Raven Property Group — Increasing rents and property valuations

Raven Property Group is a self-managed, long-term investor in modern, Grade A, warehouse assets in Russia, where it has a leading position. At 30 June 2021, the portfolio comprised c 1.8m sqm of logistics warehouse property (of which c 70% is in the Moscow region) and 48k sqm of office property in St Petersburg, with a total portfolio market value of £1.13bn. End H121 portfolio occupancy was a strong 93% but has since increased to 96%. Warehouse tenants are predominantly large Russian or international companies operating mainly across the retail, distribution, manufacturing and third-party logistics sectors, with e-commerce growing quickly in line with market trends. The investment property division is the core of the group’s operations, which also include a third-party logistics business in Russia (RosLogistics).1

The company’s income-focused strategy has remained constant since IPO, but in recent years has adapted to meet the challenges of volatile economic and currency/oil market conditions as well as sanctions. The Russian warehouse market is now performing strongly, supported by strong demand-supply fundamentals, a recovering economy, and continued strong growth in e-commerce activity, in step with most other markets. With warehouse penetration and rents low in an international context we see strong opportunities for this to continue.

The ordinary shares are listed on the Main Market of the London Stock Exchange (LSE), with secondary listings on the Moscow and Johannesburg stock exchanges. The group also has preference shares that are listed on the LSE.

With the Russian economy recovering to pre-pandemic levels2 following stronger than expected Q221 growth, and e-commerce activity continuing its strong pace of growth, the Russian warehouse market is performing strongly. With occupancy at high levels (and increasing further in H221), Raven’s underlying rouble performance was strong, with rents and property valuations both increasing. The pandemic had no impact on trading, with full rent recovery in the period and no material outstanding debtors or rent. Although the value of the rouble versus sterling changed little in the period, the average rate was much lower than in H120, masking this strong performance when translated into the sterling reporting currency. Little affected by FX, the balance sheet showed a strong improvement, with net asset value (NAV) increasing c 13% and NAV per share by c 25%, including the benefit of accretive share repurchases. This included a successful conclusion to the purchase of ordinary and preference shares from Invesco Asset Management, partly acquired by a new joint venture (Raven Holdings) between Raven and its senior management as explained on page 7.

Headline occupancy of 93% at 30 June was slightly below the 31 December level of 94% but was affected by a 59k sqm (3.3% of the total) lease maturity in May (DSV at Istra). We estimate that average occupancy during the period was higher, and Raven reports that the current occupancy level has already increased to 96% with the re-letting of the DSV space. Management is aiming for a further increase and aims for ‘full’ occupancy by the end of the year. Demand for space is strong from large e-commerce operators and retailers and existing vacant space or vacancies arising from lease maturities is being quickly re-let. In total, 209k sqm of new lettings were completed in the period with lease extensions amounting to 88k sqm. H221 sees 129k sqm of expiries, of which 72k sqm has already been extended or re-let. With minimal vacant space available in the portfolio, Raven is now in advanced negotiations to extend the larger maturities that will arise in 2022.

The much smaller office portfolio is effectively fully occupied, with 98% occupancy and performed in line with management’s expectations in H121 with all tenants continuing to meet their rental obligations in full. There are no lease breaks in H221 but there are maturities of 17k sqm (of the total 48k sqm) in 2022, or 20k including lease breaks.

JLL estimates vacancy of 2.8% in Moscow, which represents c 70% of Raven’s warehouse portfolio, and even lower in St Petersburg. It expects take-up 2021 take-up to exceed new completion (c 2.0m sqm versus c 1.1m sqm) as it has done each year since 2014. Given the tightness in the market, rental growth is accelerating and Moscow prime rents are forecast to increase towards RUB5,000 per square metre by year-end compared with c RUB4,500 currently. This would represent a similar nominal level to 2014 but still below the pre-financial crisis peak. Raven’s average rouble rents increased to RUB5,062 per square metre at 30 June compared with RUB4,833 a year earlier and RUB4,973 at 31 December. The transition from legacy US dollar leases with above-market rents that has dragged on income is now largely complete such that increasing rouble rents should drive the top line. By area, US dollar leases now account for 3% of the total compared with 14% a year earlier and 8% at 31 December.

Raven’s portfolio value increased by c 3% in rouble terms in H121 driven by increasing market rents, and management is very optimistic that this will continue. Raven estimates that the cost of constructing a Grade A warehouse has risen by at least 15% in the last 12 months, affected by the rising cost of materials and a reduction in the foreign labour force due to COVID-19 lockdowns and the closing of Russia’s international borders. Many foreign temporary construction workers returned to their homes in the middle of 2020 and are yet to return. This is having an impact on developer margins and is restricting new development activity despite continuing demand for space and high levels of occupancy. Valuation yields are high in Russia (JLL estimates Moscow prime yields at c 9.75%) compared with more developed markets, making it more likely for rent growth to drive valuation growth. In the long term, as the investment market in Russia develops, there is scope for yields to tighten.

To a very large extent, Raven is now a rouble-denominated operating business that reports in sterling and makes shareholder distributions (ordinary and preference share) in sterling at group level. At the level of the rouble-based operating subsidiaries, the main exceptions to this are the small number residual US dollar-denominated leases (now reduced to just 3% of total warehouse space) and euro-denominated secured debt (38% of total secured debt).

Against sterling, the end-H121 closing rate was little changed from end-FY20, while the H121 average rate was c 15% below H120. Comparing the rouble with the euro, the end-H121 closing rate was almost 6% higher, while the average rate was c 15% below H120.

In the income statement, the impact of a weaker rouble in H121 was:

Due to the modest change in the rouble value versus sterling between end-H121 and end-FY20, there was only a modest impact on the sterling balance sheet.

From a low point of 2.3% in February 2020, Russian inflation has climbed to 6.5% in July 2021 (unchanged on June) with indications that it is yet to peak.3 The Russian Central Bank has responded with a 2.25% increase in its key rate from 4.25% at the beginning of the year to 6.5% today, including a significant 1.0% increase on 23 July. The impact of these rate increases will be more fully felt in H221, and beyond if inflation does not moderate, allowing rates to fall. The effect will in part be mitigated by indexation of rouble rents. We have assumed an unchanged 6.5% in our forecasts through to FY23. More positively, the rate increases demonstrate the flexibility that the central bank has in tackling inflation, having entered the pandemic with strong internal and external financial balances, providing room for fiscal stimulus, and foreign exchange and gold reserves at multi-year highs. The increase in interest rates as well as oil prices have seen the rouble stabilise versus sterling and even begin to strengthen. Any further strengthening would be beneficial to Raven’s financial performance reported in sterling.

In Exhibit 8 we provide a summary of the H121 underlying financial performance and a reconciliation to the statutory IFRS results.

We focus first on the company’s underlying basis of earnings, which is the basis for its distribution policy. It adjusts IFRS earnings for a range of non-cash items including depreciation, unrealised valuation movements in respect of properties and derivative instruments, amortisation of the convertible preference share redemption premium, long-term incentive payments that are settled in shares, and non-recurring items.

Underlying profit after tax increased to £17.3m in H121 compared to a loss of £10.4m in H120. This included a significant positive swing in FX movements, relating primarily to translation of euro debt within the operating subsidiaries, from a negative £23.8m to a positive £8.9m. Excluding the operating subsidiary FX movement, the underlying profit, in sterling, was slightly lower in H121 (£8.4m) compared with H120 (£13.4m), largely reflecting group level FX translation into sterling. Within this:

IFRS net earnings were £41.2m in H121 compared with a loss of £31.7m in H120. Compared with underlying earnings the main differences were:

Since 2019, Raven has worked to remove a stock overhang relating to two of its largest shareholders at the time, Woodford Investment Management and IAML.

In July 2019, using available cash resources, it repurchased 89.1m ordinary shares (14.8% of the outstanding at the time) at a significant discount to NAV. This comprised all of the shares owned by Woodford (72.1m/12%) and part of the ordinary shares owned by IAML (17.0m/2.8%), leaving IAML with more than 30% of the remaining ordinary shares, more than 40% of the preference shares and a significant holding in the convertible preference shares. All outstanding convertible preference shares were redesignated as new ordinary and new preference shares in July 2020, simplifying the capital structure. In October 2019, Raven repurchased an additional 10.0m ordinary shares from IAML, and in December 2019 announced that it had conditionally agreed to repurchase all remaining ordinary shares held by IAML funds (28.5% of the outstanding at the time). Due to the market uncertainty created by the pandemic during 2020 this agreement lapsed, and Raven sought an alternative structure to remove any remaining stock overhang, allowing for the repurchase of all ordinary shares and preference shares owned by IAML funds.

H121 Raven reached an agreement with IAML that enabled it to dispose of all its remaining c 156.7m ordinary shares (c 27% if the pre-transaction total) at 21.6p (compared with the end-FY20 NAV per share of 40p) and c 63.5m preference shares (c 15% of the outstanding) at 90.8p. Raven first repurchased from IAML and cancelled 9.8m ordinary shares. Of the remaining ordinary and preference shares, the majority (100m ordinary shares and 32.5m preference shares) were acquired by a newly created joint venture vehicle, Raven Holding (RH), jointly owned by Raven and its executive directors and senior management. The balance of ordinary shares (c 46.8m) and preference shares (c 31.1m) were successfully placed in the market. Raven’s investment in RH was funded from the proceeds of a new five-year €60m loan with VTB Bank priced at 5.65% over Euribor (‘the VTB loan’); it acquired a 50% stake for £15.4m and issued a loan to RH (‘the on-loan’) of £35.7m at a 6.65% rate of interest. Raven’s £15.4m stake was matched by the executive directors and senior management who contributed to the JV c 53m ordinary that they already owned.

The RH repurchase has removed a significant share overhang, has limited the cash outlay for Raven and has a much smaller impact on group gearing than would be the case if the company had repurchased all the shares directly. The structure of the transaction and its accounting treatment is complex but the essential points are that RH is treated as a JV under IFRS accounting and Raven equity accounts for its share of the results. There is no cash flow impact on Raven as all the cash flows earned in relation to the entire 100m ordinary shares and 32.5m preference shares (by way of distributions or tender offers) are used to repay debt (with RH repaying the on-loan from Raven and Raven using the cash flow to repay its loan from VTB).

Within RH, the repurchased preference shares are carried at market value and the repurchased ordinary shares at book value. After ‘day 1’ accounting adjustments, and including its c £2m share of H121 JV profits, Raven’s share of the RH net assets was c £17.4m and its balance sheet presentation includes:

The JV has a five-year life, after which it will be unwound. Assuming no change in the market value of either the ordinary shares or preference shares, we forecast an 11–12% pa increase in the value of Raven’s investment, with an additional final uplift if the market value of the ordinary shares is above the 21.6p book value. As the returns generated during the life of the JV are non-cash, they are excluded from Raven’s calculation of ‘underlying earnings’.

Raven is funded by a mix of floating rate secured debt, unsecured perpetual fixed coupon cumulative preferred preference shares, and equity. With an equity/assets ratio of c 20%, the ordinary share NAV is geared to changes in investment property (88% of total assets) values, both positive and negative. This is particularly the case in relation to underlying (rouble denominated) asset values but also applies to FX driven changes in the sterling value, partly offset by sterling revaluation of rouble debt. This was seen clearly in H121 when a c 3% uplift in rouble property values contributed around half the c 25% increase in NAV per share. Meanwhile, although the equity/assets ratio is low, the average secured debt gross loan to value ratio (LTV) remains comfortably within the average banking covenant requirement of c 70%. A material cash balance (c £53m at end-H121) provides additional support. The ordinary shares would also fully benefit from a closing of the share price discount to NAV.

Given the fixed charge nature of the preferred shares, the ordinary shares also have a geared exposure to underlying earnings.

The further property revaluation gains expected by management would be expected to have a materially positive impact on NAV and capital value returns to ordinary shareholders. Given the difficulty in predicting revaluation movements with any accuracy, particularly given the relatively smaller size of the Russian property investment market, and because of the significant sensitivity of NAV to any change, we prefer to show the potential impact in a sensitivity analysis. Our published forecasts do not include assumed property revaluation and are thus potentially very conservative.

Our forecasts are based on the spot FX rates at 30 June 2021, from which there has subsequently been no material movement. We therefore assume no additional FX movements in H221 and beyond, in either the income statement or the balance sheet.

For the core property investment business, our forecasts for net rental and related income (NOI) are slightly increased, reflecting accelerating rent growth and a slightly increased occupancy rate, partly offset by a faster than previously assume run-off of US dollar-denominated warehouse rents. We forecast occupancy to increase from the current 96% to 97% by end-FY21 and to remain at this level through FY22 and FY23 (previously 96%). We assume an increase in average rouble rents from RUB5,062 per square metre at end-H121 to RUB5,150 at end-FY21 and rising steadily to c RUB5,800 by end-FY23, or c 6% pa, benefiting from reversion to increasing market rents and the indexation of existing rouble leases.

For Roslogistics we forecast slightly lower NOI than previously, reflecting a more selective approach to contracts, offset by a higher EBIT margin.

In the income statement we expect the sharp increase in Russian interest rates and the average cost of borrowing to have a greater impact in H221 than it did in H121, more than offsetting the positive development in underlying operational performance. Management firmly expects this positive operating environment to further lift property valuations and NAV, and if this occurs our forecasts for NAV growth and total returns will be proven highly conservative.

We have assumed no increase from the current 6.5% central bank rate, nor have we assumed any decline in FY22 and FY23 as may be expected if inflation subsides in line with central bank expectations. Including a margin over bank rates, we assume an 8.25% cost of rouble debt and a 4.5% cost of euro debt, giving a blended average c 7.4%. Higher interest costs will weigh on near-term underlying net profit and cash flow and we have reduced our expectations distributions to c 1.25p per share (previously 2.5p), in line with FY20.

Largely reflecting the H121 uplift, our NAV forecasts are materially increased and may materially rise further if property valuations increase as management expects. As described above, we have not forecast any further growth in property valuations despite our expectation that rents will continue to rise.

Our IFRS earnings forecasts are shown in Exhibit 17 at the back of this report and also include a relatively small amount of depreciation, unrealised valuation movements in respect of properties and derivative instruments (we assume none prospectively), long-term incentive payments that are settled in shares (none assumed prospectively), the contribution from the RH JV and one-off items.

Our forecasts indicate a continuing healthy cash position and a stable LTV in respect of the secured debt. If property valuations increase, LTV should reduce, providing Raven with added flexibility to deploy its financial resources.

At the end of H121, secured bank borrowing amounted to £679m, including c £6.1m of unamortised loan arrangement fees carried on the balance sheet within payables. The borrowings comprised 18 different debt facilities, with an average cost of 6.37%, prior to the 1.0% increase in Russian official rates on 23 July 2021. The weighted average term to maturity was 3.8 years, with only 1% (one facility) maturing before end-2022 and 14% (three facilities) maturing before end-2023. Significant maturities (seven facilities/46% of total secured debt) occur in 2024. Compared with the investment property portfolio value (including properties under development) of c £1,134m, the gross LTV was 58%.

As Raven’s property leases have transitioned towards rouble-denominated leases, so too has its secured debt funding. Dollar debt has been replaced initially with a mix of rouble- and euro-denominated debt, 62% and 38% respectively at end-H121. We expect a full transition to rouble debt over time although the recent rise in Russian interest rates will slow this process, particularly as the euro debt is hedged at a materially lower strike price. Secured debt amortisation (£12.3m in H121) is focused on the euro-denominated debt and represents an ongoing shift away from euro debt as it is refinanced.

The secured bank debt is floating rate, but Raven has entered a series of interest rate derivative financial instruments that cap its interest rate exposure to the underlying benchmark borrowing rates, before the lending margin. Rouble debt cost is hedged at a weighted average strike rate of 7.6% (a little more than 1.1% above current levels) with a weighted average term to maturity of 2.8 years; euro debt cost is hedged at a weighted average strike rate of 0.9% with a weighted average term to maturity of 3.7 years.

The ordinary shares have responded strongly to the interim results, and rightly so in our view. However. the c 11% increase in the share price from c 28p per share to c 31p is less than the H121 increase in NAV. This leaves the shares at an almost 40% discount to H121 IFRS NAV per share and a c 50% discount to our estimate of H121 EPRA NRV.

The group strategy remains income focused and despite sometimes volatile economic and market conditions, it has consistently made distributions to ordinary shareholders. These are made through share repurchases effected by way of tender offers, providing shareholders with a choice of receiving cash (in return for shares tendered) or retaining their shareholding and benefiting from an increased ownership share in the company. Since listing, it has repurchased and cancelled more than 400m ordinary shares. Although the recent increase in Russian interest rates will squeeze near-term distributable cash flow, we expect continuing distributions at a reduced level, representing a prospective implicit yield of c 4%. Over the medium term we would expect cash flow and distributions to benefit from rental growth and/or a retracement of interest rates.

Raven has a high-quality portfolio of modern assets in a market where demand continues to outstrip supply. It is benefiting from similar retail and distribution trends, with a strong growth in ecommerce, as more developed international markets. Starting from a lower level of e-commerce penetration it is arguable that its growth prospects may be stronger, mitigating some of the risks that attach to an emerging market. While we would not attempt to draw a direct comparison between Raven and the UK quoted warehouse stocks listed below, mostly larger and operating in more developed markets, we do think it worth highlighting the strong share price performance of the group (all trading at close to 12-month highs) and the high P/NAV of the sector relative to the broader UK listed property sector (we estimate a little below 1.0x).

Compared with the wider European market, Russian warehouse rents remain at relatively low levels, while yields are significantly higher. Notwithstanding the relative lack of development of the Russian property investment market, this is a positive indicator for value creation over the medium to longer term. In the near term, against a positive fundamental sector backdrop and compared with international markets and local interest rates, Russian warehouse valuations appear very well underpinned with upside potential.

At a price of 113p, the yield on the cumulative non-redeemable preference shares is a little more than 10% based on the fixed yield of 12% on the nominal value of 100p. The preference shares have the added security of ranking ahead of the ordinary shares for distributions, but do not provide the upside exposure to underlying income, property valuations and any closing of the ordinary share discount to NAV.

The global economy is in a period of recovery from the impacts of the COVID-19 pandemic, but there is significant uncertainty about the durability of that recovery amid a general increase in inflationary pressures. The Russian economy is particularly sensitive to oil prices (recently improving) and faces continuing political and economic tension with the United States. Although US-led sanctions have continued to increase, the Russian economy has significantly adapted and this may also mitigate the effects of external economic events. These country-specific risks have the impact of reinforcing normal sector risks including occupancy and rent levels, funding access and cost, and property valuations. We highlight the following: