Custodian Property Income REIT — Enhanced income-driven strategy

In addition to recent financial performance, this report covers CREI’s long-term performance and strategy. In summary, the investment case for the company is as follows:

CREI’s income-focused strategy has generated positive annual total returns in each year since listing in March 2014, with the exception of FY23, when the adjustment to increased bond yields led to sharp falls in property values across the UK commercial property sector. The aggregate return from listing to end-Q124 is 54.4%, effectively all accounted for by fully covered dividends paid. The average annual return is 4.8%.

With property valuation yields showing significantly greater stability compared with H223, NAV return has been positive in the past two quarters (Q423 and Q124) although still driven by income. For Q124, fully covered dividends paid contributed 1.4% (or an annualised 5.6%) to a total return of 0.7%, with NAV per share declining slightly to 98.6p from 99.3p at end-FY23. Although DPS is yet to return to pre-pandemic levels (Exhibit 3), the dividend yield on NAV is broadly similar as a result of the decline in property values and NAV in FY23. As we show in the valuation section below, with the shares trading at a discount to NAV, the dividend yield on the share price is significantly higher.

The greater stability of CREI’s income return as a percentage of NAV compared with more volatile capital returns is consistent with across-the-cycle sector returns, but the contribution from income to CREI’s returns is above the sector average, which we estimate to be c 70%.

While capital returns are volatile, we note that in FY23 the like-for-like valuation decline on the CREI portfolio of 11.8% compared favourably with the c 17% market-wide decline. An element of this outperformance is likely to be the above-average yield on CREI’s smaller lot-size assets in a market where otherwise ‘popular’ lower-yielding assets showed a sharper correction, regardless of underlying fundamentals. Calendar year to date, there has been a greater stability in values, with the market having substantially adjusted to higher interest rates while rental growth has continued. During Q124, CREI’s property valuation remained broadly flat, reflecting a marginal like-for-like decrease of 0.5% or £3.3m, net of a £2.0m valuation increase from active asset management activity.

Since IPO, CREI has sought to provide enhanced income returns from UK real estate by following a smaller lot-sized, regional property strategy. Its portfolio is built on a balance of core and core-plus strategies, or core/core plus. The core strategy is expected to deliver stable, long-term income from well-let, good-quality, predominantly smaller regional properties, in attractive locations. The core-plus strategy provides the opportunity to enhance income through asset management initiatives such as lease renewals, regears and new lets and refurbishment. Taken together, CREI aims to generate better risk-adjusted returns than would be possible from a core strategy alone, without a material increase in the volatility of underlying asset values.

Investment strategy does not target value-add acquisitions, often requiring significant improvement and void reduction measures, although the company will invest to reposition existing assets when there is the potential for attractive risk-adjusted returns. Investment policy allows for the redevelopment of properties already owned to a limit of 10% of gross assets. To be clear, CREI will not acquire land assets or properties with the intention of development or redevelopment. The purpose is to provide additional flexibility to enhance asset quality, including environmental performance, to better meet the demands of tenants and drive income growth.

The higher yield on smaller properties is often considered to reflect higher risk and, typically, a higher cost of management relative to income. However, smaller size does not in itself determine the quality of the property, its appeal to tenants or the quality of tenant. While there may be less competition for smaller assets from investors, there is an active owner-occupier market which supports vacant possession values and mitigates valuation risk. Asset selection and a long-term approach to investment are key to managing risk and hence CREI’s strategy for producing an attractive risk-adjusted income return, more than sufficient to offset the additional administrative complexity. Other key elements of CREI’s investment strategy for achieving above-average, risk-adjusted returns include:

Exhibit 4 compares the transaction net initial yields for properties below £10m versus those above, on a two-year rolling average basis. On this basis, over a c 20-year period, the yield spread of sub-£10m transactions over those of more than £10m has averaged c 1.1%. At end 2023, the spread had widened to c 1.9% compared with c 1.4% immediately before the pandemic. Independent data provided to CREI indicate that the spread based on lot sizes of less than £15m is a little narrower than for lot sizes of less than £10m but is still clearly positive. We would not take the change in investment policy with regards to lot sizes as an indication that CREI plans a greater focus on larger, lower-yielding assets. Rather, the company will have increased flexibility to invest selectively in a wider range of opportunities.

Although CREI’s smaller lot-size strategy has remained constant, the pool of suitable properties for investment has evolved over time, in step with market changes, and the stated investment policy has been adjusted to match. This primarily relates to the specified maximum lot size and the minimum weighted average unexpired lease term (WAULT).

The 2020 AGM approved the amendment of the company’s portfolio WAULT objective, which had previously targeted a minimum of five years, due to market shifts, including increasing tenant demand for shorter and more flexible leases.2 The additional flexibility that this provided recognised that the quality of the properties in the portfolio and the ability to re-let these on suitable terms are the fundamental drivers of income security rather than a simple focus on WAULT. Acquisitions are targeted at properties with lease maturity profiles that enhance the overall portfolio WAULT which, including the impact of asset management activity and despite the passage of time, increased to 5.0 years at end-FY23 compared with 4.7 years at end-FY22. Leases representing approximately one-third of gross contracted rents, or c £14m, mature over the next three years.

Portfolio diversification provides a mitigation to risk in uncertain times such as these and CREI’s portfolio is well spread across the main commercial property sectors and by location, tenant and lease term.

At 31 March 2023 (end-FY23), the externally appraised portfolio value of £613.6m3 reflected a net initial yield of 6.2%, up from 5.7% at end-FY22, with a rent roll of £42.1m pa. The number of properties has been relatively stable in recent years at c 160 and, allowing for multi-lets, the total number of tenancies is more than 300. The portfolio value at 30 June 2023 (end-Q124) was £614.3m, adjusted for capex, disposals and a 0.5% like-for-like valuation decrease.

At end-FY23, the top 10 tenants represented a little more than 22% of overall rent roll, with rents from the largest tenant, Menzies Distribution, spread over seven individual assets. Menzies is one of the UK's leading urban logistics businesses.

Exhibits 8 and 9 show the sector and geographic spread of the portfolio. Geographically, it has minimal exposure to London, but exposure to every other region. It is split between the main property sectors, in line with the company’s objective of maintaining a suitably balanced portfolio, with relatively high exposures to the industrial, retail warehouse and alternative sectors (‘other’, including pubs and restaurants, gymnasiums, drive-through restaurants, car showrooms, leisure, units and trade counters), with relatively low exposure to offices and high street retail.

The current investment focus is summarised by the company as:

The Investment Property Forum’s 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.

In an inflationary environment and with a lack of supply of modern, smaller regional properties, the company expects to see continued rental growth over the year ahead, especially for properties with strong environmental credentials. Additionally, meanwhile, the portfolio contains significant reversionary potential while rents continue to grow. During Q124, the externally estimated portfolio rental value increased by 1.2% on a like-for-like basis.

Providing a strong opportunity to organically increase income, the end-FY23 ERV of £49.0m was £9.1m or c 22% ahead of cash passing rent of £39.9m and £7.0m or 17% ahead of contracted rent of £42.1m, which included c £2.1m of lease incentives. Void reduction represented £4.7m of the potential upside to income with a further £2.2m from a closing of the gap between current rents and externally estimated market rents.

At 90% at end-Q124, EPRA vacancy is well above the average of 5% since listing but is in line with close peers. The main uplift in vacancy came during the pandemic and, more recently, has reflected increased refurbishment activity within the portfolio. Properties under refurbishment accounted for 37% of end-Q124 vacancy and a further 39% was under offer to let. Just 24% of the vacancy was available to let at the time. While the income upside potential is strong, a continuation of leasing progress will be required, both in respect of refurbished properties as they reach completion and at lease maturities.

The sustainability credentials of the assets in the portfolio have become increasingly become ever more important for occupiers and investors and are now central to the asset management. Positively, where investment is required, it is being reflected in greater tenant demand, additional rental growth and, increasingly, in valuations. All ongoing capital works are expected to enhance the assets’ valuations and, once let, increase rents to give a yield on cost of at least 7%, ahead of the company’s marginal cost of borrowing.

In FY23, capex amounted to £10.0m, or 1.5% of the opening portfolio value, compared with an average £2.7m/0.5% in the five years previously. An additional £1.2m was invested in electrical vehicle charging points, included in fixed assets. During Q124, capex was £5.3m. The investment was spread across a range of assets in different sectors but, notably, included the redevelopment of an industrial site in Redditch. The Redditch development accounted for £3.6m of the FY23 spend and £2.7m in Q124 as it approaches completion. The 1980s industrial building has been fully upgraded to a modern industrial/distribution facility, expected to be rated BREEAM4 ‘excellent’ with an EPC5 A rating. The base build is carbon neutral, includes electric vehicle charging points (referred to above), solar voltaic panels, LED lighting, cycle storage and shower facilities. The site also incorporates a bat roost. Demand for the property is strong and the ERV has reached £660k per year.

Where the risk-return balance of investing in properties is unfavourable they will continue to be sold, often for alternative use. For this reason and other strategic reasons, the company has properties under offer for sale with an aggregate value of c £10m and expects to achieve proceeds ahead of this, to be invested in its remaining capex pipeline. Further potential sales have been identified, with proceeds expected to be used, at least initially, to reduce borrowings.

From 2023, MEES6 regulations prohibited the leasing of space that is rated EPC F or G and it is proposed that from 2027 a rating of at least EPC C will be required. During FY23, within the CREI portfolio, the weighted average share of properties EPC rated A to C increased from 63% to 70% as a result of improvements embedded in refurbishment programmes as well as asset disposals. There were just two properties containing EPC F-rated units, for which asset management plans are underway.

More broadly, CREI’s approach and strategic objectives are set out in its inaugural ESG report.

With much of the sector trading at wide discounts to NAV, CREI sees a strong case for further consolidation, especially among the subscale listed REITs. Leveraging its own low gearing and below average discount to NAV, the company seeks opportunities to purchase complementary portfolios via mergers or corporate acquisitions, similar to its acquisition of Drum in November 2021. Drum was acquired for £43.5m, adding a portfolio of 10 assets with a valuation of £49m, with the consideration settled by the issue of new CREI shares.

CREI has debt facilities of £180m or £190m including an accordion option7 on its £40m revolving credit facility (RCF) with Lloyds Bank, of which £178m was drawn at end-Q124. £140m of debt is fixed rate with a blended cost of c 3.6% and average term to maturity of 6.8 years at end-Q124. Including the £38m of shorter-term, flexible, floating rate RCF with Lloyds Bank, the total average cost of debt at end-Q124 was 4.0%, with an average term to maturity of just 5.6 years.

With 79% of end-Q124 debt fixed/hedged, CREI is substantially protected from further interest rate increases such that a 0.5% increase in the SONIA benchmark rate applied to the RCF increases the average cost of debt by just 11bp or c £0.2m.

CREI operates with moderate gearing and at end-Q124 the net loan to value ratio (LTV) was 28.0% (end-FY23: 27.4%), just a little ahead of its medium-term target of 25%, with significant headroom against debt covenants.8 With a substantial pool of assets unencumbered by borrowings (£166m at end-FY23), the company estimated at end-FY23 that at portfolio level, property valuations would have to decrease by 19% to risk breaching the overall 35% LTV covenant. The rate of loss or deferral of contractual rent on the borrowing facility with least headroom would need to deteriorate by 30%9 to breach interest cover covenants.

FY23 EPRA earnings were in line with our forecast, although the composition included lower rental income than we forecast, offset by lower expenses and finance costs. Our FY24 forecast is little changed. We forecast FY24 and FY25 EPRA earnings to be broadly in line with FY24, with steady but modest rental growth offsetting higher interest costs on the portion of borrowing that remains unhedged. Forecast rental growth is driven by net leasing and rent reviews. We have not assumed any acquisitions or disposals, although these are likely, explicitly assuming that the disposals expected by the company, referred to above, are offset by a combination of income on reinvestment, lower direct property costs and lower finance costs.

Given the continuing uncertainty regarding market-wide property valuations, we have assumed no change net of capex (capex contributes positively to total portfolio valuation). We assume capex of £10m pa from Q224 onwards.

CREI’s target DPS for FY24 of at least 5.5p represents a prospective yield of 6.5%. Meanwhile, the shares trade at a c 15% discount to the Q124 NAV per share of 98.6p.

In Exhibit 18, we show a summary performance and valuation comparison of CREI and what we consider to be its closest diversified income-oriented peers. CREI’s share price performance is similar to that of the peer group and the broad UK property sector over one year and ahead of the sector, but below the peer group, over three years. The sector has underperformed the broader market, most recently as interest rates have risen.

CREI trades on a higher P/NAV than the average of the group, as it has done for most of the period since IPO and, while its trailing yield is slightly below the average, its dividend is fully covered.10. The company’s focus on smaller lot-size properties with a yield premium that has historically supported risk-adjusted income returns.

FY23 results were published in June 2023 and the company has subsequently published its quarterly update for the three months ending 30 June 2023 (Q124). A summary of the Q124 performance is shown in Exhibit 19.

FY23 included a steady recurring income performance, with DPS fully covered by EPRA earnings, but a sharp reversal in the prior year property gains, particularly in Q323 (September to December 2023), in line with but less pronounced than the wider market trend. Seven assets were acquired for an aggregate £52.6m (before costs) at a blended net initial yield of 6.3%. Six assets were disposed of for an aggregate £28.8m, at a 28% premium to valuation, generating a £4.4m realised gain (net of selling costs), and reflecting a net initial yield of 8.3%. Gross contracted rent roll increased by £1.5m to £42.0m, including £1.3m from acquisitions net of disposals and £0.3m from rental growth and a small increase in occupancy. Gross rent roll was little changed in Q124, although positive leasing events added a gross £2.2m of annual rental income, in aggregate in line with ERV, offsetting lease maturities and terminations, with occupancy flat at 90%. EPRA EPS increased to 1.5p (Q423: 1.4p), fully covering DPS of 1.375p.

Exhibit 20 shows a summary of the FY23 results. We highlight the following:

Custodian Property Income REIT is an externally managed UK real estate investment trust (REIT), listed on the Main Market of the London Stock Exchange. Its stated purpose is to offer investors the opportunity to access a diversified portfolio of UK commercial real estate, with strong environmental credentials, which can provide an attractive level of income and the potential for capital growth. It aims to be the REIT of choice for private and institutional investors seeking high and stable dividends from well diversified UK real estate.

CREI’s board of directors comprises six members, all of whom are non-executive and five of whom are deemed independent. The board is chaired by David MacLellan, who joined the board in May 2023, taking over from David Hunter as chair on his retirement from the board at the 2023 AGM after nine years of service. David MacLellan has more than 35 years’ experience in private equity and fund management and has an established track record as chair and as a non-executive director of public and private companies.

The other directors are Hazel Adam, who joined the board in December 2019, bringing a range of experience including in the buy-side and sell-side investment industry, strategies and markets, Elizabeth McMeikan, a former Tesco executive and experienced board member, appointed in March 2021, Chris Ireland, a former CEO of JLL UK and former chair of the Investment Property Forum, who also joined the board in March 2021, Malcolm Cooper, who has extensive board experience and a background in corporate finance, infrastructure and property, and who joined the board in June 2022, and Ian Mattioli, who as chief executive officer of Mattioli Woods and a board member of the investment manager, is deemed not to be independent. Ed Moore, finance director of Custodian Capital, is company secretary to CREI. Full details of the board can be found on the company’s website.

The company is externally managed by Custodian Capital, a wholly owned subsidiary of Mattioli Woods. Custodian Capital was appointed investment manager at the IPO, an arrangement that is subject to regular board review. Richard Shepherd-Cross is the managing director of Custodian Capital and the fund manager of CREI. He is a former director of Jones Lang LaSalle in London, where he led the portfolio investment team before joining Mattioli Woods in 2009, with responsibility for its syndicated property initiative, the precursor to Custodian. Richard is supported by Custodian Capital’s other key personnel, including Ed Moore (finance director), Alex Nix (assistant investment manager) and Tom Donnachie (portfolio manager), along with a team of five other surveyors and four accountants

Management and administration fees are paid to the manager on a sliding scale that allows shareholders to benefit from growth in NAV. The fees on continued growth in NAV above £500m were reduced during the year.

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. CREI’s development exposure is modest and limited to the improvement of existing properties. In this respect, it may best be seen as an extension of its refurbishment activity, aimed at enhancing long-term income growth and returns. Forward-funded development activity is likewise modest and, in our view, very low risk. More generally, we note the sensitivity to: