Custodian REIT — Income and capital growth supporting valuation

NAV total return in the three months ended 31 December 2017 was 2.6%, with NAV per share increasing by 1% to 106.0p per share (30 September: 104.9p per share) and a quarterly dividend per share of 1.6125p paid in the period.

The NAV movement in the period is summarised in Exhibit 1.

To satisfy continued investor demand and part-fund continuing acquisitions, a total of 17.5m new shares were issued during the period under the block listing facility, generating proceeds of £20.1m before expenses of £0.3m. The average issue price of just under 115p per share represented an 11.8% premium to the unaudited NAV per share at 30 September 2017. The resulting accretion to NAV was 0.4p per share, which substantially offset the negative effect on NAV per share of the costs associated with the acquisition of investment properties, primarily stamp duty.

Acquisitions continued at a brisk pace during the period, with six properties acquired for £43.0m (9% of the opening portfolio value), before acquisition costs (details of the properties below). Acquisition costs of c £2.5m (0.6p per share) were 5.8%. One property was sold for £4.63m, generating a gain of c £700k, an approximately 25% uplift on the carrying value.

Asset management initiatives contributed c £2.6m in aggregate to the portfolio valuation, primarily reflecting the finalisation of a rent review in Southwark that both substantially increased the rent and exceeded the expected rental value or ERV, adding £2.5m to the property value. The annualised rent increased by 87% to £374k (£16.25 per sq ft) from £200k (£9.00 per sq ft) compared with an ERV of £257k (£12 per sq ft). The other valuation gains of £1.6m were primarily driven by yield tightening in industrial assets.

The portfolio was valued at £518.7m at the end of December 2017 (September: £474.3m), consisting of 146 properties, accounting for more than 275 individual tenancies, with an annualised rent roll of £37.0m. The valuation reflects an average net initial yield of 6.7%, down from 6.9% at end-September, with the tightening reflecting the overall strength of the portfolio and, in particular, asset management initiatives and the industrial yield shift. Income-based occupancy was 97.2%, up from 96.7% at 30 September and the weighted average unexpired lease term to first break (WAULT) increased to 5.9 years (September: 5.8 years). The increase in WAULT reflects asset management initiatives and a higher average WAULT on the acquisitions made during the period (9.2 years). Management continues to believe that, in general, the valuation of longer lease assets is unattractive and says that the longer WAULT on the acquired properties was a welcome feature of the assets, which it believes represent attractive value, rather than being a target in itself. The company continues to favour high quality properties that are likely to be re-let into a robust occupier market rather than properties that are highly priced to reflect long leases.

The diverse nature of the portfolio, both by asset type and by geography, is shown in Exhibits 2 and 3. Exposure to office properties remains relatively low, reflecting the manager’s view that pricing often underestimates the cost of obsolescence. The strong exposure to industrial properties continued to be beneficial in the period, delivering £4.8m in gross revaluation gains.

The assets added to the portfolio in the quarter are listed in Exhibit 5. The assets acquired are substantially within the retail warehouse sector (£27.3m), and were acquired at an average net initial yield of c 6.8%.

CREI has gradually increased its exposure to retail warehouse from 11% at the start of the year to 16% in H118 and now 20% at the end of Q3. Retail warehousing vacancy rates are close to historical lows with development activity constrained by restricted planning policy among other factors, while retailers continue to target larger format stores, easy parking, and ‘click and collect’ capability. The property disposed of during the period under review was an industrial property in Chepstow which had undergone intensive asset management, delivering significant rental growth. Demand for industrial assets has remained strong, with constraints on the supply of available stock; the manager considered these optimum market conditions in which to crystallise a significant valuation gain of this asset. The change in relative sector weights in the three months under review can be seen in Exhibit 6.

We have updated our estimates to reflect the Q4 NAV update, recent property acquisitions and share issuance. Overall, there is very little change in our forecasts for earnings, dividend cover and NAV per share.

Since listing in March 2014, CREI has grown its portfolio significantly, deploying c £10m per month on acquisitions. The manager says that an active pipeline of new acquisition opportunities that both fit with the company’s investment strategy and offer further diversification benefits, are being considered. After a seasonally quiet start to the year, activity is expected to pick up, while share issuance to part-fund growth has continued into 2018. Since 1 January 2018, an additional 7.5m shares have been issued at around 115p per share, generating gross proceeds of £8.6m. These shares are reflected in our forecasts and we have allowed for an additional acquisition spend of £10m in the final quarter of FY18 in view of the funds raised and the pipeline referred to by the manager. We expect acquisitions to exceed this amount and continue in FY19, but have not included this in our forecasts given the obvious uncertainty over the timing and financial details of any transactions. For the notional £10m of acquisition spend that we have included, we assume a net initial yield of 6.8%, in line with the Q3 average.

Net gearing was 22.3% at 31 December 2017, still below management’s conservative target level of 25%. From debt facilities of £150m, including a £35m revolving credit facility, and cash, management says that it has £34m of funds available for deployment.

The targeted 6.45p dividend per share for the current financial year, paid in equal quarterly instalments, is covered 106% by our forecast EPRA EPS. It represents an attractive dividend yield of 5.6%. CREI has a strong focus on income and dividends paid have on average represented 75% of the total NAV returns generated since listing (an annualised 7.1% pa to 31 December 2017). Management’s strategy is aimed at sustainably growing fully covered DPS and our forecasts for FY19 look for an increase to 6.55p per share, 90% of forecast EPRA EPS. Although the commercial property market as a whole has historically displayed significant volatility in returns, and is likely to do so in the future, income returns have been considerably more stable than capital values. It is this relative consistency of income returns, backed by high levels of occupancy, that CREI is targeting.

CREI’s prospective dividend yield places it towards the top of a peer group of companies within the sector that we think should be considered as its closest comparators. This yield premium provides the support for a continuing P/NAV ratio premium to the group.

In terms of price performance, the stocks shown in Exhibit 8 have slightly outperformed the FTSE All-Share Index in recent weeks, and have done so more clearly over 12 months. Custodian REIT is very slightly weaker over one month versus the peer group average, but this is little more than rounding, and its P/NAV premium is maintained.