Custodian REIT — Diversified income focus

Custodian REIT is a Main Market listed REIT focused on UK commercial property outside of London with a target lot size of sub-£10m. It is income focused, with the potential for capital growth and is committed to paying a high, sustainable, covered dividend while maintaining a conservative level of gearing. It is managed by Custodian Capital, a property management and investment business, regulated by the FCA. Custodian Capital is a subsidiary of Mattioli Woods, a specialist wealth management and employee benefits consultant, with £7.8bn of assets under management or advice as at May 2017. CREI listed in March 2014 and originates from syndicated funds, managed on behalf of Mattioli Woods clients by Custodian Capital over a 12-year period. These funds provided a seed portfolio of £95m to which the IPO proceeds added £55m. Subsequent placings have seen the market capitalisation increase to the current c £426m.

Including properties acquired since end-H118, the diversified portfolio comprises 144 properties, let to more than 275 different tenants, and spread across the UK with a value that is approaching £500m. It includes investments in all of the main commercial sectors: office, retail, industrial and distribution, as well as a range of alternatives, including leisure, car showrooms, trade counters and day nurseries.

Despite targeting smaller lot sizes where competition for assets can be lower, especially competition from larger investors, CREI seeks quality properties, which it describes as institutional grade, that it expects to maintain above average occupancy and income levels over the longer term.

We briefly review the highlights of the FY18 interim results below as many of the key numbers have previously been reported in the company’s monthly Factsheets. The period saw continued growth in the income generating asset base, substantially funded by ongoing equity issuance at a premium to NAV, with a conservative level of gearing maintained. 12 properties were acquired during H118 at an average net initial yield of c 6.8%, well above funding costs. Meanwhile, the changes to the management fee structure announced in June enhance the opportunity to benefit from scale economies. Ongoing charges during the period were c 1.2%, similar to FY17. Occupational demand remains healthy, supporting rental growth and low vacancy rates across the portfolio.

The financial highlights of H118 were:

CREI remains focused on maintaining and enhancing cash flow from the portfolio to support its objectives to pay fully covered dividends and secure sustainable growth. It believes that rental growth in regional markets will be a key driver of the company's performance, which it seeks to enhance through the deployment of new debt and equity and continued asset management of the portfolio. 

Occupational demand remains healthy, supporting rental growth and occupancy across the portfolio. The manager sees no signs of an oversupply of property in the occupational market and observes that with a continued low level of development it is tightness of supply rather than excessive demand that is driving rental growth. Rental levels in many regional markets, it is argued, remain too low to bring forward material new development, which is a positive indicator for continued rental growth and should better insulate the market from potential shocks compared with previous rental growth cycles. In this environment, CREI sees continuing opportunities to invest. Competition for assets remains strong, requiring a disciplined approach to acquisitions, but with the interim results CREI said that it had agreed terms on £18.9m of properties and was considering an active pipeline of new acquisition opportunities as vendors prepare to conclude sales prior to the end of 2017. It has subsequently announced the acquisition of a retail asset in Worcester for a consideration of £5.54m.

Although the commercial property market is cyclical, the company believes that its strategy of securing sustainable income will support future dividends through any medium-term market volatility and deliver capital growth for shareholders over the long term despite the potential for cyclical impacts on NAV along the way.

In the following section we provide an update on the portfolio and operational performance.

Excluding the recent acquisitions, the portfolio was valued at £474.3m at the end of September 2017, consisting of 141 properties, let to 206 tenants, accounting for 255 individual tenancies. Income-based occupancy was 96.7% at 30 September with a weighted average unexpired lease term to first break (WAULT) of 5.75 years. The annualised rent potential was £35.4m. Since the period end, CREI has added a further three properties for an aggregate consideration of c £19.2m before acquisition costs, taking to the total portfolio size to close to £500m and adding c £1.4m in annualised rental income.

The 12 assets added to the portfolio in H118 are listed in Exhibit 4, along with the three assets that have been added since the period end. The aggregate H118 consideration of £56.1m, before costs of acquisition and adjusted for rent-free top-ups, represents an average net initial yield of c 6.8%.

The like-for-like portfolio valuation increase was c £3.7m (0.9% of the opening value), although this was substantially offset by c £3.4m of costs related to the properties acquired in the period, equivalent to an average 6.2% of the consideration. The strongest underlying gains were seen in industrial and retail warehouse properties. Asset management initiatives generated £1.7m of the £3.7m valuation uplift.

The diverse nature of the portfolio, both by asset type and by geography, is shown in Exhibits 1 and 2. Exposure to office properties remains relatively low, reflecting the manager’s view that pricing often underestimates the rate of obsolescence. The strong existing exposure to industrial properties was beneficial during H118 and valuations in retail warehousing, the main area where exposure has been increasing, were also positive. Retail warehouse acquisitions represented £32.6m or 58% of the H118 total and the retail warehouse weight in the overall portfolio increased from 11% to 16%, and has increased further since period end. Retail warehousing vacancy rates are close to historical lows with development activity constrained by restricted planning policy among other factors, while retailers continue to target larger format stores, easy parking, and “click and collect” capability.

Our revised forecasts are shown in Exhibit 6. The main change is to incorporate the acquisitions and equity raising that has taken place since we last updated our forecasts, to which we have added an additional £10m of “notional” acquisitions from the acquisition pipeline, at a net initial yield of 6.8%, utilising already drawn debt facilities.

Our revenue forecasts previously included the seven Q118 acquisitions (£31.28m in consideration) shown in Exhibit 4. We now include the five additional acquisitions completed in Q218 (c £26.3m aggregate consideration and c £1.9m in annual rental income), the three acquisitions announced since period end (c £19.2m in consideration and c £1.4m in annual rental income), the three disposals discussed above (all made in Q218) and the notional further acquisitions.

We have also adjusted for the 26.34m new shares issued since end-Q118 under the block listing facility, generating proceeds of £30.2m at an average issue price of 114.5p per share.

Our forecast net rental income increases by 4.7% in the current year and a larger 13.2% in FY19 as the acquired properties make a full year impact. The rental income increase in the current year (see below) is slightly more than offset by a revision to our forecast for interest costs, largely because the £35m of debt that was drawn in April of this year had a greater impact on average borrowing than we had allowed for in our modelling. Looking ahead, CREI has recently drawn an additional £15m in debt, the cost of which is included within next year’s forecast, although the proceeds are yet to be fully committed to income generating assets. The notional acquisitions assumed avoid a drag from unspent cash on earnings, an unlikely outcome given management’s pipeline of acquisition opportunities under offer.

Our FY19 EPRA EPS forecast increases to 7.30p leading us to raise our DPS expectation to 6.55p per share, a 90% pay-out of EPRA earnings, and growth of 1.6%.

With the interim results, CREI commented that it had c £57m in available funds to deploy on property acquisition opportunities as at 30 September 2017. This consisted of £7m in uncommitted cash and undrawn borrowing facilities of £50m. The £15m debt drawdown in early November represents the second tranche of a £50m 15-year fixed rate facility agreed in April 2017. In addition, CREI has a £35m revolving credit facility (RCF), which remains undrawn. Allowing for subsequent acquisitions and equity issuance, we estimate that c £47m of available funds remain, of which we have allocated just £10m to the notional acquisitions included in our forecasts.

CREI targets a conservative level of gearing and a net LTV of 25%. At 30 September it was 19.7% and the company recently indicated a level of 20.2%, which allows for recent acquisitions and equity issuance. The weighted average maturity of all of CREI’s agreed debt facilities is 10 years, with a 77% fixed rate, and the average cost is 3.1%.

For the current financial year, CREI is targeting an aggregate annual DPS of 6.45p, paid in equal quarterly instalments, fully covered by earnings. This represents a dividend yield of 5.6%, covered 104% by our EPRA EPS forecast.

During the three and half years since listing (March 2014), CREI has paid 19.4625p in dividends in aggregate and has increased EPRA NAV per share from 98.2p at listing to 104.9p at 30 September 2017. This represents an aggregate total return of 26.6% over the period, or an annualised total return of 7.0%.

The focus on income is clear, with dividends paid representing 75% of the total return since IPO. Management’s strategy is aimed at sustainably growing fully covered DPS and our forecasts for FY19 look for a 3.1% increase to 6.65p per share, 90% of forecast EPRA EPS. Although the commercial property market as a whole has historically displayed significant volatility in returns, and is likely to do so again in the future, income returns have proven to be considerably more stable than capital values. It is this relative consistency of income returns, backed by high levels of occupancy, that CREI is targeting.

Turning to a comparison of CREI with other listed property vehicles, Exhibits 8 and 9 show prospective dividend yields and historical P/NAV ratios for a broad universe of property investment companies and REITs. This universe is quite diverse, including specialist investors such as the healthcare property REITs and others focused on long duration income streams, as well as a range of companies with more mainstream commercial portfolios and varying degrees of focuses on income and capital growth. There is no significant correlation between this yield and P/NAV data, although it is reasonable to believe that those companies that are expected to offer the most attractive returns over time (a combination of both dividend income and capital returns) are likely to command a higher P/NAV.

CREI’s prospective dividend yield places it towards the top of this broad group, and this provides support to the P/NAV ratio, which at 1.09x is also above average. The manager’s ability to continue to secure accretive asset acquisitions, the opportunities to actively manage the existing portfolio, and the prospect of continuing rental growth all suggest that CREI should be able to continue to grow income returns, with further potential for capital growth.

Given the broad diversity of the investment vehicles shown in Exhibits 8 and 9, in the following table we show a sub-set of data for those companies that we think should be considered as the closest comparators to CREI. A similar picture emerges with CREI providing a higher than average yield and commanding a higher than average P/NAV.