Picton Property Income — Earnings and outperformance maintained

Despite growing headwinds from the war in Ukraine, sharply rising inflation and interest rates, the UK economy has avoided recession and the occupier market has, at least for now, remained resilient. Picton remains focused on growing income further, through increased occupancy and capturing reversionary rental upside, and gaining cost efficiencies through growth, where opportunities arise. While property market valuations are difficult to predict, the opening months of 2023 have shown increasing signs of stability, despite persistent inflation maintaining upwards pressure on interest rates and bond yields. Over time we would expect valuations to follow the development of income. The key elements of Picton’s investment case, covered throughout this report, include the following:

FY23 EPRA earnings were in line with our forecasts, while NAV was slightly stronger, the likelihood of which we flagged following the trading update published by the company in April. A key feature of the EPRA earnings performance was strong leasing activity amid continuing rent growth, sufficient to offset higher property costs, the result of inflationary pressures and higher void costs. While leasing activity successfully captured rental upside in the portfolio, EPRA occupancy was lower at 91%, down from 93%. In part this includes the impact of acquisitions and a small number of lease surrenders, both creating asset management opportunities, but also a more cautious approach by businesses to taking new space amid economic and political uncertainty. On a like-for-like basis, contracted rents increased 3% and, as lease incentives rolled off, passing rent by 10%. Estimated rental value increased by 10%. We discuss the property portfolio outperformance in the following section, but note that the 12% like-for-like decline in the value of Picton’s portfolio compared favourably with the MSCI UK Quarterly Index capital return of -16.1%.

Key features included:

Picton’s investment strategy is total return driven with an income focus and aims to generate attractive returns through proactive management of the portfolio, investing in assets where it believes there are opportunities to enhance income and/or value. Its dividend policy is to distribute most of the recurring income earnings to shareholders via quarterly dividends, maintaining full cover, and generating surplus cash for reinvestment back into the portfolio. Despite a challenging FY23, the cumulative 10-year NAV total return2 has been 171.9%, or an average 10.5% pa. Reflecting the total return investment strategy, capital returns have contributed c 60% of total returns.

In common with the sector, the across-the-cycle income return has been much more stable than the capital return. Successful asset management is thus key to a sustainably enhancing total return.

The key driver of Picton’s total return performance has been the consistently strong property portfolio return, measured before the impact of gearing or non-property costs. The company has outperformed the MSCI Quarterly Property Index in each of the past 10 years, and is ranked fifth out of 141 funds, with upper-quartile performances over three, five and 10 years and since launch in 2005. Although the FY23 property total return was negative, -8.7%, this compared favourably with the index return of -12.6%

Among the factors supporting this strong performance, we note PCTN’s successful record of asset management, diversified sector strategy and disciplined, opportunistic acquisition strategy:

A responsible approach to business and an increasing environmental focus, for the benefit of all stakeholders, has become essential. In May 2022, Picton published its net zero carbon pathway and became a signatory to the Better Buildings Partnership (BBP) Climate Commitment.3 The pathway sets out the company’s plan to achieve net zero carbon (NZC) for both operational and embodied emissions4 by 2040, 10 years ahead of the government target, including the emissions of occupiers. The focus has initially been on Scope 1 and 2 emissions, which have reduced by 24% compared with the 2019 baseline. Renewable energy is now being incorporated across larger refurbishments and, increasingly, the company is working with occupiers to reduce the most significant part of the portfolio’s emissions, which fall under Scope 3.

With much work still to do to meet its targets, Picton has continued to develop team training on sustainability issues and has additionally recruited a head of building surveying, who will coordinate the building fabric related improvements that are required to improve its assets.

The end-FY23 ERV of £55.8m was £12.5m or 29% ahead of passing rent of £43.3m, providing a strong opportunity to organically increase income. Void reduction represented £5.3m of the potential upside, with the balance comprising the upside from lease incentive run-off (c £4.2m) and the potential to increase existing rents to market levels at lease expiry (c £3.0m).

By sector, the greatest potential is within the industrial and office sectors. With occupancy high in the industrial sector (and of the eight units that are vacant, four are under refurbishment), the upside is from reversion to market rents, which continue to increase. The passing rent of the industrials portfolio increased by 13% in FY23 and the ERV grew by 18%, or £4.1m on a like-for-like basis.

At 90.5% at end-FY23, EPRA occupancy is in line with the five-year average but below the 10-year average of c 93% and almost 6% below the 10-year high. As noted above, the office sector provides significant potential from void reduction, through letting or in some cases repurposing. With service costs typically higher in the office sector, void reduction also has a disproportionately positive impact on property costs. The £3.6m office void potential represents 6pps of the total 9.5% portfolio void.

Utilising its strong balance sheet, the company continued to undertake opportunistic, accretive acquisitions during FY23. In May 2022 it acquired two mixed-use properties, with retail/leisure on the ground floors and offices above, in Hammersmith and Cheltenham, for £19.0m before acquisition costs. Both properties were acquired at low capital values, below their estimated replacement cost.

The Hammersmith property, currently providing office and retail space, is located close to Olympia, which is currently undergoing a £1bn redevelopment delivering a new creative district, with a new theatre, entertainment venue and hotel, office, retail and leisure space, which will enhance the surrounding area. The property offers significant asset management potential, with the £13.7m consideration, settled from available cash resources, reflecting an immediate net initial yield of 3.3%, but more than 8% once fully let. Meanwhile, Picton has applied for planning consent for conversion of some of the vacant office space to residential use. Residential values in the area are approximately £1,000 per sq ft, well ahead of the overall £417 per sq ft capital value at acquisition.

The Cheltenham property, located in the town centre, was completely refurbished in 2020 and has strong environmental credentials, with an EPC rating of B on the office and retail elements. It is fully leased to four occupiers including Tesco, Just Go Holidays and Barnardo’s, with an average lease length of 12 years to expiry and eight years to break. The consideration of £5.3m, funded from Picton’s flexible revolving credit facility, reflected a net initial yield of 7.2%, rising to 9.0% by 2026 with most leases containing fixed rent uplifts.

Discounts to NAV persist across the REIT sector, prohibiting equity raising to part-fund acquisition-led growth, to increase scale and generate cost efficiencies. For as long as this persists, we expect further sector consolidation aimed at creating larger, more liquid and efficient businesses.

Picton’s internal management model means that its costs are not linked to net asset value or portfolio value, providing a clear opportunity for earnings accretion from external growth, for which its strong balance sheet, experienced management team and strong portfolio performance position it well. The company says that it has proactively considered various opportunities and is open to transactions that would create value for its shareholders.

Picton’s balance sheet is strong and substantially protected against further interest rate increases. Following a late-FY22 debt refinancing, both the company’s long-term credit facilities are fixed rate with a blended average cost of 3.7% and a blended average maturity of c 10 years. A shorter-term floating rate revolving credit facility5 (RCF) of £50m, providing flexibility to take advantage of further growth opportunities when identified, was c £12m drawn at end-FY23.

Total drawn debt at end-FY23 was £224.5m at a blended cost (including the RCF drawings) of 3.8% with a weighted average maturity of 8.4 years. Adjusting for cash of £20.1m, net debt was £204.4m and the loan to value (LTV) ratio was 26.7%.

At 31 March 2023 (end-FY23), the externally assessed fair value of the investment portfolio was £766m (the balance sheet value includes an adjustment for lease incentives and finance leases), reflecting an EPRA net initial yield of 5.0% and a reversionary yield of 6.7%.

The portfolio comprises 49 assets, let to more than 400 individual occupiers, of which the top 10 account for 24.7% and the largest (4.8%) is various public sector entities.

Exhibit 12 shows the split of the portfolio in greater detail.

During the year to 31 March 2023, MSCI data shows annual rental growth across all sectors even though valuations declined significantly as the market re-priced to higher interest rates. A feature of this re-pricing was that lower-yielding assets were the most affected, showing larger than average declines in property valuation. This extended to the relatively lower yielding industrials sector, despite strong rental growth, healthy occupier demand and generally limited supply. Reversing the trends of recent years, industrials total returns (-20.4%) were below the all-market average (-12.6%), while among the main sectors, high yielding retail assets showed the strongest performance (-7.9%). These are market averages, and no two portfolios are the same. Picton’s 8.7% return reflected positive asset management developments, despite its overweight industrials position.

We do not expect significant changes in Picton’s investment stance in the coming months. However, we expect less polarisation between sector performance than has been the case in recent years. Fundamentals in the industrial and retail warehouse sectors are strong. While general retail rents appear to have stabilised and yields are high, structural headwinds remain. Over time, Picton’s examination of alternative use in certain office sector assets may release capital for recycling and it seems likely that the company will identify reinvestment opportunities in other sectors.

The Investment Property Forum (www.ipf.org.uk) second quarterly survey of the year, based on data received from 18 organisations, whose forecasts were generated between end-March and mid-May 2023, showed a clear uplift in consensus expectations for rental growth and capital performance compared with the previous survey. The industrial and retail warehouse sector is confirmed as offering the strongest expected total returns over the next two years, supported by rental and capital growth.

FY23 EPRA earnings were in line with our forecasts, while NAV was stronger, the likelihood of which we flagged following the trading update published by the company in April.

In aggregate, our FY24 forecasts are little changed, with higher gross rental income offsetting higher property costs to generate a c £0.2m increase in EPRA earnings to £21.8m or 4.0p per share. With FY23 delivering 1.12x dividend cover, we continue to forecast a 2.8% or 0.1p increase in aggregate FY24 DPS to 3.6p (1.11x covered).

We have introduced FY25 forecasts, which include additional income growth in rental income and a slower increase in non-recoverable property costs (moderating inflation and reduced void space), reflected in moderate growth in EPRA earnings (c 3%) and DPS (c 3%). The actual outcome will depend significantly on the continued resilience of the economy and occupational demand. The modest changes in NAV that we project reflect retained earnings with no assumed net valuation movement. The increase in rents compared with a flat valuation implies an additional c 20bp increase in the valuation yield, providing some offset to potential market-driven yield widening.

We estimate that each 1% increase or decrease in the total portfolio value is equivalent to an increase or decrease in FY24e NAV per share of c 1.4p.

The current level of quarterly DPS (0.875p) represents an annualised rate of 3.5p or a 5.0% yield. We forecast further increases in quarterly DPS in FY24 and FY25.

The shares trade at 0.70x the end-FY23 NAV6 per share, well below the 10-year average of 0.95x and a high of c 1.1x. In common with the UK REIT sector, Picton shares have de-rated as interest rates have risen and the current valuation is broadly in line with its level at the height of pandemic uncertainty in early 2020.

Exhibit 17 shows a summary performance and valuation comparison of Picton and what we consider to be its closest diversified income-oriented peers. Over one and three years, Picton’s share price performance is slightly ahead of the widely spread group average. Based on 12-month trailing DPS declared, Picton shares trade on a lower yield than the group average (7.3% excluding Regional REIT), primarily reflecting its strategy of balancing sustainable dividends with the capital requirements of active management, as well as relatively low gearing. Its P/NAV is broadly in line with the average. The company’s strong track record of property level performance, the future income and valuation growth potential embedded in its portfolio, and its strong balance sheet with relatively modest gearing all provide valuation support.

The company was launched in October 2005 as the ING UK Real Estate Income Trust in an offshore structure, listed on the Channel Islands Stock Exchange and the London Stock Exchange. In 2011, the company name was changed to Picton Property Income and in January 2012, management was internalised, giving the company greater flexibility to manage costs and benefit fully from the growth in assets. In 2018 it became a UK-domiciled REIT and 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. Throughout this period, there has been no change in the company’s diversified, actively managed total return investment strategy.

The board comprises six members: four non-executive and two executive directors. The non-executive directors bring considerable experience from across the real estate, real estate financing and financial services sectors. The board is chaired by Lena Wilson CBE who brings a wide range of business and board experience to the group. She is on a number of boards in a non-executive capacity, including NatWest Group, and is also chair of Chiene + Tait LLP and AGS Group. Previously she was chief executive of Scottish Enterprise from 2009 until 2017 and, prior to that, was a senior investment adviser at The World Bank. The other non-executives are Mark Batten (chair of the audit and risk committee and the senior independent director), Maria Bentley (chair of the remuneration and nominations committees) and Richard Jones (chair of the property and valuation committee).

The executive board members are CEO Michael Morris and FD Andrew Dewhirst. Michael Morris has more than 25 years’ experience in the UK commercial property sector and has worked with the group since it was launched in 2005. Andrew Dewhirst joined Picton in 2011 and has over 30 years’ experience in the real estate and financial services sector. Brief biographies of the key members of the leadership team may be found on page 15 and detailed board biographies may be found on the company website.

Including the CEO and CFO, the broader Picton management team comprises 11 individuals, of whom five are property professionals.

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. More generally we note the sensitivity to: