Palace Capital — Income and NAV growth in H1

Palace Capital is a property investment company listed on the Alternative Investment Market (AIM) of the London Stock Exchange (LSE) and registered in the UK. It focuses on commercial property, mainly outside London. Its strategy seeks to enhance capital values and provide a sustainable and growing income stream by acquiring assets with potential for rent increases through the reduction of void costs, refurbishment and, in some cases, redevelopment or refurbishment. Most properties are held for long-term rental income, but the company also realises capital value through selective disposals where opportunities arise.

On a spectrum with very low-risk buy-and-hold REITs at one end and speculative developers at the other, Palace is in the middle: it has the flexibility to invest earnings in capital-enhancing asset management projects, unconstrained by the REIT property income distribution requirement (albeit the payout ratio is currently similar to a REIT’s), and is willing to assume some development risk where the potential returns are attractive, but also has a stable core portfolio producing sustainable rental income as well as providing opportunities for capital growth.

The company was given its current form in 2010 when Neil Sinclair (the current CEO) and others acquired an AIM-listed vehicle for the purpose of property investment. The current portfolio has been built by acquisition since late 2011, the most recent being the corporate acquisition of RT Warren, which completed in October and therefore does not have an impact on the interim results but is covered in detail in our last update note. The RT Warren portfolio was valued, on an open market and fair value basis, by Cushman & Wakefield at £71.8m and represents a substantial 35% increase on the £202.8m value of Palace’s pre-acquisition portfolio value as at 30 September. It brings an immediate £3.7m in annual gross rental income, which also represents a significant, but smaller, 26% uplift on the pre-acquisition contracted gross rental income. The smaller contribution to income highlights the opportunity for Palace management to grow the newly acquired commercial rents over time through more active management, while most likely disposing of the residential assets, subject to price. The capital freed up will then be available for recycling into higher-yielding commercial property assets, which remain the company’s focus.

Following the completion of this acquisition, Palace has commenced preparations to apply to join the Official List of the London Stock Exchange, a move that should broaden the appeal of its shares to a wider group of investors.

The interim results covering the six months that ended 30 September 2017 show continued growth in income, earnings, and net asset value. But importantly, the results do not reflect the impact of the recent significant RT Warren acquisition and accompanying capital increase. This was covered in detail in our last published note. We have made only small adjustments to our forecasts, increasing NAV per share, slightly reducing forecast earnings but with DPS unchanged and remaining fully covered.

Key features of the interim results were:

Our existing forecasts were made at the completion of the RT Warren acquisition and accompanying capital increase and thus require only modest adjustment now. NAV per share is increased, despite a slight cut in earnings, while the DPS forecast is unchanged and remains fully covered.

Gross rental income was slightly ahead of where we expected it to be in H118 and void costs were lower. However, the period end gross contracted rent roll fell slightly short of our forecast with a knock-on into H218 and FY19. We continue to assume that the remaining c 44,000sq ft of refurbished office space in Manchester, Leeds, and Milton Keynes will be let over the next year, with a positive impact on FY19 rental income. At an assumed £17.25 per sq ft (similar to the recently agreed let on 5,200sq ft of space at the Manchester property (Boulton House), the positive impact on our gross rent roll going into FY19 is c £760k.

Recognising the expanded scale and continuing ambitions of the business, we have also slightly increased our expectations for administrative costs through H218 and FY19.

Our revised forecasts are shown in Exhibit 2.

We have noted above that strategically, Palace sits somewhere between the income-focused REITs and the more development-focused companies, giving it flexibility to invest earnings in capital-enhancing asset management projects. While our forecasting has built in c £5m pa of general capex spend we still expect the high payout ratio of the past two years (an average 84%) to continue over the next couple of years.

Hence, although Palace Capital is not a REIT, this current level of payout is at a similar level to the UK REIT sector and the prospective dividend yield of 5.7% is towards the upper end of prospective yields offered by the broad universe of property investment companies and REITs shown in Exhibit 4, below. The 9.5p per share dividend, announced on 30 November 2017, will be paid on 29 December 2017 to shareholders on the register as at 8 December 2017. In combination with the move to quarterly dividend payments from April 2018, we estimate that shareholders entitled to this most recently announced dividend will see dividend payments of 24.125p over the next 12 months (9.5p plus the first three quarterly dividends in respect of FY19, which we estimate at 4.875p each), representing c 7% of the share price.

But Palace’s strategy is about more than income returns and the company has built a strong track record of value creation since its first major portfolio acquisition, the Sequel portfolio, in October 2013. In the three and a half years to the end of the last financial year (March 2017), it grew NAV per share by 103% and while still increasing dividends per share strongly: from the 4.5p per share declared in respect of the year ending 31 March 2014 to 19.0p declared for the current year.

To capture both income returns and capital returns we show the NAV total return since end-FY14 in Exhibit 3. Including the 4.1% NAV total return generated in the first six months of the current year (8.2% annualised), Palace has generated a 46.8% NAV total return over the entire 3.5 years shown. This represents a compound annual return of 11.6% pa.

The shares have retreated from a 12-month high of 395p before the announced RT Warren acquisition and capital increase, a downward move of c 10%, somewhat less than the 14% near-term dilution of our FY19 NAV per share forecast prior to the transaction. Our estimates imply that taking account of that near-term dilution, the four-year NAV total return to the end of FY18 will drop to a compound 7.4% pa but that is before taking account of any of the asset management upside that management anticipated from RT Warren. Given the difficulty in credibly forecasting this ahead of events, it is not reflected in our forecasts.

The 15% discount to our forecast end-FY18 NAV per share that Palace now trades on positions it in the lower half of the universe (Exhibit 5).

We would argue that the current valuation has built in no anticipation of such progress from the newly acquired assets or ongoing portfolio initiatives, particularly the Hudson House development in York. Furthermore, as Palace Capital is now a larger and potentially more liquid company, we would expect the shares to appeal to a wider group of investors especially as Palace makes preparations to apply to join the Official List of the London Stock Exchange.