Regional REIT — Lancing the boil?

Following a Q123 DPS of 1.65p, the quarterly DPS was rebased to a more sustainable level of 1.2p. Aggregate FY23 dividends declared are 5.25p and the annualised run rate going into FY24 is 4.8p. The Q124 DPS declaration is scheduled for May, following the release of FY23 results on 26 March.

The end-FY23 portfolio was valued at £700.7m compared with £789.5m at end-FY22.

During the year, disposals amounted to £26.1m (before costs) at a blended net initial yield of 4.5% (7.9% excluding vacant units), broadly in line with the respective valuation points. £11.5m of the disposals came in H2, including the sale of the Venlaw and Elmbank Gardens offices at Charing Cross, Glasgow, for £6.25m, 26.3% ahead of the end-H123 valuation. The purchaser intends to redevelop the office space for student and residential use. So far in FY24, completed sales amount to £5.0m (before costs) at a blended net initial yield of 10.7%, in line with the December valuation, while a further £22.2m of disposals is agreed and in solicitors’ hands.

New lettings for the year amounted to c £2.5m pa of new rental income (£1.2m in the first half of the year and £1.3m in the second half), on average completed well above estimated rental value (ERV).2 RGL says that the leasing market has been slower than it anticipated, with occupiers maintaining a cautious ‘wait and see’ approach when it comes to new long-term commitments, primarily reflecting uncertainty around future office working patterns, but also due to macroeconomic and geopolitical concerns. Nonetheless, the company has recently seen an increasing number of enquiries for its assets.

New letting activity has been offset by the impact of net lease expiry and cancellations. The end-FY23 gross rent roll was £67.8m, £2.0m lower than the £69.8m at end-H123 (end-FY23: £71.8m), including the impact of disposals that we estimate at £0.8m. ERV was £87.0m compared with £88.9m at end-H123, with disposals having a greater impact than for rent roll.

With EPRA basis occupancy3 of 80.0% (H1: 82.5%; end-FY23: 83.4%), the income potential from an improvement in occupier demand and the leasing of vacant space is significant. With occupiers increasingly focused on building quality and sustainability credentials, the strong improvements in portfolio EPC4 ratings during the year, continuing through Q4, are positive. RGL says it remains on target to achieve EPC ratings of B or better across the portfolio by 2030, to be achieved primarily within its rolling capex programme and through disposals, particularly for alternative uses.

In our view, RGL’s hugely depressed share rating, with a discount to net tangible assets (P/NTA) of less than 0.5x and a prospective yield of 16.2%, reflects far more than the challenges that the office sector has been facing. RGL’s balance sheet structure currently weighs most heavily on the shares, in particular its LTV that is well above the listed sector average and the impending unsecured bond maturity in August 2024. The company says that LTV reduction continues to be a key focus and that it plans to reduce LTV to the long-term target of 40% through selective sales and repayment of debt. Meanwhile it is actively exploring a range of refinancing options for the retail bond. We believe that given the continuing weak investment market, a challenging backdrop against which to make value-creating asset disposals, it would be sensible for equity raising to be among the refinancing options. We believe this has the potential for a cathartic effect on the low valuation.

The company’s £50m unsecured Retail Eligible Bond, with a fixed coupon of 4.5%, will mature in August 2024. The bonds are traded on the London Stock Exchange ORB platform with a mid-price at 29 February 2024 of c 88p and will pay a final 2.25p coupon in August.

Ahead of maturity, the options open to RGL include:

As a REIT, RGL is required to distribute 90% of its property income profits. The FY24e dividend distribution amounts to c £25m. It would be possible to suspend dividend payments and remain a REIT, but the profits would then become taxable at the company level. We would not anticipate this to be a preferred option for management, particularly given its strong commitment to paying a high level of sustainable dividends.

Secured debt at end-H123 was £382m. Taking account of H223 asset sales, we expect this will have reduced to c £370m at end-FY23. Including the unsecured bonds this implies total debt of c £420m. The 55.1% end-FY23 net LTV indicates net debt of c £386m and therefore cash of c £34m (H123: £41m). The cost of the secured borrowing is fixed or hedged to maturity at a maximum blended average of 3.4% (3.5% including the bond). The average duration today is c 3.8 years (3.5 years including the bond) with earliest maturity in August 2026.

Each secured facility has distinct covenants, which generally include historical interest cover, projected interest cover, LTV cover and debt service cover. At the interim stage RGL indicated that LTV covenants would be tested at around 60% and that for the debt facility with the highest current LTV (the Royal Bank of Scotland, Bank of Scotland and Barclays facility), LTV of 52.7% at end-H123, it would require a c 11% average decline in the value of properties held as security. Since H1, the amount of drawings from the facility has reduced and asset prices have weakened.

Although an equity raise is just one of the options open to RGL and there is no indication from the company that this would be its preferred option, we believe the solution has merit.

We have based our sensitivity analysis on our FY24 forecasts, as if any transaction had occurred on 1 January 2024. The purpose is to indicate the impacts on an annualised basis and should not be read as an alternative FY24 forecast. As a working hypothesis, these forecasts allow for a refinancing of the £50m bond, although the assumed 10% pa cost now appears unrealistic.

The FY24 forecast that we are using is slightly revised from that in our last published note. It updates for the Q423 valuation movement and implied, but not yet published, NAV. Further, to avoid debate about future valuation movements, we now assume a flat development, having previously assumed a like-for-like increase of c 2% (c 3p per share), despite the growing potential for a supportive decline in interest rates. Our FY23 EPRA NTA per share forecast is now 59p (previously 61p) and for FY24 it is 59p (previously 65p). Forecast FY24 net LTV is now 51.7% (previously 46.9%).

Even if RGL would consider an equity raise, there are number of uncertainties, including:

An open offer of new shares would entail dilution of existing shareholders’ interest in the company. Alternatively, if structured as a ‘rights issue’ with all new issuance reserved for existing shareholders, those who do not exercise their right to acquire new shares would also see their interest in the company diluted.

As a result of equity issuance, earnings would increase versus our forecasts due to the saving on bond interest less a slight increase in management fees related to the increase in net assets. Net assets would increase in line with the additional equity, net of costs. However, quoted in per share terms, both earnings and net assets would be lower. Moreover, we would not expect the increase in earnings to match the increase in equity such that the return on equity would be lower post-issuance. As we show below, with the LTV reduced and the bond repaid there would nonetheless be a strong argument for the shares to re-rate and create a net benefit to shareholders.

Our FY24 forecast assumes £60m of asset sales, a level that is in line with previously expressed company aspirations, and an LTV of c 52%. If combined with an equity raise of £75m (of which £50m to repay the maturing bond), not included in our forecast, LTV would reduce to 40%, in line with RGL’s medium-term target. Exhibit 4 provides a sensitivity of LTV to varying amounts of new equity and asset sales. Asset sales of £100m without an equity raise would be consistent with bond repayment and a 48% LTV. An equity raise of £100m would require £20m of asset sales to achieve a 40% LTV.

The number of new shares that would need to be issued is dependent not only on the size of any equity issuance, but also on the price or the discount to the current share price. In Exhibit 5 we show the number of new shares that would be issued according to a range of discounts, assuming the forecast £60m of asset sales is complemented by £75m of new equity issuance (of which £50m used to repay the bond).

The higher the discount, the greater the number of new shares issued. The discount and number of shares issued also determines what we call the adjusted share price, post issuance. This is the weighted average of the pre-issue market price and the price at which the new shares are issued. It can be thought of as the expected post-issuance share price before any market movements.

As shown in Exhibit 5, on a post-issuance basis, and assuming an increase in dividend cover from c 1.0x to c 1.1x, providing retained earnings and cash flow to fund rolling capex, the adjusted share price suggests a dividend yield potential of 13.7% and a P/NTA of 0.54x. However, assuming a subsequent re-rating to the peer average P/NTA of 0.66x would represent a share price that is 29% above the adjusted share price and a dividend yield of c 10% (Exhibit 6).

By way of example, assuming £75m of new share issuance at a 50% discount to the market price of 21.0p per share suggests a theoretical post-issuance price of 14.9p. An investor that does not, or cannot, participate fully in an equity raise5 may expect the value of their holding to be diluted by a similar amount, other things being equal. The illustrations in Exhibit 5 also indicate that the earnings attributable to that investor would reduce from the currently forecast 4.8p to 2.2p (with a consequent impact on the DPS to be expected) and EPRA NTA per share would reduce to 30.7p from the currently forecast 58.7p.

Turning to Exhibit 6, the re-rating assumption, if it occurs as illustrated, may see the shares trade at a level of 20.2p, well above the theoretical post-issuance price of 14.9p but still slightly below the current share price of 21p. Positively, we estimate that LTV will have been reduced to 40%. Moreover, based on the existing FY24 forecast (adjusted only for the issuance effects) it would support a fully covered dividend (1.1x cover), equivalent to a 10% yield.