Circle Property — Increasing forecasts again

Circle is an internally managed property investment company, registered in Jersey. It was initially founded as a limited partnership in 2002, became a Jersey Property Unit Trust (JPUT) in 2006, and has been quoted on AIM since February 2016. Its focus is office properties in the UK’s provincial cities, targeting assets that may be too small for most institutional investors but too large for most private investors, and where the income profile is likely to deter REIT investors. It typically targets short-let properties (or vacant properties, if the letting prospects are sufficiently strong) where it can add value by undertaking lease renewals, rent reviews, lettings and refurbishments.

Circle’s senior management team includes three full-time property professionals and the company is governed by a highly experienced board. Together, the management and board own approximately 30% of the company, closely aligning their interests with external shareholders. The company has a strong track record of NAV total returns, both prior to IPO and since, and this continued through H118.

The current portfolio of 15 assets is now valued at £103.5m (30 September 2017) of which 11 office buildings comprise 90%. All the assets, with one exception (an office property in Moorgate), are outside London and significant refurbishment programmes have been recently completed at three of them, which are expected to increase rent and capital values significantly on those assets. The concentration of assets is mitigated to some extent by a more diverse lease portfolio of 113 units let to 53 tenants, ranging from major international companies such as Compass Group to local businesses.

For a full description of the company and its strategy see our initiation note.

H118 results that were released in December show ongoing asset management initiatives continuing to drive operational progress, delivering strong growth in rental income and cash earnings, and lifting investment portfolio valuations. Rental income in H118 benefited from the more than £600k of lease contracts signed in H217, while the period under review saw a further 7.2% added to the annualised rent roll, which is yet to be fully recognised in income. Further leasing progress has already been made in H218 and we review this, and the implications for our forecasts, in a later section.

The financial highlights of H118 were:

Management remains positive about the prospects for the regional office market, noting a robust occupier market and ongoing constraints on supply, with the investment market also remaining strong with little or no sign of a softening in yields. It expects the favourable demand-supply situation in the occupier market to remain as long as the ongoing conversion of office space to residential continues, or until rents rise sufficiently to encourage new development. While tenants are showing a degree of caution in making long-term leasing decisions against the backdrop of Brexit uncertainty, Circle expects the location and quality of its assets, particularly those that have been refurbished, to continue to appeal to tenants. As discussed below, there is considerable reversionary potential in the portfolio, which should support the company’s ability to both attract tenants and grow rental income.

The investment portfolio fair value increased by 11.3% in H118 to £103.5m (the balance sheet value of £96.3m, up from £86.1m at end-FY17, includes an adjustment for unamortised lease incentives). The fair value uplift included a 7.9% revaluation gain, with most of the balance accounted for by capex. In terms of composition, the portfolio is relatively concentrated, with 15 properties, and with a current focus on the regions (75% in Milton Keynes, Birmingham and Bristol) and offices, which represent 90% of the value (Exhibits 1 and 2). The annualised contracted rent roll excluding rent-free periods rose to £5.95m at end-H118 (end-FY17: £5.62m), still considerably below the expected rental value (ERV), which also increased to £9.34m (end-FY17: £8.89m). Around £2.0m of the reversionary potential (the potential uplift in rents to ERV) is represented by vacant space at recently completed major refurbishment projects (discussed below) and the balance by leasing events spread across the portfolio. Despite the strong gains in valuation during the period, and since IPO, there is considerable scope for further upside. Although the end-H118 valuation represents a net initial yield of 5.4%, the reversionary yield is 8.48%, while the capital value is low at an average £163 per sqft (which management indicates is below replacement value) with an average rent of £12.80 per sqft.

The weighted average unexpired lease term to first break increased to 7.73 years from 7.39 years at end-FY17 and to 11.29 years to lease expiry from 11.23 years at end-FY17. Lease contracts signed during the period added £379k (gross) to the contracted rent roll, or 7.2%. The rent roll (net) increased by c 6%. Further letting progress has been made in H218 and management indicates that, should all the negotiations currently underway convert to lettings, annualised contracted rental income should exceed £6.0m by the end of FY18.

The most significant driver of income growth and asset valuation over the next 18 months or so will be progress in letting the three recently refurbished assets (the “development portfolio” assets) described below. The additional gross rent potential from fully letting remaining available space in these properties is c £2.0m pa, with the potential to lift the contracted rent roll to £8m.

The H118 financial results were ahead of our unpublished expectations for this stage of the current year. Driven by leasing progress, net rental income was c £200k ahead of our expectations while administrative costs were c £100k lower. Given the income profile of the portfolio, with its significant exposure to asset management projects, the impact of these differences on our forecast adjusted earnings is quite material. Forecast adjusted EPS for the current year increases 31% to 7.0p (from 5.4p) and we have also increased FY19 to an expected 8.6p (from 8.2p). Given this strong profile of adjusted earnings growth we have also raised our dividend expectations and now look for 5.3p in FY18 (was 5.2p) and 5.5p in FY19 (was 5.2p).

Recent new lettings have already improved the income profile of the portfolio and we expect this to continue. Our revised estimates assume £6.2m or c 66% of ERV (end-FY18 c 64%). We allow for c 2% pa ERV growth through H218 and FY19. The effect is to lift forecast FY18 net rental income by c 5%, largely representing a pulling forward of the letting progress that we previously allowed for in FY19. Our FY19 net rental income forecast increases by just under 1% and is based on end-FY19 annualised contracted rents of £7.3m (c 76% of forecast ERV). Faster net rental income growth is the main driver of our forecast upgrades, with a lesser contribution from expected administrative costs and, in FY18, the follow through of a H118 tax credit that was not reflected in our previous forecast.

Our NAV forecasts had already taken account of the H118 revaluation gains that were pre-announced in October. However, consistent with our assumptions for letting progress, we have increased our forward-looking revaluation gain forecasts. We believe that these remain relatively conservative and make no assumption about the general level of market valuation yields. For H218 we assume a £1m uplift, taking the total increase on the opening value in the year to 8.9% from 7.9% in H118. For FY19 we assume a £4m gain, or 3.8% of the opening value. Looked at alongside the increase in annualised contracted rents, the implied end-FY19 net initial yield actually increases to a little over 6.2% (from 5.4% at end-H118), while the implied reversionary yield declines to c 8.2% (from 8.48% at end-FY18).

The letting of vacant space at a faster pace than we have allowed for in our estimates is a potential source of significant upside to our forecast adjusted earnings and NAV. If we were to capitalise the £8.0m of potential contracted rent including a full contribution from the development assets (but excluding the £1.35m of additional reversionary potential in the portfolio) at 7.0%, the implied value of the investment portfolio assets is £114m, which adds c 14p per share to the current NAV, without any benefit from the remaining reversionary potential or from retained operating earnings between now and end-FY19. The potential uplift is smaller than we last published because we assumed higher revaluation gains in our forecasts. On a full year basis, underlying earnings per share would increase substantially (c 50%) given the operating and financial leverage on the increased rental income (c £1.1m pa above that forecast in FY19).

For Circle, unlike a REIT, capital returns are expected to be a significant element of overall total returns, which we think is best measured by NAV total return (the change in NAV per share plus dividends paid per share). In the 10 years to FY16, the average annual return was more than 7.5% pa. NAV total return since IPO has increased and we calculate a 24.1% annual total return for FY17 and our estimates suggest a c 19.9% annual total return in the current year and 10.6% in FY19 (on which we believe are conservative revaluation assumptions). As we have indicated in the financial section above, in current market conditions there is considerable scope for further progress in NAV, over and above that built into our near-term forecasts, as the letting of vacant space progresses, and this would further support NAV total return.

For an investor, expected future capital returns are perhaps less easy to predict than expected dividend returns driven by currently contracted rental income, and this creates a tendency for stocks with the highest yields to also trade at the higher P/NAV ratios. A strong management track record provides additional comfort on the delivery of potential capital returns, and given Circle management’s experience and track record, the current 25% discount to our forecast FY18 NAV per share, supported by a dividend yield of more than 3%, continues to represent a relatively low valuation with nothing obviously being factored in for the upside potential. Some discount for Circle’s relatively small market capitalisation and thin share trading liquidity, and for its above average gearing, may be anticipated. Moreover, while the relatively concentrated nature of the Circle portfolio allows the company to focus its efforts, it does not provide the risk diversification offered by some larger regional commercial property companies. However, despite these considerations and bearing in mind the potential for future NAV growth described above, the low valuation ascribed to Circle within the context of the broad UK-listed property sector is shown clearly in Exhibits 7 and 8.

As noted above, Circle management is keen to support trading liquidity in the shares and is considering options for enlarging the shareholder base. Moreover, given the stated desire to grow the portfolio further, we would expect Circle to consider increasing its capital resources, both equity and debt, to fund future acquisitions, although an alternative option would be to recycle capital by disposing of assets that have been repositioned and then fully let. We have not included any property acquisitions in our forecasts, which indicate the net LTV trending down to c 40% by end-FY19. In our previous note we illustrated potential options for funding portfolio growth while managing gearing. Property acquisitions have the potential to enhance EPS and dividend-paying capacity, capturing the likely positive spread between asset yields and funding costs and generating scale efficiency. However, given the current discount to NAV it may be difficult to avoid some NAV per share dilution if the funding of acquisitions includes an element of equity funding. Overall, we do not believe that it would alter the conclusion that the shares are trading at a low valuation compared with the current forecasts and potential for further value creation, while any increase in Circle’s market capitalisation and share trading liquidity should broaden its investor appeal.