UK Commercial Property REIT — Making steady progress in uncertain times

Over the year to end June 2018, UK real estate outperformed UK equities and government bonds (Exhibit 2, left-hand chart). Although there was a modest narrowing of the yield premium on real estate relative to government bonds over the year, UK property assets continue to offer a materially higher income return than 10-year UK government bonds (Exhibit 2, right-hand chart). This is likely to maintain the appeal of UK real estate as an asset class to income-seeking investors.

The manager’s view is that the industrial sector will continue to lead market performance in the near term, while the weaker trend in the retail sector is expected to persist. Relatively modest returns are anticipated across the UK commercial property market in 2018 and 2019, with income the key driver. In this environment, the alternative sector (including hotels) is also expected to see continued interest from investors, due to the attraction of long, stable, inflation-linked leases.

Launched in September 2006 and listed on the London Stock Exchange, UKCM is a Guernsey-registered, closed-ended investment company that aims to provide an attractive level of income to shareholders with the potential for capital and income growth from a diversified UK commercial property portfolio. On 1 July 2018, following shareholder approval, UKCM entered the UK real estate investment trust (REIT) regime and changed its name to UK Commercial Property REIT. UK REIT status exempts UKCM from significant capital gains and corporation tax (currently 19%) charges that are proposed under changes to tax legislation taking effect in 2019 and 2020.

UKCM makes direct property investments, primarily in the industrial, retail and office sectors, with lesser exposure to the leisure and hotel sectors. The portfolio is quite concentrated (42 properties at end December 2017) and new investments are typically in a £30m to £50m range. Performance is benchmarked against the MSCI Investment Property Databank (IPD) Balanced Monthly & Quarterly Funds index, which comprises direct property funds. The manager seeks property assets that are considered prime due to their location, build quality or tenant profile and aims to acquire properties at attractive prices, often when they are not viewed as prime assets by the wider market.

UKCM has been managed by Aberdeen Standard Investments (formerly Standard Life Investments) since July 2014, when it acquired Ignis Asset Management, UKCM’s previous investment manager. Will Fulton was appointed as lead manager in 2015 and he aligned UKCM’s portfolio with the house investment strategy, turning over c 25% of the portfolio by value, leading to an increase in industrial sector exposure and a reduction in retail sector exposure.

Will Fulton notes that UKCM’s portfolio performance in the first half of 2018 was stronger than its NAV total return, with 2.1% income and 2.6% capital returns combining to outperform the 4.3% benchmark total return. Non-recurring items affected NAV, including a £3m dilapidations settlement that will not be credited to NAV until the property is vacated in March 2019, and UKCM’s conversion to REIT status led to a £3.3m deferred tax asset write-off. Fulton emphasises that the 3.8% NAV total return was achieved with low net gearing (11.9% loan to value at end June 2018), noting that performance was helped by the portfolio’s strategic overweight to industrials, the strongest sector in the half year, with UKCM’s industrial portfolio generating a 10.2% total return in the period.

Looking ahead, Fulton points out that UKCM has a strong, diversified portfolio with overall exposure well aligned to Aberdeen Standard Investments’ house view of where the strongest returns will be generated on a three-year view. Within sectors, he emphasises that income resilience and asset selection can make a significant difference to performance, noting that the property market has been rewarding income resilience in good locations with positive fundamentals, to the benefit of UKCM. The portfolio void rate was 7.1% of income at end-June 2018, but Fulton comments that over 50% of this void is in strong industrial locations, noting that Radlett has now been let following refurbishment, and strong interest has been received at Lutterworth, which is under refurbishment.

The reversionary potential of the portfolio is seen by the manager as providing considerable scope for earnings improvement over the near and medium term. This potential includes a number of factors (including vacancies being filled, lease renewals, pre-let developments) that could lift rental income by c 26% to its estimated rental value (ERV), which is based on market rents. Further potential upside comes from the current £30m of uncommitted cash (out of a total £84m), that could be invested to add to rental income.

UKCM focuses on identifying and acquiring institutional-grade, income-producing commercial property, and seeks to identify assets that benefit from wider infrastructure improvements delivered by others. Investments are made in four commercial property sectors: industrial, office, retail and other commercial/alternatives. No limits are imposed on regional exposures within the UK or property sector weightings, with broad sector and regional allocations influenced by the top-down market views of Aberdeen Standard Investments’ property research and strategy team.

Individual property investment decisions incorporate future capital and income growth potential, sector and geographic prospects, yield, lease length, covenant strength and asset management opportunities, drawing on the local market knowledge of the wider property investment team. When acquiring and selling assets, the manager aims to identify market developments before they are reflected in pricing. There is also a focus on asset management activity to improve the rental value of properties, which can involve re-gearing/extending a lease early or refurbishment. Apart from the 2015 realignment, portfolio turnover has been fairly low and the manager expects this to continue.

The portfolio manager is in regular contact with property agents to monitor investment opportunities and potential buying interest in UKCM’s existing portfolio properties. The investment manager’s size and reputation means that private, off-market deals are regularly presented to the team. For any new property of interest, the manager conducts an initial assessment of the building, its location and potential returns, and follows up with a site visit if the preliminary screening is positive.

Investment risks are managed by maintaining a diversified portfolio, with the following restrictions:

UKCM’s portfolio comprised 39 properties at end June 2018, compared with 42 at end 2017. The reduction is accounted for by the sale of three Shrewsbury shopping centres, which moved UKCM’s shopping centre subsector exposure below that of the benchmark. Total retail exposure has fallen by 6.0pp since June 2017, with reductions in shopping centres (-3.7pp), retail warehouses (-1.8pp) and retail high street (-0.7pp). UKCM’s overweight in the industrial sector has increased to 12.5pp from 10.9pp a year earlier, with increased exposure in both the South East (+2.8pp) and the rest of the UK (+1.7pp) subsectors (see Exhibit 3). Similar to the benchmark index, UKCM’s largest regional exposures are the South East and London, together accounting for over 60% of portfolio value (see Exhibit 1). While South East exposure has increased by 5.6pp, making it UKCM’s largest overweight (+8.3pp), London exposure has hardly changed and remains UKCM’s greatest underweight (-7.4pp). UKCM also has a significant 6.6pp underweight in the North West and a 5.4pp overweight in the South West, despite a 3.0pp reduction in exposure to this region.

UKCM’s portfolio included 257 tenancies at end June 2018, down from 343 at end 2017, largely due to the sale of the three shopping centres. While this has led to an increase in rental income concentration by tenant, the top 10 tenants provide 35.9% of rental income, compared with 35.4% a year earlier, and only one tenant accounts for more than 5% of income, as shown in Exhibit 4.

Exhibit 5 illustrates the marked contrast between UKCM’s share price and NAV performances over one year to end June 2018, with its share price total return marginally down, while its NAV total return was 10.6%, slightly ahead of its MSCI IPD Balanced Monthly and Quarterly Funds Index benchmark. As shown in Exhibit 6, UKCM’s NAV total return outperformed the benchmark over one, five and 10 years, while modestly lagging over three years. Although relatively weak over one, three and five years, UKCM’s share price total return is appreciably higher than the benchmark over 10 years, which is reflected in the discount narrowing from c 22% to c 7% over the period.

As illustrated in Exhibit 7, UKCM’s share price has predominantly ranged between a 5% premium and a 10% discount to EPRA NAV over the last three years, except for a brief sharp widening of the discount at the time of the UK’s vote to leave the European Union in June 2016. The discount steadily narrowed subsequently and the shares reached a 5% premium to NAV in June 2017. However, the share price moved decisively back below NAV in October 2017, and the discount has since widened, with the shares now trading at a 5.2% discount to EPRA NAV.

UKCM has a single share class, with 1,299.4m ordinary shares in issue. While UKCM has annually renewed authority to purchase up to 14.99% and allot up to 10% of its issued share capital, no shares have been repurchased or issued since 2014. UKCM has two fully utilised debt facilities: £150m expiring in 2020 and £100m expiring in 2027, with a 2.89% pa blended cost. It also has an undrawn £50m revolving credit facility to provide short-term investment flexibility. The £250m debt equates to 16.9% gross loan to value at end June 2018, while the net loan to value was 11.9%. The £150m facility has an associated interest rate swap (swapping the facility’s variable rate for a fixed rate of 1.30% pa), which had a fair value liability of £1.1m as at end June 2018.

UKCM has agreed a reduced, tiered management fee structure from January 2019, calculated at a rate of 0.60% pa on total assets up to £1.75bn and 0.475% pa on total assets over £1.75bn. Currently, Aberdeen Standard Investments is paid a management fee at a flat rate of 0.65% pa of total assets and a £0.1m pa administration fee. No performance fee is payable. Based on current gross assets, fees would reduce by £0.8m pa. Excluding direct property costs, FY17 and FY16 ongoing charges were both 0.9% of average net assets. Including direct property costs, FY17 and FY16 ongoing charges were 1.5% and 1.4% of average net assets, respectively.

UKCM’s initial dividend policy was based on the prospect of strong rental growth, but expectations were lowered following the 2008 financial crisis, leading to UKCM rebasing its quarterly dividend to a more sustainable level in 2014 (see Exhibit 1). The dividend has subsequently been held steady, with 0.92p declared quarterly through to Q218 and the 3.68p total annual dividend was 93% covered by revenue earnings in FY17 (94% covered in FY16). Looking ahead, the manager sees significant near- and medium-term reversionary potential for the portfolio rental income (in aggregate, market rents are higher than those being received under current lease terms), which would improve UKCM’s revenue earnings and provide higher dividend cover.

Exhibit 8 shows members of the AIC Property Direct UK sector that have a market cap of more than £100m and a performance history of at least three years. UKCM is distinguished by being one of the largest companies in the peer group by market cap and having one of the lowest levels of net gearing. Lower gearing moderates UKCM’s performance in a strong market relative to its peers that are more highly geared, and this is reflected in its NAV total returns ranking in the lower half of the peer group over three and five years. However, UKCM’s performance is ahead of the peer group average over one year and it ranks second out of six over 10 years, a period during which many property investment companies were severely affected by the 2008 financial crisis. UKCM’s 4.1% yield is lower than the peer group average, which may be a reflection of its current vacancy rate and significant reversionary potential, as well as its focus on prime properties and lower gearing. UKCM’s discount is slightly wider than average among the seven companies in the peer group that are trading at a discount to NAV, with four of the peer group trading at a premium. UKCM’s ongoing charge is one of the lowest in the peer group, with no performance fee payable, and this position will be reinforced by the lower management fee that will be effective from January 2019.

UKCM’s board comprises six independent non-executive directors. Continuing the phased succession of long-serving directors initiated in 2016, John Robertson retired in March 2018, having served on the board since UKCM’s launch in 2006, and two new directors have recently joined the board. Margaret Littlejohns, who is chair of Henderson High Income Trust and a director of JPMorgan Mid Cap Investment Trust, was appointed as a director in January 2018 and Robert Fowlds, who most recently led the real estate investment banking team at JP Morgan Cazenove, joined the board in April 2018. Andrew Wilson is scheduled to stand down from the board at the 2019 AGM, after close to 12 years as a director and two years as chairman, with a new chairman to be selected in due course. The other board members (and dates of appointment) are Ken McCullagh (February 2013), who is CEO of LNC Property Group; Sandra Platts (December 2013), former MD of Kleinwort Benson in Guernsey; and Michael Ayre (February 2016), a Guernsey resident and qualified accountant with a focus on taxation.