Regional REIT — Acquisitions driving growth and diversification

RGL is an externally managed, UK-based, real estate investment trust (incorporated in Guernsey) that was admitted to the premium segment of the Official List and to trading on the Main Market of the London Stock Exchange in November 2015, becoming a constituent of the FTSE All-Share Index in March 2016 and the FTSE EPRA NAREIT Index in June 2016. It targets a 10-15% total return pa, including high dividends from sustainable earnings, through investments in UK commercial property (predominantly office and industrial property) in the main regional centres of the UK, effectively outside the M25 motorway. A highly diversified portfolio provides protection from sector, industry and tenant risks (Exhibits 3 and 4).

The 2017 DPS increased c 3% to 7.85p, maintaining its position as the highest-yielding REIT (Exhibit 7) with a fully covered dividend, and the company has indicated a continuation of its progressive dividend policy in the current year. The Q118 dividend will be declared with the trading statement to coincide with the AGM on 17 May. A key part of strategy has been to grow the investment property asset base and build scale, and in 2017 growth was 47% to c £737m, including three significant portfolio acquisitions, with immediate enhancement to income and potential to benefit from ongoing asset management.

Despite some softening of UK economic growth expectations, the regional commercial property market remains in robust health, with occupier and investment demand for regional office and industrial property remaining firm during the year, although RGL notes that letting decisions are taking longer to execute in some instances.

2017 was marked by significant acquisition activity, in part financed by additional debt funding and the issue of 98.0m new shares during the year (c one-third of the opening number). A significant refinancing in December 2017 substantially simplified the debt structure and increased average maturity from 2.5 to 6.2 years. The key financial highlights were:

Management says that it is confident that RGL’s diversified and high-yielding property portfolio will deliver good shareholder returns in 2018, including the benefits from continuing asset management initiatives.

The degree of diversity within the RGL portfolio is a differentiating factor, and one that has the potential to mitigate sector risks and can fairly be seen as representative of the UK economy as a whole.

As at the end of 2017, the portfolio comprised 164 different properties, covering 1,368 individual property units, let to well over 1,000 tenants. The largest single tenant represents 2.6% of contracted rents. The increase in occupancy during FY17 (from 82.7% to 85.0%, by value) in part reflects the acquisitions and disposals made, but like-for-like occupancy also increased (from 83.4% to 84.1%). The weighted average unexpired lease term (WAULT) was 5.4 years (2016: 5.2 years) and the WAULT to first break was effectively maintained during the year (3.5 years) despite the passing of time. The gross contracted rent roll grew to an annualised £61.9m and the net contracted rent roll to an annualised £52.0m. The expected rental value also increased to £73.8m, with the uplift from the gross contracted rent roll substantially representing the opportunity from reducing voids.

Exhibits 3 and 4 provide an insight to the spread of the portfolio by geography and sector. More than 90% of the portfolio is represented by the office and light industrial properties that the manager has been targeting. Geographically, the Scottish weighting has continued to reduce (from c 35% at IPO) in line with the stated strategy, and faster growing areas of England, like the south-east, the midlands, the north-west and the south-west now represent more than 60%.

The attraction of the regional towns and cities to both occupiers and investors continued in 2017 and RGL finds the regional commercial property markets to be in good health. Management says that it has experienced increased tenant demand, although in some instances letting decisions are taking longer to execute. 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 the good quality secondary space targeted by RGL. In industrial, continued occupier demand and constrained supply has seen a 4.9% increase in industrial rents in 2017, according to IPD.

Overall investment volumes in UK commercial property (including London) in 2017 were 27% higher than in 2016, with an increasing share taken by regional markets. Data for the office market suggests 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 (Exhibit 5). The manager believes this trend has further to go.

The headline 2017 earnings result was better than we had forecast. Net rental income was 3% ahead of our expectation, and administrative and other costs (including the performance fee) were lower by a similar amount, benefiting unexpectedly from RGL’s recent success in registering for VAT, allowing a c £0.8m recovery in respect of prior years and a recurring saving in the amount of c £0.3m for FY17. EPRA NAV per share of 105.9p was 1% above our estimate, while the DPS of 7.85p had been previously declared.

Our forecasts for FY18 and FY19 are little changed. In FY18, income on the properties acquired in FY17 compensates for the increased number of shares, although the non-repeat of prior-year VAT recoveries means that adjusted EPS is likely to be a little lower than in FY17.

Our FY18 forecast includes the acquisition of an office property in Portsmouth (the ‘pipeline asset’ agreed in principle with the completed December portfolio acquisitions), which is expected to complete by the end of March and add an annualised c £400k to rental income. We also factor in the £10.5m sale, agreed last year, on a subject-to-planning basis, to Unite Students, the manager and developer of student accommodation, of a development site (no revenue impact) in Leeds that was acquired as part of the Wing portfolio in 2016. RGL has said that it expects to generate a profit on completion of c £9m on the original acquisition price, and we would also expect a significant uplift to the current carried value of the asset. We have assumed a £6.5m realisation gain in our 2018 forecast. Other than these two transactions we have allowed for no other purchases and sales, although these are likely. In particular, management has indicated a willingness to take advantage of continuing investor interest in some industrial assets where disposal at market values may lock in potential that is not reflected in valuations.

Management expects to make further progress towards its 90% (like-for-like) occupancy target during the current year, and we continue to assume 87% by end-FY18 and 88% by end-FY19, with modest like for like rent growth of 0.5%pa in both FY18 and FY19. We continue to expect the increase in occupancy, supported by last year’s refurbishment investment, to drive revaluation gains in the current year, equivalent to 2.5% of the opening value (FY17: 2.6% like-for-like, with reported net gains reduced by acquisition costs). The gains lift our forecast EPRA NAV per share, and therefore our forecast performance fee accrual for the performance period that runs from listing until end-FY18. The first performance fee is payable, in FY19, and for modelling purposes is treated as a cash payment, although in reality it is payable 50% in shares. Stripping out the performance fee, our forecast DPS (+2.5% on FY17) is 105% covered, and substantially covered (97%) including performance fees, as a result of the growth in capital value increasing income account costs. Continuing occupancy improvement and further interest cost savings (see below) should lift income and EPS further.

Further refinancing measures are planned over the next 12 months, including refinancing of one of the remaining five borrowing facilities and repayment of the zero dividend preference shares (ZDP) that were acquired, on a temporary basis, as part of the Conygar transaction. The £65m borrowing facility with ICG Longbow is not due until August 2019, but given the 5.0% fixed coupon, relatively high in current market conditions, management indicates that it expects to exercise an early refinancing option in August 2018, potentially extending the amount borrowed and reducing the cost. This is reflected in our forecasts along with repayment of the £39.9m ZDP, with a coupon of 6.5%, from cash resources in January 2019.

The net LTV ended the year at 45.0%, down from a peak pf 49% immediately after the Conygar acquisition. Given the increased scale and diversification of portfolio achieved since IPO, management says that it will target a level of 40% (increased from 35%). Our own forecasts show the net LTV continuing to decline (to 42.4% by end-FY19) and meeting the 40% target within this timeframe could be achieved by the net sale of c £33.0m in investment assets. Although this would involve some loss of income, allowing for lost rental income at the portfolio average NIY of 6.8%, and savings on interest costs and portfolio management fees, the annualised net impact on EPRA earnings would be c £1m or 0.3p off our FY19 adjusted EPS forecast of 9.2p, leaving forecast DPS well covered.

Regional REIT continues to offer the highest yield in the sector. The dividend is fully covered by adjusted EPRA earnings before performance fee accruals and management has signalled a continuing progressive dividend policy.

The premium yield is not reflected in RGL’s P/NAV rating, with the c 7% discount to the historic (December 2017) EPRA NAV of 105.9p placing it in the middle of the group.

Within the peer group, a number of the companies with long duration leases (primary healthcare, industrial warehousing) continue to command higher than average P/NAVs, which suggests many investors in the broad sector continue to be attracted to the visibility of future income that this provides. The market valuation of RGL and a number of its closest peers focused on more mainstream commercial property and active asset management, combining above-average yield and NAV discount, seems to imply investor caution about the ability to meet occupancy and income expectations and/or the potential for asset values to weaken. This is effectively a macroeconomic call, but is more pessimistic than the current industry expectation. In the case of RGL, we would note that the recent refinancing has significantly extended its debt maturity profile, of which 90% is hedged or fixed, and reduced its direct interest rate risk. Meanwhile, completed refurbishment and other asset management projects provide support to income and capital growth, irrespective of market valuation yields.

Combining capital growth with income returns, RGL has generated a 19.9% EPRA NAV total return since coming to market in November 2015, of which 14.1% represents dividends paid. The compound annual return is 8.8% but included within this are a number of non-recurring costs such as the IPO-related expenses and the 2017 expenses related to the refinancing and equity issuance. Adjusted for the 2017 costs only, the return would have been 9.4%, close to management’s 10-15% target.

Our forecasts imply that EPRA NAV total return will increase over the next couple of years, through a combination of increasing DPS, one-off items falling away, and increasing occupancy driving capital growth (on the assumption that valuation yields neither fall nor rise from here).