Custodian Property Income REIT — Occupier demand continues to drive income

As we discussed in our recent detailed report, the continuing strength of the occupational market across most sectors is supporting rental income and earnings, and underpinning dividends, CREI’s focus for delivering shareholder returns. This is in contrast to the property investment market, where investment activity remains subdued, and while some subsectors are showing signs of recovery, taken as a whole, market valuations have continued to drift lower.

For CREI, during H124, portfolio rent roll has increased to £43.2m from £42.0m at end-FY23, and the estimated rental value (ERV) of the portfolio increased to £49.7m from £49.0m, mainly driven by investment in portfolio assets. New leases and lease renewals continue to be agreed at levels that are on average above ERV/passing rents, with Q224 activity accounting for much of the year-to-date growth in rent roll. During H1, a total of 23 new leases/lease renewals were signed, securing £2.8m of annual rent. Seven rent reviews were settled at a weighted average 16% above previous levels.

EPRA occupancy increased to 91.5% compared with 90.3% at end-FY23 and 89.3% at end-H123. The company expects a further increase to 93% by the end of FY24 based on lettings and sales under offer. Closing the £6.5m gap between passing rent and ERV represents a material opportunity for further income growth.

During the period, two properties were sold for £1.6m, in line with valuation, and since the period-end, the sale of a children’s day nursery for £0.6m has completed. Four properties valued at £12.4m are under offer to sell, which the company expects to generate sales proceeds of c £14m. Further disposals are under active consideration and despite an overall subdued property investment market, CREI notes a continuing active owner-occupier market for smaller regional properties. The proceeds from asset sales will provide funding for the company’s remaining pipeline of capital expenditure (capex) and reduce variable rate borrowings. H124 capex amounted to £12.2m, more than the £10m invested in the whole of FY23, with a number of projects reaching or approaching completion. Positively, where investment is required, it is being reflected in greater tenant demand, additional rental growth and, increasingly, in valuations. All ongoing capital works are expected to enhance the assets’ valuations and, once let, increase rents to give a yield on cost of at least 7%, ahead of the company’s marginal cost of borrowing. Current projects accounted for 2.8% of H124 vacancy.

Rental growth, occupancy improvement and strong rent collection offset inflationary cost pressures and higher financing costs.

In particular we highlight the following, comparing H124 with H123 unless stated otherwise:

Market-wide property valuations continued to drift lower during the six months to end-September, particularly during the latter three months, as the market consensus for interest rates reflected a view that they would stay higher for longer. For CREI, the impact was softened by portfolio mix and a £6.1m valuation benefit from asset management initiatives.

CREI’s portfolio value declined by 0.6% to £609.8m from £613.6m. Adjusted for capex and disposals, we estimate a like-for-like decline of 2.4%, less than the 2.7% recorded by the MSCI Quarterly UK Property Index. Within the company’s diversified portfolio, the industrial sector (49% portfolio weighting by value) delivered H124 gains, driven by asset management and strong market fundamentals, and office (11% weighting) capital returns were the weakest. Overall, asset management positively contributed £6.5m to valuation, more than offset by general valuation movements amounting to a loss of £22.1m.

While fully covered dividends paid have continued to lead accounting returns, with valuation yields showing significantly greater stability in recent months, property values have been more robust than they were in the second half of CY22.

The H124 NAV total return of -0.7% comprised dividends paid of 2.75p and the 3.4p decline in NAV per share.

On an annual basis, NAV total return has been positive in each year since the company listed in March 2014, with the exception of FY23. The aggregate return from listing to end-H124 is 52.1%, more than 100% generated by fully covered dividends paid. The average annual return is 4.5%.

Most (76%) of CREI’s H124 drawn borrowings were fixed rate, providing substantial protection against the further rise in interest rates during the period, with a comfortable margin over the income returns the property portfolio continues to generate. We estimate that a 0.5% increase in the SONIA benchmark rate applied to the drawn revolving credit facility (RCF) would increase the average cost of debt by just 12bp or c £0.22m.

The £140m of fixed rate debt has a blended cost of c 3.4% and a current average term to maturity of more than six years. Including £45m drawn from the shorter-term, floating rate RCF, the total average cost of debt was 4.2%. The RCF (with Lloyds) has been refinanced since end-H124, with an increase in the funds available from £50m to £75m, including a £25m accordion option,1 with an increase in the term to three years, and an option to extend the term by a further two years, subject to the bank’s consent. The cost of the facility is unchanged although the headline rates of annual interest now include a LIBOR transition fee of 12 basis points (0.12%) pa that was previously applied separately. The headline rates are between 1.62% and 1.92% over SONIA, with the level determined by the facility LTV.

The RCF refinancing provides additional funding headroom and flexibility, including for capital expenditure, although in the near term, the amount drawn on the facility (£45m at end-H124) is more likely to reduce, utilising a part of the proceeds from asset disposals. Total debt facilities, including the RCF accordion option, are now £215m and based on end-H124 borrowings, we estimate an average current term to maturity post the RCF refinancing of a little under six years.

The end-H124 net LTV was 29.6% (end-FY23: 27.4%), ahead of the company’s medium-term target of 25%, but with significant headroom against debt covenants and a substantial pool of assets unencumbered by borrowings (£126m at end-H124).

Our forecasts for EPRA earnings increase by almost 2% in each of FY24 and FY25, primarily driven by rental income, and reflecting continued leasing progress.

Including the completed acquisition and properties under offer referred to above, we have assumed £15m of disposals, at an average 10% premium to this book value, and an average net initial yield of 4%. The net initial yield reflects a blend of vacant and income-generating asset disposals. We assume half the proceeds are directed towards debt repayment and the balance to funding CREI’s ongoing capex programme, forecast at £10m pa through to the end of FY25 (H124: £12.2m).

Our NAV forecasts for end-FY24 and FY25 are reduced by c 3%, reflecting the continued drift in property valuations in H124. Looking forward, given the continuing uncertainty regarding market-wide property valuations, we have assumed no change net of capex (such that capex contributes positively to total portfolio valuation).

CREI’s target DPS for FY24 of at least 5.5p represents a prospective yield of 6.5%. Meanwhile, the shares trade at a c 11% discount to the H124 NAV per share of 95.9p.

In Exhibit 9, we show a summary performance and valuation comparison of CREI and what we consider to be its closest diversified income-oriented peers. The broad UK property sector has strongly underperformed the UK stock market over three years, but has recently shown some recovery with increasing signs that interest rate tightening has peaked.

CREI trades on a higher P/NAV than the average of the group, as it has done for most of the period since IPO and, while its trailing yield is slightly below the average, its dividend is fully covered.2 The company’s focus on smaller lot-size properties with a yield premium has historically supported risk-adjusted income returns.