, but EPRA NTA is increased slightly and DPS is unchanged, fully covered by EPRA earnings.

Our forecasts assume no net impact from acquisitions and disposals over the year, although both are likely.4 The driver of our forecasts is thus net rental income. Annualised contracted gross rental income increased 8% in FY21 to £72.1m from £64.2m, driven by net acquisitions and partly offset by lower occupancy. We expect a modest increase in contracted rent to £73.5m in FY22 and £75.6m in FY23, driven by an uptick in occupancy (to c 83% versus 81.8% at end-FY21) as the letting market begins to recover. Our forecasts show an increase in non-recoverable property expenses, but the full period impact of the increased portfolio masks a slight underlying reduction in line with the occupancy improvement.

We have assumed modest growth in property valuations of c 1% pa, driven mainly by occupancy improvement. RGL is hopeful of stronger growth including an improvement in external valuer sentiment as improving investment volumes provide more transactional evidence of underlying market valuations. We estimate that a 1% increase/decrease in the FY21e value of investment properties increases/decreases EPRA NTA by c 1.9%.

In Exhibit 8 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 high trailing FY21 dividend yield of 7.4% continues to be at the very top end of both this narrow peer group and the broad UK property sector (we estimate c 4.5% on a trailing basis), particularly in respect of covered dividends. This is reflected in a narrower discount to NAV of c 10% versus the peer group average of c 18%.