Palace Capital — Continuing to move ahead

Palace Capital is an internally managed property investment company that focuses on commercial property in major cities and university towns in the UK, outside London, with a c £270m portfolio value. It operates a total return model, seeking to enhance capital values and to provide a sustainable and growing income stream, applying active asset management strategies in order to unlock potential and grow sustainable cash returns. Management seeks to be entrepreneurial and opportunistic in its approach to asset selection, which is sector-agnostic and allows for each potential investment to be evaluated on its own merits, subject to limits on the exposure to market fluctuations in any one sector. As we show in a later section of this note, the approach has not precluded the growth of a diversified portfolio, principally invested in office, industrial, and leisure assets. A core portfolio of sustainable income-producing assets has supported the progressive dividend policy. Meanwhile, as a non-REIT and unconstrained by REIT property income distribution requirements, Palace has the flexibility to reinvest surplus cash to refurbish, reposition and recycle property in order to grow the underlying capital values. This includes a willingness to assume some development risk where the potential returns are attractive.

The company was given its current form in July 2010 when Stanley Davis (the current chairman) and Neil Sinclair (the current CEO) acquired board control of an AIM-listed vehicle for the purpose of property investment. The current portfolio has been built by acquisition since late 2011, mostly off-market corporate acquisitions that are tax efficient and have minimal purchase costs to absorb. Recognising the growth of the company, it transferred to the Main Market of the LSE in March 2018.

The first transformational acquisition came in October 2013 when a portfolio of 24 properties from around the UK, known as the Sequel portfolio, was acquired from Quintain and Buckingham Properties. Palace paid £39.25m for the properties which were valued individually at the time at £44.2m with a net rent receivable of £5.25m pa. Active asset management since acquisition has seen the disposal of several properties, with an aggregate value of £17.53m up to 30 September 2017. The remaining portfolio was independently valued at that date at £65.4m, representing an overall increase of 111.3%, adjusted for acquisitions, compared with the acquisition purchase price. Two further properties from the Sequel Portfolio have since been sold, for an aggregate consideration of £4.16m.

The August 2014 acquisition of the PIH portfolio, comprising 17 properties split into 55 individual tenancies, for £32.0m was a further significant step. Two of the properties have since been sold for £2.58m, either at or above book value. At 30 September 2017, the remaining properties were independently valued at £39.54m, representing an overall increase in value of 31.6%, adjusted for disposals.

Outside of these notable portfolio acquisitions, Palace has been active with numerous smaller acquisitions, investing almost £100m in a number of transactions in the three years since the PIH acquisition (excluding RT Warren).

In terms of scale, the £67.9m October 2017 acquisition of RT Warren (Investments) represents the most significant move to date, albeit off a larger base, and provides significant potential asset management upside. RT Warren brought a portfolio, externally valued at £71.8m, comprising 21 commercial properties, mostly located in the Home Counties that surround London, and a number of residential assets. Palace expects to be able to increase the rental income on the commercial assets over time while the residential assets are targeted for disposal with the capital recycled into higher yielding commercial assets.

The acquisition of the RT Warren portfolio significantly increased the value of the investment portfolio, by £71.8m or 35%, to £274.6m from the £202.8m that was reported with the FY18 interim results to 30 September 2017. The lesser increase in contractual rental income resulting from the acquisition, c 26% to £17.8m, provides an insight into the asset management potential that the acquisition provides, including measures to increase income from the commercial property assets acquired and the recycling of capital from lower yielding residential property assets acquired into additional commercial assets. RT Warren took the total number of commercial properties from 41 to 62, increasing the gross lettable floor area (GLA) from c 1.6m sq ft to c 1.8m sq ft. The residential assets included within the RT Warren portfolio comprised 65 (now 62) residential units located around the London Borough of Hillingdon, valued at £23.3m.

Despite Palace’s sector-agnostic approach to asset selection, the company nevertheless has a diversified portfolio by both sector and location. The London weighting of 10% overwhelmingly represents the RT Warren residential assets, with the group commercial property assets exclusively situated outside of Central London. The 21 RT Warren commercial assets are predominantly located in the south-east of England, apart from one mixed retail and office building in the centre of York. By sector, the RT Warren commercial assets are mostly office, but also include one supermarket on a long lease with minimum rental growth built in, as well as some retail assets in affluent locations and a multi-let industrial estate.

The tenant base is also diversified, with the largest accounting for 5.4% of contracted rents, and the top 15 tenants accounting for c 38%.

The RT Warren assets represent a little more than 25% of the total. The key attraction to Palace was the potential for rental growth that management sees in the commercial assets, from rent increases and from increased occupancy. By area, 14.7% of the RT Warren commercial space was vacant at acquisition, and early progress has seen the vacant office building in London Court, Southampton, let on a 10-year lease. In addition to increasing income on the commercial assets, the sale of the residential assets will allow capital to be recycled into higher yielding additional commercial assets. The residential assets were valued at £23.34m at acquisition, with gross rental income of c £0.9m pa (a yield of less than 4% compared with a net yield of c 6% of the group portfolio as a whole). Three of the 65 residential properties acquired with the RT Warren portfolio, generating combined income of £40,800 pa, have already been sold for an aggregate £1.23m, or 14% above book value. There are ongoing discussions for the sale of 60 of the remaining units while two units will be retained for strategic purposes.

As noted above, active asset management is a key element of Palace’s strategy, reinvesting surplus cash to refurbish, reposition and recycle property in order to grow the underlying capital values. Recent and current initiatives include:

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 has seen 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 significantly widened, 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 spread of secondary over prime yields remains wide despite more recent tightening.

The six-member board is chaired by Stanley Davis, who holds 3.6% of Palace’s shares and was a founding shareholder. The two independent non-executive directors, Anthony Dove and Kim Taylor-Smith, are both independent and chair the remuneration and audit committees, respectively. Stanley Davis was closely involved with the formation of the group’s business and has been an important supporter of its early fundraisings. According to the UK Corporate Governance Code, he cannot be treated as independent and therefore the board has appointed Anthony Dove to the position of senior independent director.

The executive directors, Neil Sinclair, Stephen Silvester and Richard Starr have over 100 years of collective experience in the real estate market, as well as having management experience in public property companies. The non-executive directors have broad commercial and property experience: the chairman built up and sold a significant share registration business; Anthony Dove was a partner at law firm Simmons & Simmons; and Kim Taylor-Smith was chief executive at Birkby and, following its takeover, at Mentmore.

Palace outsources day-to-day project and property management and concentrates internally on asset management. In step with the growth of the portfolio, the internal management team has been increasing and now numbers 12, including two recently appointed senior asset managers.

We have previously published updates on the interim results to 30 September 2017 that were published on 4 December 2017, and separately on the RT Warren acquisition that completed in October 2017. There have since been a number of further developments in relation to asset management initiatives and funding, as well as completion of the move to the Main Market of the LSE (on 28 March 2018), and a trading update. Full-year results to 31 March 2018 will be published on 11 June 2018. We list the main developments, including the information from the trading update, which covers the period to 24 April 2018, below:

A 5,500 sq ft office building with vacant possession (Nicholson Gate, Fareham) has been acquired for £750,000. It adjoins Admiral House, High Street Fareham, which was acquired as part of RT Warren and collectively the properties provide medium-term development potential.

In the trading update management guides that adjusted profit before tax for the year-ended 31 March 2018, allowing for the major acquisitions and fundraise, is likely to be ahead of market expectations (before profits on disposal and any revaluation gains). We have not yet made adjustment to our FY18 estimates, awaiting further details with the full-year earnings release on 11 June 2018.

Taking into account the recent letting at Milton Keynes, the contracted rent roll has increased to £18.1m from £17.8m at H118, adjusted to include the subsequent completion of the RT Warren acquisition. Allowing for empty property rates, uncovered service charges and head rents, the effective net rental income is now £16.88m.

Looking beyond FY18, we had previously assumed that the letting of the remaining c 44,000 sq ft of recently refurbished office space at Boulton House in Manchester, Bank House in Leeds and Solaris House in Milton Keynes would have a positive impact on FY19 gross rental income. While this is true in the case of Solaris House, the lettings at Manchester and Leeds are taking longer than we had assumed, and although we anticipate contracted rental income increasing to c £18.6m pa by end-FY19 there will be little benefit to forecast earned FY19 net rental income. The expected rental value (ERV) at H118, adjusted to include RT Warren, was £20.7m pa, demonstrating further significant upside from lettings and rental uplifts. The ERV includes nothing for Hudson House.

Our net interest expense forecasts also now allow for the additional cost of hedging interest rate exposure. In combination, these two factors, before any potential acquisition offsets, reduce our expected adjusted EPRA EPS to 18.7p from 20.6p. On the basis that management remains committed to a progressive dividend policy, our forecast for the FY19 DPS remains unchanged at 19.5p, not quite fully coved by our current forecast for adjusted earnings.

Following the recent refinancing, Palace has additional borrowing headroom of c £14m, as well as cash resources, providing what management describes as considerable firepower to make significant acquisitions and boost returns. The H118 cash balance was £8.7m and including H218 disposals we estimate this may have increased to c £17.0m. None of this potential income upside is currently reflected in our forecasts. By way of example, £25m invested at a net initial yield of 7% would add c £1.75m to net rental income (c 10% of the FY19 forecast) or c £1.0m to adjusted earnings (c 10%) after financing costs and tax (at an assumed 15%). The FY19e LTV would increase from c 33% to c 39%.

Although PCA is not a REIT, this current level of payout is at a similar level to the UK REIT sector and the prospective (FY19e) dividend yield of 5.6% is towards the upper end of prospective yields offered by the broad sector (Exhibit 8). Our forecasts show FY19e dividends covered 96% by adjusted earnings and 94% by diluted EPRA earnings (the difference between adjusted earnings and EPRA earnings is non-cash share based payments charges). As noted above, this may prove conservative as we included nothing in the forecast for potentially accretive acquisitions.

The c 20% discount to the FY18e EPRA NAV on which Palace shares trades positions it in the lower half of the sector (Exhibit 9).

Palace has built a strong track record of value creation over a number of years. Using our forecast end-FY18 EPRA NAV per estimate of 395p, but noting that management is indicating an above-consensus result for the year, the NAV total return in the four years and six months, from September 2013 (H114) is 109.6% or a compound 17.9% 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 that we expect in FY18 is the result of the share issuance to fund the RT Warren portfolio, and captures none of the future asset management driven value creation that management targets.

As noted above, our forecasts have built in no upside from asset management on the newly acquired assets because there is no convincing way that this can be prospectively modelled. But that is not to say that we do not expect such action. Meanwhile, we would argue that the current valuation has built in no anticipation of such progress from the newly acquired assets or ongoing portfolio initiatives, including potential further accretive acquisitions from deploying the strong cash position, and the Hudson House development in York.

The recent move to the Main Market of the London Stock Exchange should broaden the appeal of the shares to a wider group of investors.

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: