Palace Capital — HQ completion opens strong growth opportunity

The FY21 financial performance was robust with a clear improvement in the second half of the year (H221 adjusted PBT of £4.5m vs £3.1m in H121), and ahead of our forecast. For the year as a whole, COVID-19 had a negative impact on valuations and slowed leasing activity, but rent collection remained robust with 95% collection during the year. Quarterly DPS was reinstated at the beginning of the year and increased by 20% in Q421. Since end-FY21, HQ has been completed, to budget, and sales of residential apartments have accelerated as the lockdown has been eased.

The key financial highlights include:

The FY21 operational highlights include:

FY21 rent collection was strong and PCA attributes its 95% collection rate (98% from the top-20 tenants that account for more than 40% of contracted rents) in part to its early and active outreach to its 182 tenants. This collection performance has continued into the current year, with 95% (including agreed monthly collections) collected to date1 for the March 2021 rent quarter. Significant support was provided to tenants, amounting to £1.1m via rent concessions and rent deferrals, regearing leases to provide rent-free periods, and payment plans to help tenants manage their cash flow.

Provisions against rent receivables held on the balance sheet were c £1.3m at end-FY21, of which 63% relates to the retail and leisure sectors, increasing by £0.9m during the year. PCA expects to recover some of the rents provided for as the lockdown restrictions eases.

The portfolio was externally valued at £282.8m at end-FY21, comprising 48 assets let to 182 individual tenants. PCA’s current and future focus is on the office (c 41%) and industrial (c 14%) sectors and management estimates that the combined total of these two sectors will increase from c 56% to more than 70% once the HQ residential apartments have been sold and the commercial space let. The contractual rent income of £16.4m pa at end-FY21 is reflected in a portfolio net initial yield of 5.6% and with an externally assessed estimated market rental value at full occupancy (ERV) of £20.6m the reversionary yield was 7.3%. The FY21 ERV includes £0.9m in respect of the HQ commercial space. The gap between ERV and contractual rent provides a significant opportunity for income and value generation, discussed below.

The flagship HQ development in York2 (HQ) was completed on budget on 20 April and the first occupiers, both residential and commercial, have already moved in. HQ is a large project for PCA (the gross development value represents c two-thirds of market capitalisation) and completion provides the potential to crystalise sales profits on the residential apartments, recognise development gains on the commercial space, and earn recurring income as it is let. Completion on budget also represents a significant de-risking, while the proceeds of residential sales can be used to de-gear and/or can be recycled, depending on market conditions and opportunities. Our forecasts include c £10m (gross) of development/disposal gains from HQ (c £8.8m net of residential disposal costs) over FY22 and FY23, c 20p per share, and for the commercial space to add c £0.9m to rental income on an annualised basis, in line with ERV, once fully let.

Although the pandemic slowed completion slightly (by about three months compared with the original schedule), forced the closure of the residential marketing suite for much of the past year, and slowed activity in the commercial letting market, underlying market conditions in York remain favourable for both the residential and commercial assets and the high quality and strong location of the scheme should appeal.

The pace of residential sales has accelerated as lockdown restrictions have eased. Sales have now been completed or contracts exchanged on 46 of the 127 residential apartments3 with a sales value of £12.5m, with an additional four apartments under offer, with a sales value of £3.4m. At c £550 per sq ft, PCA expects the gross sales value of the residential assets to be c £52m and although most of the apartments sold to date have been lower-value studios and smaller one-bedroom apartments, the most recent sales show a noticeable increase in average sales value. Palace expects at least two-thirds of all apartments to be sold by the end of FY22, taking total sales proceeds (including the existing apartments where contracts have been exchanged) to at least £30m. Including existing financial resources, PCA expects to repay the Barclays development facility, utilised to part-fund the entire project, in full by the end of calendar 2021.

While the pandemic has also slowed pre-letting activity, 4,500 sq ft of office space, on the ground floor of one of the residential buildings, has been pre-let to Knights, a quoted law firm, at a record rent for York of £25 per sq ft, and PCA has seen strong interest in the 35,000 sq ft of self-contained commercial space, which it expects to be let or under offer by the end of FY22.

Having grown the portfolio primarily through portfolio acquisition, non-core disposals have been a regular feature, enabling capital deployment to be optimised and supporting operational efficiency. Disposals are typically driven by the completion of the business plan for the asset or where the risk-return balance favours disposal, in some cases generating an immediate saving on property operating costs. PCA has identified and targets the disposal of at least 15 properties with an aggregate value of more than £30m in the current year and has already made good progress, with £9.4m of sales completed or exchanged at a premium to book value.

With up to £30m of net proceeds (net of repayment of the development loan) over the next two years and the £30m proceeds from the non-core disposal programme, PCA will have considerable capital to recycle into income generating investments and new asset management opportunities. Although we expect HQ to generate significant profits for PCA this is in the form of capital growth (at least until the commercial assets are let) rather than immediate income. We anticipate that the net income forgone on the non-core disposals will be below that achievable from reinvestment and in some cases will yield savings on vacant property costs.

Regional offices and industrials, particularly logistics, remain the core focus for reinvestment, while in time we expect PCA to divest of its two large leisure assets, valued at more than £35m, particularly if valuations improve as a result of recent asset management activity (including three new lettings in the past year) and a sector recovery, which would provide additional capital recycling opportunities.

The majority of PCA’s portfolio has been assembled through cost-effective corporate acquisitions, which generate a considerable savings on stamp duty, and this continues to be its preferred method of acquisition. It expects corporate acquisition opportunities may emerge later this year or early next year as government support for companies is withdrawn.

In addition to capital recycling and HQ there is a broad range of additional asset management opportunities embedded within the PCA portfolio, including lease renewals, new lettings and regears, as well as refurbishment, and further development projects.

The most immediate opportunity is the reversionary potential within the existing portfolio. Exhibit 5 shows the ERV and vacant/void ERV by sector. Of the £4.2m difference to current contractual income, c £2.8m is accounted for by voids (including the opportunity to let the recently completed HQ commercial space) and the balance by lease incentive run-off and reversion to market rent levels.

Void reduction within the office assets, including several properties that have recently been refurbished or are currently being refurbished, and reversion to market rent in the effectively fully occupied industrial assets are the largest opportunities. During the past year, in response to the pandemic, PCA has prioritised those capital expenditure projects that are expected to have the most immediate impact on value or tenant use. This included the ongoing refurbishment of the c 99,000 sq ft office property at St James Gate in Newcastle, which is expected to complete in August 2021, and PCA says that it is confident that the c 20,000 sq ft of vacant space will be let before end-FY22.

There are several medium-term refurbishment and development opportunities for which detailed asset management plans have been identified, potentially providing further opportunities to add value to the portfolio, including:

For FY22 a slight reduction in forecast net rental income is offset by slightly lower administrative expenses. In FY23 a combination of slightly higher forecast net rental income, lower administrative, and lower financing costs drives a c 6% increase in adjusted PBT and adjusted EPS. Our new FY24 forecast requires caution given the continuing economic uncertainty, but indicates further strong growth driven by net rental income. The growth in net rental income includes reversionary capture and a full period contribution from assumed FY23 acquisitions as detailed below. FY21 EPRA NTA was above our expectation and this feeds through into our forecasts, which also benefit from like-for-like growth including realised gains on sales of HQ residential assets, development gains on the HQ commercial space and reversionary capture/reduced voids.

The key component of our adjusted PBT forecast is net rental income for which we assume:

Our IFRS earnings and the change in NTA include the following capital valuation assumptions:

Our forecast for DPS increases in FY22 and FY23 are unchanged, and we expect continuing growth in FY24, with dividend cover consistently 1.5–1.2x. With the forecast proceeds of residential sales and non-core disposals exceeding our assumed reinvestment, our forecast net loan to value ratio (LTV) for end-FY24 is 32%.

End-FY21 debt facilities of £141.7m were diversified across several lenders. £128.3m had been drawn and adjusting for £9.4m of cash, net borrowing was £118.9m with an LTV of 42.0%. The average cost of debt was 3.0% (FY20: 3.1%) with costs fixed by hedging on 49% of debt. Immediately available debt and cash resources amounted to £14.4m at end-FY21.

At end-FY21 the average debt maturity was 2.6 years, but since then the maturity date of the Barclays development facility has been extended and repayments from the proceeds of completed residential asset sales have reduced the drawn balance to £11.6m. On an FY21 pro-forma basis, including the development loan part-repayment the group LTV has reduced from 42% to 40.4 PCA expects continuing residential sales to enable a full repayment of the development facility before the end of 2021 and for LTV to reduce further.

At the group level, interest cover was 2.7x at end-FY21 (end-FY20: 3.5%). Each debt facility is secured at a special purpose vehicle (SPV) level, each with its own interest cover and LTV covenants. In the past year the pandemic lockdowns have put pressure on facilities charged to the two leisure assets, requiring covenant waivers from the respective lenders during periods where concessions and rent deferrals have been agreed with tenants. Additionally, PCA reduced its loan balance with Scottish Widows by £4.1m to ‘cure’ the LTV covenant with an ongoing waiver of the interest cover covenant.

Unlike many REITs, PCA operates a total return model, aiming to provide attractive income returns, as well as exposure to capital growth from the repositioning of value-add properties. Since its first major post-IPO transaction in H214, it has built a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. During this period, it has generated cumulative EPRA NTA total returns of 110.1% or a compound annual average return of 10.4%. This is a good level of return despite the negative impacts of COVID-19 on late FY20 and FY21. Our forecasts for FY22–24 indicate total returns of c 8% pa in each of the three years, driven by development gains/residential disposal profits on the completion of HQ and increased rental income through reversionary capture.

Based on the minimum 3p quarterly DPS that PCA targets during FY22, the prospective yield is 4.6%. We forecast the annualised 12p DPS to be well covered (1.2x) by adjusted earnings. Meanwhile, the shares trade at a significant discount of c 26% to end-FY21 diluted EPRA NTA per share of 360p.

In Exhibit 9 we show a summary performance and valuation comparison of PCA and a peer group of UK commercial real estate investment companies with a strong regional focus. For comparative purposes, the valuation data is based on last reported EPRA NTA/NAV and trailing 12-month DPS declared. On this basis, PCA trades at a lower P/NTA than the group average and although its trailing dividend is lower, this is yet to reflect the recent 20% DPS increase.