Regional REIT — Creating value through asset management

RGL performed strongly in FY18, generating an EPRA NAV total return of 16.6% including a significant contribution from dividend income, with DPS further increased during the year. It was an active year for portfolio transactions, with substantial capital recycling generating significant capital gains and providing an opportunity to refresh the portfolio for future growth. However, with sales running ahead of reinvestment during the year, portfolio income growth was dampened. RGL was also active in terms of refinancing borrowing facilities, extending and staggering maturity dates, increasing flexibility and reducing the average cost. In August it successfully issued £50m of retail eligible bonds at 4.5% due in 2024. The proceeds have allowed for repayment of more expensive facilities, lowering future interest costs, but incurring some temporary ‘double financing costs’. The temporary dampening of income and additional debt-related costs had a noticeable impact on the FY18 adjusted earnings growth and dividend cover but will support future returns. We expect FY19 income and earnings to benefit from reinvestment of disposal proceeds, continued occupancy and rental growth and interest savings from the repayment of higher-cost debt. We expect the FY19 DPS to increase and be fully covered by adjusted earnings.

The key highlights of the results and more recent activity are:

In a positive outlook statement, RGL says it has yet to see any notable change in occupier demand for its assets as a result of the continuing Brexit negotiations and lettings have remained strong into FY19. The company expects its continuing asset management strategy and the continued strength of occupational demand in its core regional office and light industrial property markets will continue to deliver attractive income and capital growth opportunities. With substantial net sales in FY18 and increased flexibility in debt facilities, RGL may be able to benefit from a potentially broader array of opportunities that recently increased Brexit and economic uncertainty may create.

Capital recycling is at the heart of RGL’s strategy. Supported by its fully integrated in-house asset management platform, it seeks to opportunistically acquire attractively priced, income-producing assets that will benefit from active management and may subsequently be sold to realise the value thereby created. During FY18, RGL took advantage of good investment demand to dispose of properties where its asset management plans were complete and, in some cases, where plans were yet to reach maturity but where it had identified that a better risk-adjusted return was available by selling at prevailing market prices, well above valuations. This included the strategic decision to sell 47% of the firm’s industrial portfolio into what it identified as an overheating investment market, particularly in the first half of the year. RGL says it continues to identify attractive asset management opportunities and we would expect capital recycling to continue, although at a slower pace than in FY18. In our forecasting, we assume an unchanged portfolio (other than the early February acquisition of Norfolk House in Birmingham), which implicitly allows for further sales to be matched by acquisitions despite likely short-term timing differences. In FY18, RGL front-loaded disposals, taking advantage of strong investor demand and anticipating the potential for the approach of the Brexit negotiation deadline to introduce some caution into the investment market. In the current year, we would not be surprised to see acquisitions lead disposals, for which existing cash balances and the more flexible borrowing facilities provide headroom. RGL has always been opportunistic in its approach to acquisitions and, should more significant opportunities present themselves in the coming months, we would expect the company to weigh the potential against any possible need for additional capital resources.

At end-FY18 the property portfolio was valued at £718.4m (end-FY17: £737.3m), with a contracted rental income of £59.7m (end-FY17: £61.9m). On an EPRA basis (which excludes refurbishment properties) occupancy increased to 89.4% (end-FY17 88.2%). Measured by value, which unlike EPRA includes refurbishment properties, an important part of RGL’s strategy, occupancy increased at a slightly faster pace to 87.3% at end-FY18 (end-FY17: 85.0%). The weighted average lease term (WAULT) to first break was 3.4 years and the valuation at that date reflected a net initial yield of 6.5%, unchanged on end-FY17. The estimated rental value (ERV) of £70m reflects a reversionary yield of 8.8%.

RGL’s strategy is focused on regional offices and light industrial property (91.6%), with relatively small exposure to retail and other assets, likely to be disposed of over time. The strategic sale of industrial assets during FY18 saw the industrial weighting of the portfolio reduce to 15.5% (end-FY17: 23.3%), with a corresponding increase in the office weighting to 76.1% (67.3%). The shift appears well timed, with the investment market for industrial assets showing some recent cooling. In the office sector, the regional assets are performing well due to the continued demand for space and the potential for rents to increase from relatively low levels. Reinforcing the strategic direction that RGL has taken since IPO, exposure to better-performing areas of the UK such as the south-east increased further, while exposure to Scotland reduced and is approaching the medium-term target of c 15%.

Maintaining a highly diversified tenant base is a key element of mitigating economic and sector risks to income. RGL pays close attention to the business of its tenants, of which there are nearly 900, and the breadth of its exposures can fairly be said to represent the whole UK economy (Exhibit 5).

FY18 EPRA earnings and EPS were a little ahead of our estimates, driven by net rental income, while DPS had been previously announced. The LTV, similarly pre-announced with RGL’s portfolio valuation update in February, was lower than our last published estimates. As explained in our recent update, these estimates had assumed re-investment of disposal proceeds in late in FY18, affecting our forecast end-FY18 LTV, but coming too late in the year to contribute to income. The first re-investment came in early February with the £20m acquisition of Norfolk House.

The changes to our FY19 estimates are modest and we continue to forecast DPS growth broadly in line with inflation, fully covered by adjusted earnings. There is a slight reduction in forecast net rental income, resulting from lower assumed net property acquisitions (see below) and forecast EPRA NAV per share is slightly affected by our more cautious approach to revaluation movements, as discussed below. We also introduce a FY20 forecast for the first time, anticipating continued growth in fully covered DPS, with modest growth in EPRA NAV per share.

The c 14% growth in adjusted earnings that we forecast for FY19 is driven by reinvestment, occupancy and rental growth and interest savings from the repayment of higher-cost debt. We have assumed aggregate dividends per share will grow by c 2.5% to 8.25p and expect these to be fully covered by adjusted earnings per share of 8.5p. Our main forecasting assumptions are:

RGL targets a medium-term annual total return of more than 10% and the strong 16.6% EPRA NAV total return in FY18 takes the total return generated since IPO in November 2015 to 37.5%, or a compound average annual return of 10.6%. The strong income focus is clear, with growing dividends per share contributing 59% of the total return over the period.

RGL’s high dividend yield continues to be at the very top end of the broad UK property sector. For FY19 we forecast the DPS to be both higher and fully covered by adjusted earnings, representing a prospective yield approaching 8%.

In Exhibit 8 we show a comparison with a narrow group of peers that are similarly focused on regional commercial property. To ease comparison, this data is based on 12-month trailing DPS declared and last published NAV. Compared with this narrower group, RGL’s yield is also well above the average. Its c 8% share price discount to the end-FY18 EPRA NAV per share is lower than the average for the narrower group of peers and is lower than the average for the broad UK property market (we estimate ac 10% discount). Within the group, those companies with an income focus, like RGL, and covered dividends tend to have the higher P/NAV ratings.

RGL shares have performed more strongly than the narrow peer group, the broad UK property sector, and the FTSE All-Share Index on a one, three and 12-month basis, which we attribute to its ability to demonstrate strong asset management returns, commitment to a progressive dividend policy and reduced LTV. Given the high prospective yield, the prospect of a return to fully covered dividends in FY19 has the potential to support a further re-rating of the shares.