Regional REIT — Focusing strategy and potential buy-back

RGL’s portfolio has steadily shifted towards regional offices since IPO in November 2015 and at 30 June 2020 (H120), office properties accounted for 79.9% of the total portfolio value of £742.3m. Recent transactions (see below) will have lifted the weighting clearly above 80%, as RGL continues to use the strength of investment demand for industrial assets to lock in gains and recycle capital into higher yielding office assets. Not surprisingly, the recent capital presentation focused on the strengths of the existing portfolio and the investment adviser’s positive outlook beyond the immediate challenges. The slides and accompanying webcast are available on the RGL website.

In the period since 30 June (end-H120) RGL has sold properties with a value of £37.7m and has more than replaced the income through the acquisition of three properties with an aggregate value of £25.7m. The single largest sale was Juniper Business Park in Basildon, an industrial warehouse and office park, for £32.7m, 59.4% above the March 2016 acquisition price adjusted for capex and 3.9% above the June 2020 valuation, which we estimate reflects a 5.7% net initial yield. This has been followed by the acquisitions of:

We have not adjusted our earnings forecasts although we expect the transactions to date to have a net positive impact on rental income on a full-year basis. Our revised balance sheet and cash flow captures the small reduction in LTV.

The capital markets day set out the reasons for RGL’s confidence in the prospects for the office sector, supported by positive supply-demand conditions and why it believes that predictions of the ‘death of the office’ in a post-COVID-19 world are misplaced, drawing on data from its own tenant survey as well as external analysis. It also provided additional details on the defensive characteristics of its current office portfolio, contributors to the continuing strong rent collection performance.

As previously reported on 3 November 2020, rent collection for the whole portfolio had continued to strengthen, with 96.6% of rents due for the year to date, adjusting for monthly rent and agreed collection plans, only slightly behind the 98.1% collected in the equivalent period of 2019. On an annual basis, around 99.7% of rents are typically collected and RGL hopes to exceed 99% for this year despite the pandemic.

The strong collection performance reflects a number of factors including the weight of offices in the portfolio (office collections have been above average across the market), the highly diversified income base (by tenant, industry, property and geographic location), the investment manager’s integrated multi-office platform that enables it to stay close to tenants and respond to their needs, the quality of the tenants, and the quality and affordability of the assets.

RGL has emphasised the relatively yield on its office portfolio (a H120 reversionary yield of 9.4% and net initial yield of 6.3%) is not an indication of low-quality assets or tenants. Its target is the provision of high-quality offices throughout the regions of the UK in a cost-effective manner and as a result its assets are not typically prime/grade A. Although often described as ‘secondary’ assets, RGL believes they are generally of high quality – built to a high specification, with raised access floors, air conditioned and refurbished to a high standard within the past 10 years – and most could reasonably described as ‘grade A- or B’. For those assets it considers A-, achieved rents are 40–50% lower than for similar quality prime/grade A, although are likely to be in more peripheral locations or well-located business parks. For those assets considered grade B, the gap to prime/grade A assets is 50–70% while remaining very suitable and functional for most occupiers. Across the office portfolio, RGL says it targets high-quality assets that are for fit for national, multi-national and regional and SME companies, and the presentation backs this up with numerous tenant examples. Positively in the current environment and for the foreseeable future, 60% of H120 office assets were located in out-of-town business parks with good parking facilities; the majority of the assets are low rise (one to three floors) and there are only two assets in the portfolio with more than 10 floors.

Due to the supply overhang from the last great property cycle, which peaked in 2012 (later than economic activity due to development activity in progress), regional office rents have been slow to pick up. The relatively high yield on RGL’s office assets reflects low rents (an average £13.24 per sq ft for the office assets at end-H120) and low capital values. RGL estimates the average capital value of c £131 per sq ft compares with an average build cost (excluding land costs) of c £198 per sq ft. Although available market supply has reduced in recent years (in part through re-purposing towards residential, student and hotel accommodation) and continued to shrink in H120, low rents have acted as a drag on new building, unlike previous cycles. With structural demand factors such as office migration from (more expensive) London to the regions and the political goal of rebalancing economic activity from south to north likely to remain, possibly reinforced by a shift to ‘localism’ (smaller, regional offices located in regional towns outside the capital), beyond the immediate challenge of the pandemic the investment manager sees a strong opportunity for continued rental growth.

The counter argument to this positive outlook is primarily that the pandemic may lead to a permanent shift towards home working and, combined with pressures on employment, this will reduce demand for office space in both the short and longer term. Although the ongoing restrictions have made the pace of return to offices uncertain and in most cases business are still formulating their strategic responses, RGL’s analysis leads it to conclude that the ‘death of the office’ has been vastly overstated. Core to this conclusion is the broad role the office plays in company culture and productivity, being a place for both concentrated work and collaboration, connection, innovation and social interaction. While each business will be different and it seems likely that working from home will increase for a great many businesses, it is unlikely to be a choice of either/or and more likely a hybrid and it is not clear if this will translate into a reduced requirement for workspace. Hot desking is typically unpopular with staff, who value their own space, a place to store belongings and the certainty of being in proximity to close colleagues. Even if companies can reduce the number of desks in an office, the cost savings are likely to be smaller than expected once the inefficiencies of hot desking are taken into account. RGL cites Peel Hunt estimates that a 40% reduction in workers in the office may cut desks by c 20% but floor space by just 10–15%. Social distancing at work and other behavioural changes have the potential to reverse the long-term trend towards increased ‘office density’ – a smaller amount of workspace per worker – and a relatively small decrease in density has the potential to significantly impact the requirement for floor space. US-based data shows a 65% reduction in floor space per employee since 1990 and is indicative of the trend in the UK. There was already some evidence of a limited move to lower-density working pre-COVID-19 with the additional provision of different areas and services in offices and this may well increase as a result of the pandemic, increasing the demand for space. Applied to the big eight UK regional office markets, every 1% increase in floor space requirement equates to approximately 1m sq ft, compared with available supply at H120 of c 7.6m sq ft and a stock that amounts to c 110–120 sq ft.