Picton Property Income — Aiming for consistent outperformance

Pictons’s diversified portfolio of commercial property across the UK is actively managed for total returns but with a strong income focus. Through its occupier-focused, opportunity-led approach, the company aims to be one of the consistently best-performing diversified UK-focused property companies listed on the London Stock Exchange (LSE). A strong weighting to industrial and regional office assets and significant underweighting of retail and leisure assets (no shopping centre exposure) continues to support property returns, maintaining the long-term track record of outperformance versus the MSCI IPD Quarterly Property Index on an ungeared basis, over one, three, five and 10 years to 31 March 2019. The portfolio contains significant reversionary potential and asset-management opportunities to support future value creation despite a more uncertain economic and market background. At the end of FY19 the portfolio estimated rental value (ERV) of £46.8m was 24% above passing rents and the company had 20 identified asset management initiatives that it expects to undertake over the next couple of years.

Positive returns continuing

The property portfolio showed a 0.5% like-for-like valuation increase in Q120, driven by industrial sector assets. EPRA NAV per share increased 0.3% to 93.0p and including the quarterly dividend paid, NAV total return was 1.3% or c 5.3% annualised. Fully covered dividends provide scope for reinvestment including identified asset management initiatives, with an aggregate investment of c £15m over the next couple of years. The deferral of lettings will negatively impact FY20 income, but the aim is to enhance the quality of the portfolio with the intention of delivering higher occupancy, rental income and capital values. Our FY20 EPRA earnings and EPS forecasts are reduced by c 8% as a result but dividend cover remains healthy at c 1.1x. Forecast income growth resumes in FY21 driven by continued growth in industrial and office rents and letting of refurbished space. With overall asset valuations assumed to track blended rental growth we forecast modest growth in NAV. There is upside potential to our forecasts from significant additional reversionary potential while the moderate gearing (LTV 24.1%) leaves Picton well-placed for further opportunistic acquisitions.

Although total-return driven, Picton has a strong focus on sustainable dividends and pays fully covered quarterly dividends that annualise at 3.5p per share (a prospective yield of 3.8% at the current share price) while continuing to invest surplus cash generation into the portfolio in ways designed to support occupancy and income growth with the specific goal of enhancing long-term total return. EPRA NAV total return over the five-year period ended 31 March 2019 was 93.8% or a compound annual average return of 14.2%. Our forecasts for FY20 and FY21 imply a compound annual return of 6.1% over the period with c 60% of the anticipated return coming from well-covered DPS payments. Although our forecast returns represent a slowdown from the historical trend, reflecting a more challenging market environment than has been experienced in recent years, there remains a material uplift compared with risk-free returns (the 10-year UK gilt yield is c 0.8%).

We review the main sensitivities on page 13. We consider these to be related mainly to the broader macroeconomic background and the cyclical nature of the commercial property market. Commercial property has historically exhibited substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms.

Picton Property Income is an internally managed UK REIT that invests in a diversified portfolio of commercial property assets from the main commercial property sector across the UK. It is total-return driven with an income focus and aims to generate attractive returns through pro-active management of the portfolio, investing in assets where it believes there are opportunities to enhance income and/or value. The majority of income is paid to shareholders via quarterly dividends, which have been steadily increased while maintaining full cover and generating surplus cash for reinvestment back into the portfolio. The company’s aim is to be one of the consistently best-performing diversified UK-focused property companies listed on the LSE.

The company originally launched in October 2005 as the ING UK Real Estate Income Trust in an offshore structure and listed on the LSE. In 2011, the company name was changed to Picton Property Income and in January 2012 the investment management function of the company was internalised through the creation of a wholly owned subsidiary company, Picton Capital, comprising an experienced and dedicated team substantially created by former employees of the outgoing external manager, ING Real Estate Investment Management. The interests of all Picton staff are aligned with those of shareholders through a deferred bonus scheme and long-term incentive plan.

On joining the UK REIT regime with effect from 1 October 2018, Picton also changed its technical listing status from an investment company to a commercial company, bringing it more into line with other internally managed property company peers. There has been no material change in the way the portfolio is managed.

At 30 June 2019 (Q120) the fair value of the investment portfolio was £688m (the balance sheet value of £679m includes an adjustment for lease incentives and finance leases), diversified across 49 assets and let to a broad spread of around 350 occupiers, providing stability to the income base. In terms of property sectors, the portfolio is actively positioned compared with the MSCI IPD Quarterly Benchmark, reflecting an unconstrained approach to portfolio construction that adapts the sector and asset weighting to changing market conditions. Throughout the past year, performance has benefitted from the portfolio being strongly overweight in regional industrial and office properties and taking an underweight position in retail and leisure property (with no shopping centre or department store exposure) and in central London.

At the portfolio level Picton has built a strong track record of outperformance versus the MSCI IPD Quarterly Property Index, generating above index income returns and total property returns on an ungeared basis over the one, three, five and 10 years ended 31 March 2019.

Combining these property level returns with an effective use of gearing and efficient operation, over the past five years to end-FY19 Picton has generated an aggregate EPRA NAV total return, or accounting return, of 93.8%, equivalent to a compound annual return (no dividend reinvestment assumed) of 14.2%. Q120 total return was 1.3% or an annualised c 5.3%. LTV has averaged a conservative level of c 26% over the past three years and was 24.1% at 30 June 2019 (Q120), down slightly from 24.7% at 31 March 2019 (end-FY19).

Towards achieving its aim of being one of the consistently best-performing diversified UK-focused property companies listed on the LSE, Picton describes its approach as ‘occupier focused and opportunity led’.

Occupier focused refers to working closely with its own tenants to understand their needs, enhance occupancy, improve retention and maximise income. Picton continues to invest in its assets, improving the quality of the space and ensuring it meets occupier demand. During FY19 management spent time redefining its ‘Picton Promise’ for occupiers, focused on key commitments including Action, Support, Sustainability, Technology and Community. The headline retention rate of 49% in FY19 (FY18: 63%) was significantly affected by the timing of lease expiries. Of the £3.5m ERV vacated in the year, half related to Stanford House in London’s Covent Garden, currently undergoing full refurbishment.

In a broader sense, ‘occupier focused’ also applies to the occupier market as a whole, which is closely monitored to help drive portfolio strategy and asset selection.

The company’s strategy is ‘opportunity led’ in terms of acquisitions and disposals, as well as asset-management decisions, seeking to buy, manage and sell effectively. During FY14–FY16 Picton took advantage of positive market conditions (increasing rents and rising valuations) to grow the portfolio.

Alongside a step-up in investment this also included significant disposals in FY14, ahead of valuation, as the portfolio was repositioned, including a targeted increase in average lot size. In FY17, ongoing strategic repositioning of the portfolio saw central London assets disposed of, along with several non-core assets at well above valuation, further increasing lot size and reducing gearing. In FY18, Picton acquired one office asset in Bristol city centre, benefiting from positive demand-supply conditions and with significant reversionary potential for £23.2m and sold three non-core assets for an aggregate £10.4m, 37% ahead of the start-of-year valuation. Portfolio activity was low in FY19 against the background of market-wide investor activity tailing off as Brexit uncertainty increased, in some cases opening a gap between the prices investors are willing to pay and the prices potential sellers are demanding. There were no portfolio transactions in Q120.

Picton joined the UK REIT regime with effect from 1 October 2018. From that date, profits on its property rental business became exempt from UK tax and its first dividend payment in the form of a property income distribution was made in February 2019. Conversion was a logical response to the forthcoming changes in UK tax treatment of offshore companies that would otherwise have been expected to materially increase the company’s tax burden.

In addition to the immediate tax savings, over the medium to longer term the company hopes REIT status will broaden its appeal to a larger and more internationally diverse investor pool, which may be expected to support share trading liquidity and the overall share price rating.

Prior to REIT conversion Picton was listed as an investment company, managed and controlled by a board, based in Guernsey, with its own UK-based investment management subsidiary, Picton Capital, authorised and regulated by the Financial Conduct Authority. For the conversion to take place it was necessary that management and control of the company be based in the UK. To satisfy this requirement a number of changes were made to the board composition and internal management structures. At the same time as becoming a REIT, Picton changed its technical listing status from an investment company to that of a commercial company, bringing it more in line with other internally managed property company peers and removing the requirement for FCA regulation of the management function.

At the September 2018 AGM two of the non-executive board members, Robert Sinclair and Vic Holmes, stepped down providing an opportunity for the board composition to adapt to Picton’s new status as a UK-managed and controlled REIT. Maria Bentley and Andrew Dewhirst were appointed to the board as non-executive director and finance director respectively.

The board now comprises six members, four non-executive and two executives. Nicholas Thompson is the non-executive chairman and the other non-executives are Mark Batten (chair of the audit and risk committee and the senior independent director), Roger Lewis (chair of the property valuation committee) and Maria Bentley (chair of the remuneration and nominations committees). The non-executive directors bring considerable experience from across the real estate, real estate financing and financial services sectors. The executive board members are CEO Michael Morris and Andrew Dewhirst. Brief biographies of the key members of the leadership team may be found on page 16 and detailed board biographies may be found on the company website.

Picton’s property portfolio performance continues to benefit from its sector positioning, while significant reversionary potential and identified asset management initiatives within the existing portfolio provide the opportunity for continued growth and value creation.

The externally appraised fair value of the portfolio at 30 June 2019 (end-Q120) was £688m (FY19: £685m and FY18: £684m) with a balance sheet value, after lease and other adjustments, of £679m. The valuation reflects a net initial yield of 4.9% and a reversionary yield of 6.3%. The annualised contracted rental income (or passing rent) was last given as £37.7m at end-FY19 with an ERV of £46.8m – £9.1m or 24% ahead of passing rent. More than half of the reversionary potential relates to void reduction, with EPRA occupancy of 90% at end-FY19 (and a similar level at end-Q120). The weighted average unexpired lease length is just over five years.

The sector and regional positioning of the portfolio highlights its unconstrained approach to asset selection while maintaining a diversified overall portfolio. Compared with the MSCI Quarterly Property Index, the portfolio has around double the weighting to the strongly performing industrial sector (with a high South-East share) and around half the weighting in retail/leisure sectors (no exposure to shopping centres) where returns are currently weak. The regional (rather than central London) nature of Picton’s office exposure also contributed positively to performance.

There is a wide diversity of occupiers across the portfolio with around 350 tenants from a broad spread of industry groups. The largest tenant accounted for 4.2% of passing rent at end-FY19 and the 10 largest tenants for 28%.

Transactional activity was modest through FY19 and there were no transactions during Q120. In FY19 two office assets were sold for £12.0m, 9.7% ahead of the end-FY18 valuation, contributing to an increase in average lot size to £14.0m.

Picton continues to explore new investment opportunities and has the financial flexibility to seize any that may emerge in the shorter term as a result of ongoing volatility and uncertainty in the market. Reflecting the company’s unconstrained approach to asset allocation we expect it to consider opportunities across the market but to retain its focus on the core commercial property market sectors (rather than alternative/specialist sectors) where management has expertise, knowledge and has built a strong track record.

Despite some slowing of UK economic growth and continuing Brexit-related uncertainty the overall UK commercial property market has remained robust. However, sector performance has become increasingly polarised with the industrial sector showing the strongest returns and the retail sector suffering a marked deterioration as retailers struggle with rising labour costs and business rates and, in many cases, the impact of online competition. In the year to 31 Mach 2019 (FY19) the ungeared total return on Picton’s overall portfolio was 7.5%, ahead of the 4.6% return on the MSCI Quarterly Property Index and the income return was 5.6% compared to the index return of 4.4% (Exhibits 3 and 4). Picton’s continued outperformance of the index during the year reflected its overall sector positioning rather than performance within sub-sectors, affected by lease events and asset management initiatives in respect of individual assets.

In the year to 31 March 2019, the MSCI IPD Index total return for the industrial sector was 13.8% (9.1% capital growth and 4.3% income return with ERV advancing 4.2%). Index return for the office sector was also positive with a 5.9% total return comprising 2.0% capital growth and a 3.8% income return. ERV also continued to increase by 1.0%. As widely reported, the retail sector produced a negative total return of 2.6% including a negative 7.3% capital return and a positive income return of 5.0%. ERV fell 3.2% and was negative across all sectors.

In the three months ended 30 June 2019 the MSCI Monthly Index All Property total return was 0.7% (0.5% in the previous quarter). Negative capital growth of 0.6% continued to reflect the impact of retail weakness with continuing positive returns from industrial. Rental growth was 0.1% in the quarter, positive for industrial and office assets and negative for retail.

On an EPRA basis, current occupancy of c 90% is somewhat below the c 95% of the previous four years. The reduction reflects a bunching of lease expiries towards the end of FY19 as well as management’s decision to surrender a number of leases to facilitate active asset management of the assets and drive future income growth. In FY19 Picton surrendered 11 leases where the average ERV was 13% above the passing rents, collecting £0.7m in surrender premiums.

Void reduction represented £4.8m of the £9.1m gap between end-FY19 ERV and passing rent with the balance attributable to lease events and other asset management opportunities.

The majority of the upside from void reduction was within the office portfolio (£2.9m) with the retail sector accounting for much of the rest (£1.5m). With industrial sector occupancy already at a high level the upside from void reduction was much lower (£0.4m). The major void, accounting for over a third of total portfolio vacancy, is Stanford House in Covent Garden, a well-known and busy location. This became vacant during the year ahead of a planned refurbishment of both the retail and office space and re-leasing programme. The project is due to complete by January 2020 and meanwhile, as a Grade II listed asset, the property incurs no empty rates liability.

During FY19 Picton completed 24 new lettings, securing more than £1.3m of annualised rental income, 1.7% ahead of the March 2018 ERV and 17 lease renewals were agreed on £1.9m of annualised rental income, 1.6% ahead of ERV. Representing further opportunities to capture reversionary potential, over one year, lease maturities to first break represent just under 14% of contracted rent, increasing to just over 30% over two years. During Q120, Picton completed four new lettings, on average 5% ahead of the March 2019 ERV, with combined annual rent of £0.6m. Also in Q120, seven lease renewals/regears were completed and uplifts secured on three rent reviews, on average 7% ahead of the March 2019 ERV, with a combined annual rent of £1.6m. Four lease break options were also removed or extended, securing £1.2m of income, the majority of which was at risk in the next 12 months.

The group has more than 20 identified asset management initiatives within the portfolio, representing an aggregate investment of c £15m, which we expect to be spread over the next couple of years. These initiatives are aimed at improving the quality of the existing portfolio assets with the intention of delivering higher occupancy, rental income and capital values and include:

Picton’s FY19 results, reported in late May, were in line with our expectations and are summarised in Exhibit 13. Despite the more challenging trading environment Picton delivered a solid 6.5% NAV total return for the year, comprising dividends paid of 3.5p per share (+2% year-on-year) and a 3% increase in EPRA NAV per share to 93p (FY18: 90p). Dividends were well covered (we calculate 121%) and LTV continued to decline (to 24.7% at year-end).

Net property income was slightly lower, mainly as a result of the timing of lease expiries and asset management-driven surrender activity. Underlying (or recurring) operating profit was 1% lower year-on-year but EPRA earnings benefitted from lower finance costs as a result of the repayment of relatively expensive debt, partly from cash and partly from the less expensive revolving credit facility. Net asset value increased with retained earnings.

The second-half reduction in passing rent, from £40.3m to £37.7m, was greater than we expected (we had looked for a reduction to £39.8m) as a result of the lease surrender activity focused on the last quarter of the year. Including the benefit of c £0.7m in lease surrender premium this had no significant impact on FY19 rental income but it does mean FY20 passing rents started from a lower base pending completion of asset management projects and re-letting of the properties.

Q120 EPRA NAV, up 0.3% to 93.0p, benefitted from a 0.5% like-for-like increase in portfolio valuation driven primarily by continued industrial sector gains, more than sufficient to offset continuing retail and leisure weakness. Including the 0.875p quarterly dividend paid the EPRA NAV total return was 1.3% in the quarter, which annualises at c 5.3%. Reflecting the end-FY19 reduction in passing rent, dividend cover was lower in the quarter (100%) although we forecast this to increase through the year and further in FY21.

Our forecasts assume an unchanged portfolio, although Picton continues to explore new investment opportunities and is likely to continue to divest of mature assets and take the opportunity to actively manage sector positioning.

We expect the reduction in rent roll towards the end of FY19 will temporarily reduce FY20 rental income and EPRA earnings until some of the asset management projects complete, with growth resuming in FY21. With this in mind, revised forecasts now assume no change in the current 3.5p per share annualised dividend pay-out, maintaining a good level of dividend cover at c 1.1x in FY20 and 1.2x in FY21. The FY21 level of cover may indicate scope for a resumption of dividend growth.

Our key forecasting assumptions include:

A summary of our FY20 and FY21 forecasts is shown in Exhibit 15. With rental income deferred by the asset management initiatives in FY20, our revised EPRA earnings and EPS forecasts are reduced by c 8% although dividend cover remains solid. We have assumed an unchanged dividend throughout the forecast period, although with cover rebuilding to c 1.2x in FY21 there is scope for an increase.

At 31 March 2019 (end-Q120) the gross outstanding debt (including unamortised loan arrangement fees) was £187.4m and net debt was £165.8m with a net LTV of 24.1% (FY19 24.7% and FY18: 26.7%). All of the debt is secured against property assets and the majority (90%) of outstanding debt represents long-term fixed-rate borrowing, which is supplemented by lower cost, more flexible, revolving credit facilities. The average cost of debt was 4.1% and the weighted duration was 9.8 years.

The end Q120 debt and gearing levels were slightly reduced on the end-FY19 position (gross debt of £194.7m and LTV 24.7%) with the c £7.0m (net of costs) proceeds from the June 2019 placing of new shares being used initially to repay revolving debt facilities. The 7.6m new ordinary shares were placed at 94.5p, a 1.9% premium to the end-FY19 EPRA NAV per share (92.7p). Over the medium term the proceeds are aimed at funding the identified asset management initiatives while maintaining financial flexibility for opportunistic acquisitions. At end-Q120 the company had undrawn debt capacity of c £30m in addition to cash resources of more than £20m, providing considerable financial flexibility for future investment.

We forecast lower finance expense in FY20 compared with FY19 reflecting lower levels of debt and a full year benefit from the July 2018 early repayment of £33.7m of fixed-rate debt with Canada Life, originally due in July 2022, using £23m of cash resources, with the balance coming from one of the group’s lower cost revolving credit facilities. The annualised interest saving was c £1.0m pa with c £0.6m achieved in FY19 and an additional c £0.4m to be achieved this year. In addition, Picton secured other amendments to the loan documentation covering the c £80m remaining Canada Life borrowings, which will increase operational flexibility. The repayment incurred a one-off repayment fee of £3.2m and crystallising un-amortised loan arrangement fees of c £300k, which affected FY19 NAV by c 0.7p per share.

Picton has a strong focus on income and pays fully covered quarterly dividends that currently annualise at 3.5p per share (a prospective yield of 3.8% at the current share price), while continuing to invest in the portfolio to support future income growth. In Exhibit 5 above we showed Picton’s NAV total return performance over the five-year period ended 31 March 2019, with a compound annual average return of 14.2%. Our forecasts for FY20 and FY21 imply a compound annual return of 6.1% over the period with c 60% of the anticipated return coming from well-covered DPS payments. Although our forecast returns represent a slowdown from the historical trend, reflecting a more challenging market environment than has been experienced in recent years, there remains a material uplift compared with risk-free returns (the 10-year UK gilt yield is c 0.8%).

In Exhibit 17 we show a summary performance and valuation comparison of Picton and what we consider to be its closest income-oriented peers. Over the past year Picton shares have performed more strongly than the peer group average as well as the broader UK property sector and the FTSE All-Share Index. The valuation comparison is based on last-reported EPRA NAV per share and trailing 12-month DPS declared – on this basis, the Picton yield is below the peer average and the P/NAV slightly above. We believe the outperformance of Picton shares and the share price rating reflect the company’s income focus (a less volatile element of property returns across the cycle compared with capital values), its good level of dividend cover and relatively modest gearing.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. From a sector viewpoint we 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. Picton is not a developer but is exposed to similar but lesser uncertainties as it actively invests in improvements to existing assets with the aim of enhancing long-term income growth and returns. We consider the main sensitivities to include: