Circle Property — A strong harvest continues

Circle Property delivered another strong result in FY18. Lettings successes across recently refurbished assets drove income growth and valuation gains, reflected in a further increase in dividends and a 25% rise in NAV per share. NAV per share has now increased by 54% since Circle listed in February 2016. Momentum has continued into the current year, with significant further lettings progress already achieved since year-end, but with considerable potential income reversion to estimated rental value remaining.

The key highlights of the FY18 results were as follows:

Circle provided a confident outlook statement, anticipating further growth from the capturing of reversionary potential in the portfolio and from letting the remaining space from recently completed refurbishments. It is engaged in advanced negotiations with multiple potential occupiers for 36 Great Charles St, Birmingham, and K2 Kents Hill Business Park, Milton Keynes. Management expects that the current provincial occupier demand for office space will continue, and that investment yields for good quality, well located, and securely let properties will firm further as supply remains tight. Against this backdrop, Circle will continue to actively manage its existing assets but has also increased its focus on finding additional opportunities to replenish its development pipeline, targeting assets with added value potential where the location and proven demand justify the development risks.

Circle is an internally managed property investment company registered in Jersey. It was initially founded as a limited partnership in 2002, became a Jersey Property unit trust (Circle Property Unit Trust or CPUT) in 2006, and has been quoted on AIM since February 2016. The company actively manages its assets, targeting well located regional office property where it has identified a clear opportunity add value, placing an emphasis on total returns rather than maximising short-term income.

Circle’s senior management team includes two full-time property professionals and the company is governed by a highly experienced board. Together, the management and board own approximately 24% of the company, closely aligning their interests with external shareholders. The company has a strong track record of NAV total returns both before and after IPO. In the 10 years to FY16 (the year of IPO), a period including the aftermath of the global financial crisis, it generated an average annual total return of more than 7.5% pa. Since IPO, and until the end of FY18, the compound annual increase in NAV total return has been 26.2% (see Exhibit 7), with recent asset management initiatives being positively reflected in income and supporting growth in capital values.

The current portfolio of 17 assets is now valued at £114.1m (31 March 2018), of which 13 office buildings comprise 91%. All the assets but one (an office property in Moorgate) are outside London. Significant refurbishment programmes have recently been completed at three of the assets, and we expect the continued letting of these to further significantly increase rental income and capital values.

Circle targets well located short-let, or part-let if the letting prospects are sufficiently strong, primarily office properties in the UK’s provincial cities where it can add value by undertaking lease renewals, rent reviews, lettings and refurbishments. Acquisitions are typically at close to vacant possession value, which allows management to use its expertise to undertake cost-efficient refurbishment and development to maximise reversionary rental values and secure new leases on the properties. Once the process of refurbishing an asset is underway, management will seek to attract tenants quickly with competitive rents in order to beat local competition, but still aims to achieve attractive yields. In this way, management seeks to increase both rental income and capital values. The company will dispose of properties that are not considered to have further potential and where an attractive price can be struck. The board’s strategy is to deliver annual total returns over 12% through targeting returns at the property level of at least 15% on the costs of development expenditure and acquisitions.

Although Circle seeks a diversified exposure to UK commercial property, its portfolio is currently weighted towards offices (91%), where management has identified attractive opportunities in current market conditions, and is relatively concentrated by number of properties (17), which partly reflects the very hands-on nature of its asset management strategy. Reflecting the number of properties, but also management’s focus on areas where it expects letting prospects to be strong, there is a geographic bias towards Milton Keynes, Birmingham and Bristol, in aggregate 77% of the portfolio value. Details of each of the properties can be viewed on the company’s website here.

The tenant base provides an additional level of diversification. There are currently 52 tenants, including regional SMEs, national partnerships, and listed companies from both the FTSE250 and FTSE100. The largest tenant is Compass Contract Services, which leases office space at Circle’s largest asset, Kents Hill Business Park in Milton Keynes. The Compass lease accounted for a significant 22.6% of end-FY18 rent roll but is long duration (25 years at inception, with a break at 15 years subject to a £2m penalty, with 23.5 years remaining), agreed by Circle after it acquired the property on a short lease in 2013. Other principal tenants include Which? Financial Services (4.9%), B&M Retail (4.1%) Grant Thornton (3.7%), and New World Trading (3.6%), although much of the portfolio is multi-tenanted. Circle has been focusing properties that are capable of subdivision to provide smaller office suites of up to 5,000 sq ft, more attractive to local professionals and SMEs that may well prove less prone to the uncertainties posed by Brexit.

The weighted average unexpired lease term (WAULT) to first break was 7.2 years at end-FY18 or 10.5 years to lease expiry.

As noted above, core occupancy within the stabilised portfolio is high at c 99%. The remaining unoccupied space within the portfolio is represented by recently completed significant refurbishment projects. Since end-FY18, Circle has let the entire office space at Somerset House in Birmingham (36,300 sq ft) and we estimate that the remaining void space at the recently refurbished 36 Great Charles Street, Birmingham and K2 Kents Hill Business Park, Milton Keynes (one of eight buildings on the site) to represent c 8.4% of the portfolio total (by lettable area). Management says that each of these properties has been well received in the letting market and that it is engaged in advanced negotiations with multiple potential occupiers.

With a current contracted rent roll of c £7.6m (the end-FY18 rent roll of c £6.8m adjusted to include the recent Somerset House letting), there remains considerable upside to the end-FY18 estimated rental value (ERV) of c £9.9m. Of the c £2.3m of potential upside, we estimate that c £1.1m relates to the letting of 36 Great Charles Street and K2 Kents Hill Business Park and the balance to capturing reversionary potential on the wider portfolio through lease renewal.

Despite some slowing of UK economic growth, continuing Brexit uncertainty and a significant retracement of the boost to export competiveness that resulted from post EU-referendum sterling weakness, regional property markets have remained in good health over recent months. In general, across the regional markets, a positive occupational demand–supply balance continues, although there are indications that in some instances letting decisions are taking longer to execute. Regional markets continue to benefit from structural factors such as business relocation away from London, office conversion to residential use and a relative lack of new development in the years following the financial crisis. Circle management comments that it sees no sign of the trend of diminishing office supply across the regions abating. As a result, regional office rents are growing, but from affordable levels following a number of years of decline in real terms, and in many cases remain below the threshold necessary to bring forward new development. From an investment viewpoint, market data suggest that regional offices continue to represent attractive yield compared with London, and that regional secondary office yields have room to tighten further versus prime. As a result of investor demand, the average yield spreads between the regional and London offices has continued to narrow, but remains wider than it was before recovery took hold in the London market in 2009, and is similar to the longer-term average. As London recovered, the spread of secondary over prime yields narrowed steadily, while the recovery in the regions was later to take hold such that the regional spread of secondary over prime yields remains wide, despite more recent tightening.

The UK commercial property sector as a whole has recovered strongly since the financial crisis of 2007/8, but current conditions do not appear to indicate that the regional markets face any imminent risk of another significant cyclical correction. In addition to the relative lack of speculative new building and affordable rents, interest rates have remained low, and there is a stronger banking system less exposed to real estate lending.

Circle has an experienced and highly motivated board of directors, including the small team of executive directors that provide the internal property management. The executive directors have many years of experience in real estate asset management, and their extensive range of contacts has proven useful in providing access to less competitive off-marker acquisition opportunities. By managing the portfolio internally, Circle has direct control of costs (there is no NAV-linked annual management fee) and should benefit from economies of scale as the portfolio grows in size. Administrative and financial management services are provided externally by Consortia, the Jersey licensed trust and fund services company, which was paid £252k in fees in FY18, a similar amount to FY17.

Circle CEO John Arnold was one of the founders of Circle LP in 2002, the limited partnership forerunner of the company, along with James Hambro and John Bodie. The COO, Edward Olins, joined Circle in 2006 when Circle Property Unit Trust was created by way of acquisition of the Circle LP assets. Biographies for both can be found on page 14.

Including the CEO and COO, the board comprises seven members and is led by the non-executive chairman Ian Henderson (see page 14). Ian Henderson is widely experienced in the property industry and was formerly chief executive of Land Securities. The non-executive directors are Timothy Scott Warren, James Hambro, the Duke of Roxburghe and Michael Farrow. As noted above, James Hambro was one of the founders of Circle LP and remains a significant shareholder in the company. The Duke of Roxburghe was an investor in CPUT and remains a significant shareholder in the company. Both Tim Scott Warren and Michael Farrow have extensive financial services experience, and both are directors of Consortia Partnership.

The directors’ interests in the shares of the company, including family interests, amounts to c 6.8m shares or a little under 24% of the total. The percentage of shares not in public hands, as defined by the AIM rules, is 36.5%, and also includes extended family interests that not included within the 24% figure.

In addition to their direct ownership in Circle, there is a performance-related LTIP under which the executive directors can earn bonuses of up to 100% of their salaries in nil cost options to acquire ordinary shares in the company. These are granted annually dependent on performance: a combination of total shareholder return (share price movement plus dividends) and total NAV return (NAV change plus dividends) is measured. The first is compared to a basket of peers selected by the Nomad (Peel Hunt) and the second is based on hurdle rates. If the performance is below the median, no awards will be made; if Circle reaches the median, a bonus equivalent to 50% of salary is earned, increasing to a maximum of 100% proportional to performance.

The end-FY18 NAV share of 230p was ahead of our 227p forecast and well ahead of the 214p that we had been forecasting prior to the trading update issued by Circle on 26 April. In the update note that we published in May, we left our recurring income earnings for FY18 unchanged, pending the detail of the full-year results. Net rental income was reported c 7% ahead of our forecast and adjusted net profit 28.0% ahead. Adjusted net profit benefited from a positive tax result, and the adjusted PBT beat versus our forecast was a little lower, at c 5%, with some additional administrative expense partly offsetting the income growth. DPS growth was also ahead of our forecast.

For FY19, we have increased our net rental income forecast by just over 9%, reflecting faster leasing progress than we had previously allowed for, and our adjusted PBT forecast by just over 10%. The increase in forecast adjusted earnings is just under 2%, with the FY18 tax credit being replaced by higher than previously assumed tax charges (see below). We have introduced a forecast for FY20 for the first time.

Our new forecasts now specifically include much of the upside from further letting of recently refurbished assets, whereas this was previously captured by a sensitivity analysis. The reasons for this are:

The key forecasting assumptions that we have made are as follows:

The further letting progress that we now assume in our forecasts has a material impact on our forecasts, particularly in FY20. If we were to assume no further letting over the period (other than the already concluded Somerset House let), then FY19 and FY20 adjusted earnings would show only modest growth on FY18 with adjusted EPS of 9.1p and 9.2p, respectively. The valuation gain impact on NAV would also be lower as discussed above.

Over and above the successful letting of 36 Great Charles St and K2 that is contained with our revised forecasts, there remains additional reversionary potential of £1.2m.

Given the relatively high current occupancy on the stabilised assets, and the c 98.5% occupancy across the whole portfolio implied by our forecasts, capturing this additional reversionary potential will depend very much on successful lease renewals and renegotiations as they occur.

We also note that it remains management’s intention to grow the portfolio through acquisition, in particular to replenish its pipeline of development/refurbishment opportunities, with the added benefit of potential for scale economies. There is a modest amount of headroom (c £3m) in the current borrowing facility and the year-end cash balance was c £2.6m, but for more significant acquisition opportunities we would expect Circle to consider part-funding with equity. This would additionally provide support for management’s aim to broaden the shareholder base and increase share trading liquidity.

Circle Property and its two property owning subsidiaries, CPUT and Circle Property (Milton Keynes) Limited (CPMK), are all registered in Jersey. CPUT is not liable for tax in Jersey, and the Jersey tax rate applied to rest of the group is 0%. Circle is registered under the UK’s Non-Resident Landlord Scheme and is liable to UK tax on its net rental income at a rate of 20%. The effective rate of tax since listing has been much lower, primarily benefiting from capital allowances. The UK Government has proposed changes that, if enacted, will affect the tax position of Circle. The first is that non-resident landlord companies are to be brought into the scope of UK corporation tax rather than income tax, from 1 April 2020. Additionally, from 1 April 2019, capital gains made by a non-resident on the disposal of commercial property will be subject to UK tax.

These proposed amendments have not yet been enacted and, as a result, Circle says that it is not yet possible to determine precisely their likely impact. Some income-focused companies that expect to be negatively affected by the proposed changes (eg Picton Property Income and UK Commercial Property Trust) have decided to convert to UK REIT status so as to mitigate the effects. Circle management indicates it is not considering REIT conversion, as the distribution rules would potentially inhibit the execution of the company’s total return strategy.

In FY18, Circle recognised a tax credit of £535k, primarily as a result of capital allowances related to the refurbishment programme exceeding the tax liability on net rental income. Looking forward, any impact from UK Corporation Tax inclusion is likely to fall outside of our forecasting horizon, and we anticipate no realisation of capital gains during that period. We do, however, assume an increase in the effective rate of tax, to 12% in FY19 and 15% in FY20, as capital allowances should reduce with the current refurbishment programme now completed. We have assumed £1m pa of capex during FY19 and FY20, down from c £4m pa over the past two years.

For Circle, unlike a REIT, capital returns are expected to be a significant element of overall total returns, which we think is best captured by NAV total return (the change in NAV per share plus dividends paid per share). On this basis, NAV total return from IPO to end-FY18, a period of just over two years, has been an aggregate 60.9%, or a compound 26.2% pa, well above the minimum 12% pa targeted by management. Our estimates for FY19 and FY20 imply total returns of 15.1% and 7.4%, although there remains considerable scope for Circle to do better than this if market conditions remain favourable and it is successful in continuing to let remaining vacant refurbished space and capturing reversionary potential through lease renewals.

The significant growth in Circle’s NAV and adjusted earnings per share in the past two years highlights the difficulty of comparing it with the broader sector, including many companies that focus on recurring income generation rather than total return. As significant refurbishment projects have been completed and subsequent letting has progressed, the impact of rising income has had a geared effect on recurring earnings as well as property valuations and NAV per share. The timing of progress is not always easy to predict, and we have found ourselves steadily increasing forecast for Circle over the past year, rendering a static comparison with peers a less useful guide to the investment opportunity than our financial sensitivity analysis discussed above.

With that caveat, Exhibit 8 shows a price to NAV (last reported) comparison of Circle with a broad range of listed property companies. The Circle share price has improved noticeably in recent weeks, responding to positive newsflow, and at c 0.96x FY18 P/NAV has now moved closer to the broad sector median.

A similar comparison using prospective dividend yield not surprisingly, given Circle’s total return focus, positions it towards the lower end of the group, although its dividend cover is well ahead of group.

This broad peer group contains a wide variety of property companies, REITs and non-REITs, and specialist vehicles (healthcare property, student accommodation), and covers a wide range of strategies, from a pure focus on income and collecting rents to varying degrees of asset management and capital growth. In Exhibit 10, we show a summary valuation comparison of Circle with a more similar peer group of regional property investors, although this group also includes a similar broad range of income versus total return strategies.

The strong performance of the Circle share price relative to the peer group, the UK property index, and the FTSE All-Share stands out from Exhibit 10. Since we initiated coverage on 4 September 2017, the share price has risen by more than a third, but NAV per share and forecast DPS have also increased. The trailing P/NAV discount has narrowed from c 15% to c 4% over the period, and is now slightly above the peer group median. The prospective yield is slightly lower than when we initiated (c 2.9% versus c 3.2%) and remains below the peer group average, but dividend cover has increased and is among the highest in the group.

The annual compound NAV total return over the next two years (FY19 and FY20) implied by our forecast is 11.1%. The share of dividends in this total return is c 50%, and increase from c 25% since IPO.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but fluctuating with tenant demand and rent terms. We would also highlight the increased risks and uncertainties that attach to development activity, including planning consents, timing, construction risks and the long lead times to completion and eventual occupation. We consider the main sensitivities include:

Management risk: although supported by external service providers and experienced non-executive directors, Circle’s internal management team is relatively small (CEO and COO), and if a member were to leave, he/she would need to be replaced.

Stock issuance: the board continues to be committed to enlarging Circle’s capital and broadening its shareholder base in order to increase liquidity in the stock, and ultimately reduce further the share price discount to NAV, and to take advantage of continuing property acquisition opportunities.