Palace Capital — COVID-19 impacts actively managed

Palace Capital (PCA) is an internally managed UK real estate investment trust (REIT), focused on commercial properties in major cities and university towns in the UK, outside London. It has an entrepreneurial approach to investment and operates a total return model, with a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. This strategy provides both attractive income returns, as well as exposure to capital growth from the repositioning of value-add properties. Although currently focused on regional office and industrial assets, the investment strategy is sector-agnostic over the medium term, adapting to shifting market opportunities. The existing portfolio contains strong reversionary potential and offers significant refurbishment and development opportunities. We expect completion of the flagship Hudson Quarter (HQ) development in York to materially drive returns in the next two years

Financials: Hudson Quarter to drive near-term returns

Our expectations for FY21 adjusted earnings and net asset value (NAV) are increased slightly post-H121 and become a firm forecast (previously a central scenario amid pandemic uncertainty) and we introduce forecasts for FY22 and FY23. HQ completion, expected for March 2021, is a key driver of our FY22–23 return expectations, generating c £10m of development gains in FY22, more than 20p per share, and adding c £0.9m to rental income in FY23. On an annual basis we expect gearing (LTV) to peak at just under 44% in FY21 as development funding is drawn to complete HQ, falling to around 30% as the residential apartment sales are completed in full (c £50m net proceeds). In addition to HQ, our FY23 forecast includes some capture (c £0.9m) of the current £3.2m reversionary upside potential (but not accretive acquisitions). This drives an increase in aggregate annual DPS to 16p, fully covered by adjusted earnings, compared with 10p through FY21–22.

Based on our DPS forecast the prospective yield is 5.8% (above the peer average), and based on the current quarterly rate of DPS (2.5p per quarter), the minimum payout that the company anticipates, the yield is 4.7% (in line with the peer average). We expect DPS to be fully covered by adjusted earnings. The yield compares favourably to the risk-free yield on offer (10-year UK gilt yields are less than 0.5%). The c 40% discount to EPRA NAV is clearly below the peer average and, while gearing (LTV) is above average, a successful completion of Hudson Quarter and sale of the residential apartments should both reduce LTV significantly and generate strong returns. With significant additional asset management potential embedded within the portfolio, the PCA valuation continues to appear undemanding despite the recent increase in the share price. There is clear potential for further upside if economic and market prospects become clear in the coming months.

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, with COVID-19 and Brexit creating additional uncertainties. 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. Although development activity brings additional risk, the significant Hudson Quarter is well advanced, fully funded and on budget with a fixed price construction contract. Almost one-third of apartments have been pre-sold, the first commercial pre-let agreed, and interest in the remaining commercial space has been strong.

The H121 financial performance was robust. Although COVID-19 continued to negatively affect valuations and slowed leasing activity, slightly increasing voids and reducing rent income, rent collection remained robust. 96% of rents due on the March 2020 quarter day were collected and a slightly lower 94% of rents due on the June quarter day, reflecting the increased lockdown impact. 82% of all rents due on and since the September 2020 quarter day have been collected, a higher percentage than at the equivalent stage in the previous two quarters. With December monthly payments still to come, PCA expects collection to be above 90%. Meanwhile, active asset management has secured long-term occupancy at the two leisure assets, particularly challenged by the lockdown, providing near-term rent concessions in return for lease extensions/lease break removal. Positively, HQ remains on track and on budget for delivery in March 2021 and while COVID-19 has slowed pre-sales of residential apartments, these have continued without price adjustment, and management expects an acceleration as completion approaches.

Key highlights of H121 included:

PCA management remains positive about the prospects for regional commercial property, especially in its core sectors of offices and industrial assets, both of which have been benefiting from relative shortages of supply and good levels of demand.

The supply of good quality, well located office assets remains constrained, while rents remain relatively low (particularly relative to London and also compared with rebuilding costs) and have yet to increase to a level that justifies significant new development. Permitted development rights have seen significant office supply withdrawn from the market in recent years, repurposed for residential/hotel use. With structural demand factors such as office migration from (more expensive) London to the regions and the political goal of rebalancing economic activity from south to north likely to remain, possibly reinforced by a shift to ‘localism’ (smaller, regional offices located in regional towns outside the capital), beyond the immediate challenge of the pandemic, management sees a strong opportunity for continued rental growth. PCA believes that the ‘death of the office’ has been vastly overstated, highlighting the important role that the office plays in company culture and productivity, being a place for both concentrated work and collaboration, connection, innovation and social interaction.

In the short term PCA says that it will continue to focus on rent collection and maintaining a good level of liquidity, including the disposal on non-core assets (see below). However, with positive developments in terms of COVID-19 vaccine development, it is hopeful of a more certain economic environment in 2021 and the opportunity to take advantage of opportunities as they may emerge. The proceeds from the expected sale of HQ residential assets in FY22 should allow for the repayment of development funding and overall LTV as well as investment in accretive acquisitions and/or value-enhancing redevelopment/refurbishment plans in place for existing assets.

PCA is an internally managed UK REIT, listed on the Main Market of the London Stock Exchange (LSE). It focuses on commercial property in major cities and university towns in the UK, outside London and at 30 September 2020 had a property portfolio externally valued at £281.6m. It has an entrepreneurial approach to investment and operates a total return model, with a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. This strategy provides both attractive income returns as well as exposure to capital growth from the repositioning of value-add properties. Although currently focused on regional office and industrial assets, the investment strategy is sector-agnostic over the medium term, adapting to shifting market opportunities. The existing portfolio contains strong reversionary potential and offers significant refurbishment and development opportunities. We expect completion of the flagship HQ development in York to materially drive returns in the next two years.

The management team has considerable experience in the real estate sector, across cycles. Its extensive networks and strong industry relationships have been an advantage in sourcing opportunities to grow the business, which was given its current form in July 2010 when Stanley Davis (the current non-executive chairman) and Neil Sinclair (the current CEO) acquired board control of an AIM-listed vehicle for the purpose of property investment. The growth of the portfolio and the company’s performance since then has been significantly driven by corporate acquisitions, including the £39.25m acquisition of a subsidiary of Quintain in 2013 and the £32.0m acquisition of Property Investment Holdings (PIH) in 2014. Both of these transactions had the added attraction of being tax efficient with minimal purchase costs (stamp duty) to absorb and their availability was in part due to the high leverage of both companies. While focusing on rent collection and liquidity as well as the delivery of HQ in the short term, PCA is ambitious to grow further. As gearing reduces following completion of HQ and the sale of residential assets, we expect (but have not forecast) PCA to seek new investment opportunities including acquisitions from distressed vendors and further corporate opportunities. We note the 5.04% stake that the company has in Circle Property, a relatively small, listed peer (market capitalisation of c £50m) that follows a very similar total return strategy focused on regional offices.

Exhibit 2 provides a summary of the PCA portfolio as at 30 September 2020 (H121). The external fair value of £281.6m differs slightly from the balance sheet value primarily due to lease incentive and other adjustments and comprised 52 income generating commercial properties (plus two car parks) plus the HQ development, split on the balance sheet between investment properties under development (the office and other commercial) and trading properties (the residential space that will be sold).The standing commercial assets had a gross annualised contracted rental income of £16.9m, and after non-recoverable property costs that mostly relate to voids, the net contracted rental income was £14.9m. The weighted average unexpired lease term was 4.9 years to first break and on an EPRA basis, occupancy was 84.9%. As a result of the total return strategy, voids are inevitable in the portfolio as vacancy is deliberately targeted ahead of asset management projects. However, the reduction in occupancy in H121 resulted from COVID-19 slowing letting activity across the portfolio in combination with some tenants vacating on lease break/expiry. The ERV of the portfolio of £20.2m represents a significant income opportunity, discussed below, and is expected to increase to c £21.1m upon completion of the HQ commercial space. The small reduction in ERV during the period primarily reflects a reduction at the leisure assets as well as a small office property disposal.

Since the end of H121 PCA has disposed of two non-core office assets for a combined c £2.7m, an average c 23% above the H121 book value. Meadow Court, a partially let office in Sheffield, was sold for £1.25m, 30% above book value, and the vacant Hyde Abbey House, in Winchester, with its historic Georgian façade was sold for £1.46m, 17% above book value with planning consent for a change of use to residential. As part of an ongoing disposal programme on non-core assets, typically smaller properties acquired with portfolio acquisitions and/or with limited further asset management potential, agents have been instructed on four further assets with a combined book value of £8.3m. PCA expects the assets to be sold at or above valuation.

The largest sector exposure is to regional offices (c 43% by value) where growing tenant demand, including relocations away from London, limited new supply and conversion of office space to residential have all contributed to a generally positive demand-supply balance and continuing rental growth. Industrial property (c 14% by value) has similarly benefited from firm occupier demand, limited new supply, and rental growth. There are two large leisure assets in Halifax and in Northampton, which account for c 12% of the portfolio by value. As with retail, the pandemic has presented significant additional challenges to the leisure sector. Securing longer-term occupancy and protecting valuation, and providing immediate pandemic support to the tenants, rental concessions were granted at Sol Northampton. A six-month, rent-free period was agreed with Accor Hotels in return for a five-year lease extension until 2032, and with Gravity Fitness PCA agreed nine months at half rent in return for the removal of a break clause, securing occupancy until 2034. Since end-H121 a rental concession granted to TGI Friday at Broad Street Plaza in Halifax has secured a three-year lease extension until 2030. In retail and retail warehouse (c 11% by value) the largest tenant exposure is to Aldi on a secure and recently extended long lease. The range of other retail tenants is diverse with no exposure to problem areas like mid-market fashion or department stores.

Adjusted for capital expenditure and the small disposal in H121, the like-for-like valuation decline in the first half of the year was 3.5%. Industrial valuations held up well and management expects this to remain the case; office asset valuations reflected the increase in occupancy and COVID-19, but management remains optimistic about sector fundamentals; and leisure, retail and retail warehouse assets bore the brunt of COVID-19 impacts in common with the broader market. The increased value of the development assets in H121 primarily reflects continuing construction spend.

The portfolio total return (capital and income) on an ungeared basis has been ahead of the MSCI Quarterly Index total return for the past three years and remained ahead in H121.

There is considerable potential income upside embedded within the existing portfolio, represented by:

Of the £3.3m (20%) end-H121 reversionary potential from the existing completed assets (ie excluding HQ), the single largest opportunity comes from void reduction (£3.1m). This includes vacant properties, in many cases recently refurbished, that are immediately available to let (£1.9m) and properties where vacant possession has been strategically obtained with a view to refurbishment or development activity, some of which could meanwhile be offered on short lets (£1.2m). Including HQ, end H121 potential ERV (£21.1m) was 25% ahead of the end H121 contracted rent.

Exhibit 8 indicates the reversionary potential by sector within the portfolio. Regional offices, the largest single sector in the portfolio, represent the largest void reduction opportunity and ERV upside.

HQ is a key development for PCA and the scheme remains on track and on budget for completion in March 2021, having previously been delayed by around two months due to social distancing measures and materials supply chain issues resulting from the pandemic and lockdown.

HQ occupies a two-acre site in York, within the city walls and just a minute’s walk from York railway station, which is 105 minutes (non-stop) by rail from London. The scheme comprises three residential buildings and a commercial building. The 127 flats will be sold and the commercial element, comprising 39,500 sq ft of grade A offices, of which 4,500 sq ft has been pre-let, will be retained for income. The underlying market conditions in York are favourable and interest in both the residential and commercial assets has been good.

Although the marketing suite was closed by the lockdown for four months from March to July (and again recently), contracts have been exchanged on 36 of the 127 apartments, up from 28 at 31 March 2020, with a value of £9.6m. The scheme is of high quality and PCA confidently expects an acceleration in pre-sales as completion approaches, without need to discount prices. It has recently been actively targeting overseas buyers through social media, particularly in the Far East and Middle East.

As previously announced, in February, 4,500 sq ft of office space, on the ground floor of one of the residential buildings was pre-let to Knights, a quoted law firm, at a record rent for York of £25 per sq ft. PCA has received considerable interest in the 35,000 sq ft of self-contained commercial space supported by is quality and location and a dearth of new building in recent years.

Palace has also identified several medium-term asset management opportunities that it plans to phase in over a number of years, potentially providing counter-cyclical opportunities to add value to the portfolio should market-wide rents and capital returns stall.

Exhibit 10 provides examples of some of the total returns on individual projects that contribute to the group performance. By way of example, PCA estimates that Hudson Quarter will generate a cash on cash return of c 47% (assuming the residential units are sold as expected and the commercial space is fully let and income generating 12 months after completion), or an ungeared IRR of 17%.

Reflecting the level of sector-wide uncertainty our last note included a range of scenarios for FY21 alone. With improving evidence of robust rent collection, increasing levels of market transaction activity and a gradual reopening of the economy (notwithstanding the more recent tiered restrictions), we have reinstated full forecasts for FY21 through until end-FY23. A summary is shown in Exhibit 11 below. Our forecasts for FY21 earnings and NAV are a little higher than our previously published central scenario. However, taking into account what we expect to be a relatively flat adjusted performance in FY22 versus FY21 (although we expect NAV to benefit from HQ development profits), we have slightly trimmed our FY21 DPS forecast (to 12p per share, still above the current quarterly run rate of 10p). For FY23 we expect adjusted earnings to benefit from a full year of income from the HQ commercial space and further positive leasing of vacant space and forecast an increase in annualised DPS to 16p.

Our forecasts include the post-H121 asset sales referred to above (with only a minimal impact on contracted rent) but we have not at this stage factored in the additional £8.5m in non-core asset sales targeted by management. We allow for the completion of HQ in March 2021, the sale of the residential apartments in full during FY22, and the letting of the standalone commercial space in FY22 with a first (and full year) income contribution in FY23. Our balance sheet forecasts assume that the residential disposal proceeds are fully directed at debt reduction, although in practice we would expect PCA to seek accretive acquisition opportunities and proceed with additional internal refurbishment and development opportunities (not included in our forecasts). Our key forecasting assumptions include the following:

PCA has total borrowing facilities of £151.9m of which £132.7m had been drawn at end-H121 (including unamortised debt arrangement fees). The debt was well spread across lenders with an average cost of 2.9% and an average maturity of 3.9 years. 51% of the debt was either fixed rate or hedged to mitigate interest rate risk. Other than the £25.6m Barclays Bank development facility that specifically funds construction costs at HQ, the first maturity is the £6.8m Lloyds facility in March 2023. We expect the Barclays development facility to be repaid from c £50m of HQ residential sales proceeds during FY22.

Allowing for balance sheet cash of £14.3m, end-H121 net debt was £118.4m and the LTV was 42.0%. During H121 net debt increased from £105.8m at end-FY20 and LTV from 38.1% due to additional drawing to fund construction at HQ. On an annual basis, our forecasts indicate a peak LTV of c 44% at end FY21 and assuming no reinvestment of the proceeds we expect HQ residential sales to reduce LTV to c 31% by the end of FY22. Our forecasts do not assume completion of the £8.6m of assets currently offered for sale and this has the potential to reduce peak LTV to c 42%.

Each of the facilities has its own agreed banking covenants in respect of minimum levels of LTV and interest cover (ICR) or debt service cover (DSCR, including loan amortisation). With the FY20 results PCA indicated that rental income would need to fall by more than 40% on average and asset values by 18% on average for all the ICR and LTV covenants to be challenged, respectively. The two facilities funding the leisure assets (Scottish Widows and Santander), where rent receipts were particularly affected by the pandemic lockdown, required temporary covenant waivers for the April quarterly test, but with improved rent collection met the tests in July and October. Group interest cover in H121 was 2.8x (FY20: 3.8x).

Exhibit 13 shows the end-H121 liquidity position. Cash reserves and immediately available borrowing facilities amounted to £26.3m and adjusting for £9.9m of capital commitments (the majority being the cost to complete HQ) net liquidity showed strong cover of annualised overheads. The immediately available debt includes the remaining development loan facility and a part of the undrawn RCF. To fully draw on the RCF facility requires additional properties to be charged.

Since its first major post-IPO transaction in H214 until end-H121 Palace’s total return strategy has generated cumulative EPRA NAV total returns of 106.1% or a compound annual average return of 10.9%. This is a good level of return despite the negative impacts of COVID-19 on late FY20 and H121 property valuations. Our forecasts indicate a negative (4.5%) total return for FY21 but positive returns in FY22 (10.8%, driven by development gains/residential disposal profits on the completion of HQ) and FY23 (7.5%, driven by increased rental income).

The company says that the current rate of quarterly DPS (2.5p per quarter) is the minimum that it expects to pay and that it expects to increase the payout with greater clarity on the economic outlook. We forecast 12.0p of aggregate DPS in FY21 and assume an increase to 16p in FY23 to reflect an uplift in recurring income earnings. Based on our forecast DPS the prospective yield is 5.8% and even at the annualised rate (10p) of current quarterly DPS (2.5p per quarter) the prospective yield is 4.7%, and we expect this to be fully covered by adjusted earnings. The shares trade at a significant discount (of almost 40%) to both H121 EPRA NTA per share (347p) and our forecast end-FY21 diluted NTA per share (341p).

In Exhibit 15 we show a summary performance and valuation comparison of Palace and a peer group of UK commercial real estate investment companies with a strong regional focus.

Palace shares have declined over 12 months, broadly in line with the peer average. However, the peer group performance is below that of the broad UK property sector where some of the long-income-focused specialist REITs and industrial-focused REITs have until recently been outperformers. In terms of valuation we show the trailing yield based on aggregate declared DPS over the past 12 months as well as the forward-looking yield based on the most recently declared DPS annualised. Neither is entirely satisfactory as the sector remains in a state of flux; most companies reduced DPS payouts during the pandemic and some postponed payments altogether for a time, and it will be a while before the full-year prospective DPS outlook becomes clearer and a true comparison can be made. To be clear, this trailing analysis does not reflect our FY21 DPS forecast of 12p per share. With that said, PCA’s annualised yield of almost 5%, based on the current quarterly run-rate, is in line with the peer average and compares favourably to the risk-free yield on offer (10-year UK gilt yields are less than 0.5%). Its price to NAV rating (P/NAV) is clearly below the peer average. Given the strong track record of total return generation, the prospect of HQ completion in March 2021, and the potential to drive further returns from the existing portfolio, the Palace valuation continues to appear undemanding despite the recent increase in the share price. There is material upside if economic and market prospects become clear in the coming months.

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. 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. In particular we note: