Palace Capital — A year of significant development and growth

The year ended 31 March 2018 was one of significant development and growth for Palace, including the £68m acquisition of RT Warren, its largest acquisition to date, a £70m capital raise and a move to trading on the Main Market of the LSE. We reviewed these developments in detail in our recent Outlook note and this update focuses on the publication of the FY18 results. These need to be viewed in the context of the RT Warren acquisition, which added 35% to the investment portfolio and 26% to contracted rent roll at completion on 9 October 2017.

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 some participants have indicated that in some instances letting decisions are taking longer to execute. Investor demand has also remained robust, with regional markets taking a larger share. Overall investment volumes in the broad UK commercial market rose 26% in 2017.

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.

Office supply in regional markets remains low, with occupier take-up continuing to reduce availability, particularly of Grade A space, which should be a positive for occupier demand and rental growth in good quality secondary space. In industrial, continued occupier demand and constrained supply resulted in a 4.9% increase in industrial rents in 2017, according to IPD.

Data for the office market suggest that regional offices continue to represent attractive yields compared with London and that regional secondary office yields have room to tighten further versus prime. As a result of the continuing investor demand, the average yield spreads between regional and London offices has continued to narrow, but remain noticeably wider than it was before recovery took hold in the London market in 2009. As London recovered, and yields tightened, the gap between regional and London yields widened significantly, peaking around 2015. As the market recovery broadened to the regions, this spread has narrowed but not fully unwound.

The recovery in the London market also saw the yield spread between secondary over prime properties narrow. A similar pattern followed later in regional assets as recovery reached those markets and here the spread of secondary over prime yields remains wide despite more recent tightening.

In the trading update on 24 April 2018, management guided that adjusted profit before tax (before profits on disposal and any revaluation gains) for the year ended 31 March 2018 was expected to be ahead of market expectations. In our Outlook note published in May we adjusted our FY18 estimates for the recent acquisition and for the impact of interest rate hedging on finance costs, but left our FY19 estimates unchanged, pending the details that have now been published.

FY18 adjusted earnings of £7.4m are c 5% ahead of our estimate of £7.0m, driven by rental income and slightly offset by higher costs. The average share count was also a little lower than we had allowed for, giving an additional boost to adjusted EPS, c 7% ahead of our estimate.

Diluted EPRA NAV per share was also c 5%, or 19p per share, ahead of our forecast at 414p, in part resulting from higher revaluation movements than we had allowed for, as well as the higher earnings, but also reflecting the impact of the RT Warren corporate acquisition. Palace acquired RT Warren for £67.9m, including investment properties valued at £71.8m. The c £4m difference reflects deferred tax liabilities on the assets acquired, added back to EPRA NAV, providing an additional uplift versus our EPRA NAV forecast. We would expect at least some of the deferred tax to relate to the RT Warren residential assets that are likely to be sold. This will crystallise any deferred tax although the exact impact on NAV will depend on the prices achieved.

Reflecting on recent UK macroeconomic newsflow, we have slightly reduced our net rental income expectations for FY19, although we continue to anticipate further letting progress over the course of the year, including refurbished assets. Our adjusted EPS estimate is also affected by a slightly higher tax burden (assumed effective tax rate 15% versus 6% in FY18). Our newly introduced FY20 forecast benefits from a full year contribution from FY19 void reduction and the 1% pa rental growth that we have assumed across the forecast period, partly offset by inflationary cost growth. We have assumed valuation growth in line with rental growth, although the letting progress that we assume has the potential to further support valuations.

Management has re-asserted its commitment to a progressive dividend policy and we continue to forecast an increase to 19.5p per share in respect of FY19 (FY18: 19.0p). However, the pace of adjusted earnings growth reflected in our forecasts for FY19 will not keep pace with the increase in average share count (following the September 2017 equity raise), with our forecast for adjusted EPS now at 18.1p, representing dividend cover of 93%. Although we forecast growth in FY20 adjusted EPS, we have for now assumed an unchanged FY20 DPS of 19.5p. However, our forecasts do not reflect the potential for earnings to benefit from accretive acquisition, which we discuss in more detail below.

Management continues to target earnings-accretive acquisitions. The end-FY18 loan to value (LTV) ratio was 30.0% and the cash balance, excluding restricted cash relating to tenant deposits, was £18.0m, with unutilised borrowing facilities at £14.2m. £40m of property assets were uncharged, remaining available to provide security for additional bank borrowing. For example, £25m invested at a net initial yield of 7% would add an annualised c £1.75m to net rental income (c 10% of the FY19 forecast) or c £1.0m to adjusted earnings (c 12%) after financing costs and tax (at an assumed 15%). The FY19e LTV would increase from c 31% to c 37%. None of this potential income upside is currently reflected in our forecasts.

Nor do our forecasts make any assumptions about the development of Hudson House in York, where Palace has planning consent for new buildings comprising 127 apartments, 34,000 sq ft of office space and 5,000 sq ft of other commercial space/restaurant space and parking. Demolition of the 1960s office building, within the city walls and close to the railway station, is well underway and will save c £750,000 pa in property expenses, primarily by eliminating empty rates and service charges, or c £500,000 net of residual income. Palace is no longer seeking to develop the site with a joint venture partner, with the board taking the decision that it is in the company’s best interest to proceed alone with the development, which it believes is backed by strong fundamentals, including a lack of Grade A office accommodation in York and strong residential demand. Agents have been appointed for both the commercial and residential space and discussions have commenced with potential lenders to finance the construction. The property is not charged and is valued at £16.0m.

With a prospective yield of 5.4%, Palace is positioned above the median for the broader UK real estate sector, while its P/EPRA NAV is below the median. Our forecasts show the FY19e dividends covered 93% by adjusted earnings with cover increasing to 97% in FY20, although as noted above, this may prove conservative as we included nothing in the forecast for potentially accretive acquisitions.

Palace has built a strong track record of value creation over a number of years. NAV total return in the four years and six months, from September 2013 (H114) to end-FY18 is 118.6% or a compound 19.0% 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 was less than we had forecast and results 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.