Custodian REIT — Fifth interim payment continues DPS recovery

The unaudited net asset value at 31 March 2021 (end-FY21) was £409.9m (end-FY20: £426.7m) or 97.6p per share. NAV per share has increased for each of the past two quarters, with property valuations recovering some of the H121 unrealised losses and despite an increase in the quarterly DPS paid in Q421 (and relating to Q321).

Combining the movement in NAV with dividends paid, NAV total returns have been positive in each of the past three quarters and were positive for the year, driven entirely by income returns.

Unaudited EPRA earnings were c £23.8m (FY20: £28.7m) or 5.6p per share (FY20: 7.0p). The reduction in EPRA earnings reflects:

Including both the Q421 DPS of 1.25p declared for payment on 28 May 2021 and the fifth interim DPS of 0.5p declared for payment on 30 June 2021, aggregate DPS declared in respect of FY21 was 5.0p (FY20: 6.65p). Aggregate DPS was 113% covered by EPRA EPS of 5.6p (FY20: 7.0p) and fully covered by net cash receipts, in line with the current policy of paying dividends at a level that is broadly linked to net rental receipts. For FY22, the board has set a target for aggregate dividends of not less than 5.0p, primarily subject to rent collection remaining in line with expectations. On a longer-term basis, the policy remains to grow dividends on a sustainable basis, at a rate that is fully covered by projected net rental income while maintaining investment flexibility. We continue to forecast aggregate FY22 DPS of 5.6p, above the targeted minimum.

As of 4 May 2021, of the £36.9m of contracted cash rental income for FY21 (ie rental income adjusted for non-cash IFRS smoothing adjustments of £1.9m), c 89% had been collected in cash (some after the year-end) and, including the outstanding balances of agreed short-term rent deferrals, this increases to 91%. Applied to the sector mix of the portfolio (Exhibit 3) we consider this a good performance, which CREI notes has benefited from it collecting rents directly (ie not through a third-party agent), allowing better engagement with regard to payments and facilitating an improved outcome.

Around £3.1m of rent remained outstanding and due, and the subject of continuing discussions with tenants. As a result of the government’s moratorium on the eviction of tenants for non-payment of rent (previously extended but currently due to expire at the end of June 2021), we suspect that not all of this represents an inability to pay on the part of tenants. However, clearly a portion does and in some cases rent arrears are at risk of non-recovery from CVAs or insolvency.

For the current quarter (Q122), 66% of rent (before agreed deferrals) had been collected, in line with the same point in previous quarters and expected to increase.

The end-FY21 portfolio comprised 159 assets and was externally valued at £551.9m (FY20: £559.6m). The average lot size of c £3.5m reflects CREI’s strategy of targeting assets that may be too small for many institutional investors but too large for most private investors; with less competition from buyers, yields are typically higher. The valuation reflects a net initial yield of 6.6% (FY20: 6.7%) based on a contracted rent roll of c £38.9m. Active asset management has supported income and capital values through continuing lease events (new lets, renewals and re-gears), but tenant failures during the pandemic drove the decrease in occupancy from 95.9% to 91.5% during the year. Absent further significant failures, CREI expects occupancy levels to increase over the next three to six months as more new lettings are completed.

The portfolio is characterised by a very strong weighting to industrials, with a high exposure to retail warehouse and ‘other assets’1 compared with the overall market. Offices and high street retail exposures are relatively low. Valuations were hit hard by the pandemic, across all sectors, in Q121 but the subsequent continuing strength of industrial sector assets drove a net recovery in portfolio valuation through H221.

The strong performance of CREI’s industrial assets mirrors the market-wide trend but also benefited from asset management initiatives. The sector is benefiting from the accelerated trend of online purchasing during the pandemic as well as ‘onshoring’ of supply chains in response to Brexit. The ‘out-of-town’ retail warehouse sector performed significantly more strongly than high street retail and CREI notes recent strong competition for assets in the sector reflecting its convenience, relatively low rental cost, availability of parking and complementarity to online retail. The ‘other’ sector contains a number of tenant exposures that would ordinarily be defensive in terms of the economic cycle but which in the past year have proved less resilient to the pandemic, particularly during the first lockdown; capital values have increased in each of the past two quarters.

We have updated our forecasts, bringing FY21 into line with the unaudited Q421 data. Compared with our last published forecast (August 2020), FY21 EPRA NAV was higher and EPRA EPS slightly lower. DPS was also ahead, although our forecast predated the increase in the quarterly run rate of DPS declared in respect of Q321. FY21 annualised contracted rental income was more robust than we had allowed (but was nonetheless lower), resulting in higher than forecast accounting net rental income. Although rent collection continued to strengthen, charges against receivables were higher, and perhaps more prudent, than we allowed for and were the main reason why EPRA earnings and EPS were slightly below our forecast. The H221 recovery in all portfolio valuations drove the higher than forecast EPRA NAV.

We have made relatively modest revisions to our FY22 forecast and have introduced a tentative FY23 forecast.

The key forecasting uncertainties relate to rental income and collection, and our assumptions include:

Our NAV forecasts benefit from relatively low but positive capital return assumptions which, on a sector-by-sector basis, are broadly in line with the most recent consensus forecasts published by the Investment Property Forum (IPF). For FY22, we expect a blended increase of c 1%, again driven by industrial assets, and for FY23 we expect a blended c 1.5% as the recovery in capital values broadens across sectors. As always, there is much uncertainty about this. Each 1% increase/decrease in the value of the investment portfolio compared with our forecast would increase/decrease NAV per share by c 1.3%.

Although the UK commercial property market returns have historically shown significant cyclicality, income returns have been much less volatile than capital values. In this context, CREI’s consistent strategy since IPO has been targeted at generating sustainable and growing income returns, with the potential for additional capital growth over time. Although the exceptional circumstances of the pandemic forced a reduction in DPS in FY21, quarterly dividends were uninterrupted (unlike certain peers where DPS was suspended for a period) and have been maximised while tracking cash rental receipts. Attractive income returns on NAV have been maintained, and despite volatility in capital values, total return on NAV has also remained positive, albeit at a reduced level. From listing in March 2014 to March 2021 (FY21), CREI generated an EPRA NAV total return of 41.1%, or a compound annual average return of 5.9% pa, all of which has been generated by dividend payments.

The company’s minimum target for aggregate FY22 DPS of 5.0p, represents a prospective yield of 5.1%, and our forecast 5.6p DPS represents a yield of 5.7%. The shares are trading at around NAV, below the average c 8% premium since IPO in March 2014, and have recently traded at a premium. This allowed CREI to respond to investor demand for the shares by recommencing modest share issuance, at a premium to NAV, under its tap facility. The ability to issue equity at a premium to NAV has historically been of benefit to CREI, allowing it to maintain accretive portfolio growth while maintaining a low level of gearing, and without share issuance dilution.

In Exhibit 8, we show a summary performance and valuation comparison of Custodian and what we consider to be its closest diversified income-oriented peers. For comparative purposes, the valuation data are shown on a trailing basis and so do not capture the prospective increase in CREI’s DPS from 4.5p to 5.0p in respect of FY22. CREI trades on a higher P/NAV than the average of the group, as it has done for most of the period since IPO in 2014, while its trailing yield is slightly below average. Factors supporting CREI’s valuation include uninterrupted quarterly DPS during the pandemic (albeit at a reduced level), moderate gearing and a focus on smaller lot size properties with a yield premium that has historically supported risk-adjusted income returns.