Custodian REIT — Income-driven returns continuing

CREI continued to deliver strong returns in FY18, with a NAV total return of 9.6% (FY17: 8.5%), 6.0% from dividends paid and the balance from NAV growth. Barring unforeseen circumstances, the board intends to again increase fully covered DPS in the current year. Portfolio growth continues through selective acquisitions, significantly funded during FY18 by new share issuance, for which investor demand remains high, while maintaining a conservative level of gearing.

In a confident outlook statement, CREI points to the continuing strength of the regional occupier market, giving confidence in its ability to maintain occupancy levels and achieve rental growth at lease renewals and through proactive asset management. Although the commercial property market is cyclical, the company believes that its strategy of securing sustainable income will support future dividends through any medium-term market volatility and deliver capital growth for shareholders over the long term, despite the potential for cyclical impacts on NAV along the way.

Barring unforeseen circumstances, the board anticipates an increase in quarterly dividends per share for the current year to an aggregate 6.55p (FY18: 6.45p), fully covered by earnings.

CREI is a UK real estate investment trust (REIT) listed on the Main Market of the London Stock Exchange. Its diversified portfolio comprises regional commercial properties, predominantly let to institutional grade tenants throughout the UK, differentiated by a principal focus on properties with smaller individual values (‘lot sizes’) of less than £10m at acquisition. CREI is externally managed by Custodian Capital, a property management and investment business, regulated by the FCA. Custodian Capital is a subsidiary of Mattioli Woods, the specialist wealth management and employee benefits consultants, with £8.3bn of assets under management or advice.

The company seeks to provide investors with an attractive level of income as well as potential for capital growth. It aims to appeal to both retail and institutional investors in the UK REIT sector by providing high and stable dividends from a well-diversified portfolio of UK commercial real estate with conservative levels of gearing. At 31 March 2018, the portfolio, consisting of 147 assets spread across all of the main commercial real estate sectors as well as alternatives (eg car showrooms, trade counters and nurseries), was valued at £528.9m, reflecting a NIY of 6.6%. The net LTV was 21.0%, still below the medium-term target of c 25%.

CREI was listed in March 2014 with an initial portfolio of assets that had previously been held and managed on behalf of clients of Mattioli Woods, the specialist wealth management and employee benefits consultants, with £8.3bn of assets under management or advice. It is externally managed by Custodian Capital, a property management and investment business, wholly owned by Mattioli Woods and regulated by the FCA.

CREI’s income-focused strategy targets good quality properties but with smaller lot sizes (less than £10m at the point of investment) and differentiates it from a number of peers that also focus on regional commercial property. Properties of this size may be too small for larger institutional buyers, yet too large for many private investors, and management believes that it can continue to benefit from less competitive pricing, sufficient to offset the additional administrative complexity of a broader portfolio. Other elements of CREI’s strategy for meeting its investment objective include:

The investment objectives also currently state that CREI will seek to maintain a weighted average unexpired lease term (WAULT) of over five years across the portfolio but the AGM, to be held on 19 July 2018, will be asked to approve an amendment, giving the investment manager greater flexibility with acquisitions policy. The proposed new WAULT policy reads:

The company will seek to minimise rental voids and enhance the WAULT of the portfolio by managing lease expiries and targeting property acquisitions, which will in aggregate be accretive to WAULT at the point of acquisition, on a rolling 12-month basis.

Behind the proposal is the investment manager’s view that investor focus on WAULT as a proxy for income risk has actually contributed towards an inflation in prices for longer lease assets that in many cases under-prices risk. Given the strength of the occupational market, the investment manager believes that risk is better managed by acquiring shorter-lease, good-quality properties that are likely to be re-let, even if this reduces the overall WAULT of the portfolio.

The investment manager has a long-term approach to investment, with a focus on properties with low obsolescence and low capital expenditure requirements. It also prefers properties with high residual values, rather than just focusing on the terms of the lease contracts.

Gearing is deliberately kept at relatively low levels, such that management’s sensitivity analysis suggests it would not exceed a 40% LTV in a property sector downturn similar to that of 2008.

Portfolio diversification, by property, sector, geography and tenant mix is a key element of managing the cyclicality inherent in the sector, but the investment objectives allow sufficient flexibility for CREI to be contra-cyclical where the investment manager believes this to be appropriate. The EPRA occupancy rate at end-FY18 was 96.5% (end-FY17: 98.6%), and as noted above, the investment manager is confident about maintaining a high level of occupancy in the current year. CREI’s nationwide portfolio of 147 properties covers the main commercial sectors: industrial, office and retail, but also a number of the alternative sectors as mentioned above, mainly restaurants, leisure, car showrooms and trade counters. The portfolio has a relatively low exposure to office property (11% as at 4 May 2018), which the investment manager regards as having more obsolescence risk and so requiring more capital expenditure, and has a relatively high exposure to industrial, retail warehouse and alternative sectors. Industrial property is a good fit with CREI’s strategy, with higher residual values (ie the vacant possession value is closer to the investment value than in other sectors) with less exposure to obsolescence. The portfolio is also well diversified geographically, with minimal exposure to London, but exposure to every other region.

The properties are let to more than 200 individual tenants, the largest of which represents just over 3% of total rental income, with the top 10 tenants accounting for less than 20% of the total.

As at end-FY18, the WAULT to first break was 5.9 years, unchanged on the previous year. Within this, the proportion of income due within the next 12 months has reduced.

Exhibit 7 shows how the portfolio weightings by sector have shifted over the FY18 year (data to 31 March rather than 4 May as above), driven primarily by the acquisition of new assets (20 assets) rather than by sales (five assets). Each sector saw an increase in value.

Although the share of the total portfolio has reduced, the strong existing exposure to industrial properties was very beneficial to performance during FY18. However, the retail warehouse sector saw the largest share of new investment, taking its weight in the overall portfolio from 11% to 20%. The investment manager notes that 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.

CREI acquired 20 properties in FY18 with an aggregate agreed purchase price of £105.8m, before netting off rent-free top-ups (c £1.9m) and allowing for acquisition costs of £6.2m. The aggregate annual passing rent on these properties, disclosed at the time of acquisition, was c £7.6m and the blended NIY was c 6.7%. So far in FY19, two properties have been acquired for an aggregate £8.0m before costs, adding passing rent of c £625k with a blended NIY of 7.32%. Although investing for the long term, properties are disposed of when they no longer meet the long-term investment strategy, or when they can be disposed of significantly ahead of the expected valuation. Five properties were sold during FY18 for a total of £11.3m, realising a profit on disposal of £1.6m (net of costs of £0.1m), 20% ahead of the aggregate valuation. The NIY on disposals was a blended 5.7%. The sales included two industrial properties, with an aggregate disposal value of £5.2m, at £1.1m above valuation, benefiting from the current strong demand for regional industrial units. A further property has been sold in FY19, a five-unit retail development in Stourbridge, for £2.25m, in line with the end-FY18 valuation.

Despite some slowing of UK economic growth, continuing Brexit uncertainty and a significant retracement of the boost to export competiveness that resulted from post EU-referendum sterling weakness, regional property markets have remained in good health over recent months. In general, across the regional markets, a positive occupational demand–supply balance continues, although some participants have indicated that in some instances letting decisions are taking longer to execute. Regional markets continue to benefit from structural factors such as business relocation away from London, office conversion to residential use and a relative lack of new development in the years following the financial crisis.

Regional industrial and office rents are growing, but from affordable levels following a number of years of decline in real terms, and in many cases remain below the threshold necessary to bring forward new development. Much of the retail sector, particularly secondary retail, remains a weak spot, but yields are above average and CREI has seen little impact from the aggressive use of company voluntary arrangements, which are being used to allow tenants to step away from their lease obligations or reduce rents.

From an investment point of view, CREI sees the market as characterised by a restricted supply of investment opportunities and a significant level of demand from a range of investors. Within this, investor demand has polarised, moving away from high-street retail and focusing on industrial/logistics assets and properties on long leases, especially when combined with inflation-indexed rents. CREI believes the market is over-pricing some of these assets and has taken a cautious approach to acquisitions. However, it does not believe that the sector is at risk from a significant cyclical correction, as witnessed in 2007/8, noting the relative lack of new regional supply, affordable rents, low interest rates and a stronger banking system that is less exposed to real estate lending.

The Investment Property Forum UK Consensus Forecasts survey gathers independent forecasts for UK commercial property, including London, from 26 leading consultants and fund/investment managers. We show a summary of the latest quarterly results, generated between the latter part of February and mid-May 2018, in Exhibit 8. For some time, the consensus has been for income to become the driver of continuing positive overall sector returns, with capital growth waning or even becoming mildly negative. Participants remain most positive about industrial and retail warehouse property. City of London and West End office rental growth is forecast to be negative over the next couple of years, which implies positive expectations for the regional contribution.

CREI’s board of directors comprises four members, all of whom are non-executive, responsible for the overall management of the company’s activities. The board has appointed Custodian Capital (www.custodiancapital.com), a wholly owned subsidiary of Mattioli Woods (www.mattioliwoods.com), as investment manager to provide investment and property management, and administrative services to the company.

Three of the board members are independent of the investment manager, including the non-executive chairman, David Hunter, a professional strategic adviser focused principally on UK and international real estate, who sits on the boards of a number of listed and unlisted companies, as well as holding corporate advisory roles. The independent non-executive directors are Matthew Thorne, an experienced former finance director in the UK quoted sector and non-executive director of Bankers Investment Trust, and Barry Gilbertson, an international consultant with a focus on real estate, strategy and risk, and with more than 40 years’ experience advising on property. Ian Mattioli, chief executive officer of Mattioli Woods, and a board member of the investment manager, is the fourth CREI non-executive director.

Custodian Capital was appointed investment manager at the IPO, with performance reviewed annually. It was reappointed for a further three years from 1 June 2017, with the board noting in particular the investment manager’s timely deployment of investment funds, the quality of its asset selection, and its success in generating earnings to fully cover the targeted dividend growth. At the same time, the property management and administrative fees payable to the investment manager were reduced such that further growth in CREI’s NAV will support further reduction in the ongoing charge ratio and increase the dividend paying capacity of the company. This is particularly the case when net assets increase above £500m (end-FY18: £415.2m) as shown in the fee schedule below, applied from 1 June 2017:

Richard Shepherd-Cross is the managing director of Custodian Capital and the fund manager of CREI. He is a former director of Jones Lang LaSalle in London, where he led the portfolio investment team before joining Mattioli Woods in 2009, with responsibility for its syndicated property initiative, the precursor to Custodian. In total, the Custodian Capital team that is dedicated to the management of CREI’s assets consists of 16 members, including eight property professionals, supported by a compliance officer and an investment committee.

Compared with our forecasts published after the interim results, FY18 net rental income, EPRA earnings and EPRA NAV were all slightly ahead of our expectations (Exhibit 9), generating an EPRA NAV total return for the year of 9.6%.

In our forecasts, we have only included the two acquisitions (c £8m consideration) and one sale (c £2.25m proceeds) that have been announced in the period since end-FY18 but we have not assumed further portfolio additions, given the obvious forecasting uncertainty in doing so, even though these are highly likely. Our forecast end-FY19 LTV is 22.4%, below the 25% that CREI targets over time, and by way of illustration, we estimate that an additional c £20m of property acquisitions, fully funded by cash/debt, with no equity issuance, would take the LTV to 25%. Furthermore, if the NIY on such acquisitions were to be in line with the blended FY18 average of 6.7%, on an annualised basis, it would increase our forecast FY19 EPRA EPS by c 2.5%.

In addition to factoring in the known acquisition/disposals, we have assumed c 1.5% pa rental growth in FY19 and c 1.0% in FY20, with unchanged occupancy, both of which seem consistent with the management outlook statement.

We have assumed increases in property valuation, in line with rental growth, maintaining the implied NIY on the portfolio at around 6.5%. The assumed gains add 2.1p to NAV in FY19 and 1.4p in FY20.

Our forecasts assume £10m of additional debt drawn since end-FY18 as part-consideration for acquisitions, with finance costs based on the 3.1% average cost of CREI’s overall debt facilities. All £115m of CREI’s existing long-term, fixed-rate borrowing facilities were drawn at end-FY18, but there is also a £35m RCF, attracting variable interest at a rate of 2.45% above three-month LIBOR, none of which was drawn at year-end. The RCF, on which advances may be drawn from time to time, provides tactical flexibility over debt funding for acquisitions and helps to reduce the cash drag of forward funding with equity issuance.

The changes to our FY19 forecasts, shown in Exhibit 9, are modest. The small reduction in EPRA EPS shown in the table reflects a similar reduction in forecast EPA earnings driven by an upwards adjustment to our administrative expense assumption, in part related to the higher net asset value, that is only partly offset by the small increase in net rental income. We nevertheless forecast a further small reduction in the ongoing cost ratio. We have introduced an FY20 forecast for the first time. Our FY20 forecast looks for EPRA EPS and DPS to grow modestly, with full dividend cover maintained throughout the period.

Taking our forecasts for changes in EPRA NAV and DPS together, the implied EPRA NAV total return is 8.5% in FY19 and 7.9% in FY20, with dividends representing a return on NAV of 6.1% and 6.0%, respectively.

CREI is an income-oriented REIT and management’s focus is on generating secure income over the long term. The shares combine one of the highest yields in the sector (FY19e yield 5.4%) with a good level of dividend cover (FY19e 1.1x), and conservative gearing (FY18 LTV 21.0%). Growth in EPRA NAV per share has also contributed to historical returns, contributing 2.2% pa to the compound annual EPRA NAV total return of 7.3% pa from the beginning of FY15 to the end of FY18.

Exhibit 11 shows a prospective yield comparison of CREI with a broad range of listed property companies, and this combination of dividend cover and conservative gearing positions it well among those that offer the highest yields.

Exhibit 12 shows a comparison of the same group, based on historical P/NAV per share, which shows that CREI’s above-average income profile has been rewarded with an above-average P/NAV.

This broad peer group contains a wide variety of property companies, REITs and non-REITs, and specialist vehicles (healthcare property, student accommodation), and covers a wide range of strategies, from a pure focus on income and collecting rents to varying degrees of asset management and capital growth, extending to property development. In Exhibit 13 we show a summary valuation comparison of CREI with what we consider to be its closest peers.

Custodian’s prospective yield of 5.4% is also above the median for the narrower peer group of 4.6%, and its P/NAV at a similar premium.

In terms of price performance, Custodian has slightly outperformed the broad property sector and has more clearly outperformed the FTSE All Share Index over the past 12 months, a stronger performance than the narrow peer group.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but fluctuating with tenant demand and rent terms. From a sector point of view, we would also highlight the increased risks and uncertainties that attach to development activity, including planning consents, timing, construction risks and the long lead times to completion and eventual occupation. With its income focus, CREI is not a developer and avoids such risks, but does actively invest in improvements to existing assets with the aim of enhancing long-term income growth and returns. During FY18, CREI also agreed to acquire development land and fund the pre-let development of a drive through coffee shop with parking space. We consider that the main sensitivities include:

Management risk: as CREI is externally managed, any management risk is indirect. The management agreement with Custodian Capital was renewed on 1 June 2017 and runs for three years. Custodian Capital operates with a relatively small team, and if a senior member of that team were to leave they would need to be replaced.

Stock issuance: the ability to regularly issue new equity on attractive terms has enabled CREI to grow its portfolio while maintaining a conservative level of gearing. The sustained P/NAV premium is evidence that issuance is in response to investor demand and rather than representing a share overhang is driven by the availability of attractive investment opportunities.