Custodian REIT — On track to meet income targets

CREI’s diversified portfolio continued to deliver good returns in the first six months of the current financial year that ended on 30 September (H119), with a NAV total return of 4.2% (based on DPS paid during the period). The board believes that, barring unforeseen circumstances, CREI is well placed to meet its target of paying aggregate quarterly dividends amounting to 6.55p in respect of the current (FY19) year (FY18: 6.45p), fully covered by EPRA earnings, and remains committed to growing the dividend on a sustainable basis and delivering capital growth for shareholders over the long term.

Portfolio growth continues, during the period and since, through selective acquisitions, aimed at realising the potential for economies of scale. The opportunities to deploy capital on terms that meet CREI’s investment criteria were limited during H119 by market conditions and continuing strong investment demand and, in turn, equity issuance has been moderate and insufficient to meet investor demand for new shares, maintaining a solid share price premium to NAV that remains well ahead of peers (Exhibit 9). Investment activity has picked up somewhat since period end.

In this section we briefly review the H119 financial performance. In the following section we update on the portfolio performance, activity and strategy.

In its outlook statement, CREI says that it remains confident that its strategy of targeting income from a well-diversified regional commercial property portfolio, combined with conservative net gearing, will continue to deliver the stable, long-term, income-focused returns that it seeks to deliver. It expects asset management to continue to drive performance benefiting from robust rental growth on lease renewal or rent revision across much of the portfolio. Occupational demand and limited new supply in the regional office and industrial sectors should support the maintenance of low levels of vacancy. The company notes that stress in parts of the retail market and Brexit uncertainty pose near-term risks, but may equally continue to throw up attractive opportunities for investment.

CREI’s key objective is to provide shareholders with an attractive level of income, fully covered by earnings, with a conservative level of net gearing (LTV). Portfolio diversification, by property, sector, geography and tenant mix plays an important role in meeting this objective and is a key element of managing the cyclicality inherent in the sector. As at 30 September 2018 the portfolio comprised 151 assets, 218 tenants and 259 tenancies. The largest tenant in the portfolio (the B&M retail group) represented only 3.2% of the total rent roll, spread across four different properties. Since 30 September, the number of properties has since increased to 155. The portfolio is split between the main commercial property sectors, with a relatively high exposure to industrial, retail warehouse, and alternative sectors and a relatively low exposure to offices, which the investment manager regards as often having more obsolescence risk with a corresponding requirement for capital expenditure to maintain values. CREI’s investments in the alternative sector (or ‘other’) include a broad range of property uses including car showrooms, petrol filling stations, children’s day nurseries, restaurants, gymnasiums, hotels and healthcare units.

The net initial yield on the portfolio at 30 September was 6.6%, similar to the level at 30 March. The December Factsheet (data as at 3 December) shows that occupancy (on an EPRA basis) continues to be strong at 96.3% (30 September: 96.9%; 31 March: 96.7%). The weighted average unexpired lease term (to first break) at 3 December was 5.6 years with modest near-term expiries. The portfolio’s security of income is further enhanced by 13% of H119 income benefiting from either fixed or indexed rent reviews.

Asset management initiatives, including rent reviews, new lettings, lease extensions and the retention of tenants beyond their contractual break clauses added £3.9m in unrealised valuation increase during H119. A recently agreed rental uplift from £9 per sq ft to £16 per sq ft at an industrial unit in Southwark was a significant contributor to the £4.4m gross gain on its disposal for £12.0m, 58% above the June (Q119) valuation. However, the positive impacts of market-driven growth in rents and asset management activity were partly offset by a handful of issues focused on the retail and leisure sector:

CREI has quantified the H119 valuation impact of the CVAs at £3.5m.

CREI added a net four properties during H119 (seven acquisitions and three non-core/mature disposals) and has since added four more properties to the portfolio. Year to date it has acquired assets for an aggregate consideration (before costs) of £55.7m with an average net initial yield (NIY) of 6.8%.

Of the three disposals, for an aggregate consideration of £15.4m, the most significant was the sale of the Southwark industrial unit for £12.0m. The other assets sold, in line with valuation, were two smaller retail assets where no material future rental growth was anticipated.

The company does not target any particular sector composition for the portfolio and is focused on seeking to deploy its resources into the right properties, while maintaining a good level of overall diversification. With that in mind, the impact on portfolio positioning of the H119 transactions, along with the contribution from gross unrealised revaluation gains and acquisition costs, can be seen in Exhibit 6. As a result of new investment and continuing strong revaluation gains, the share of industrial assets in the portfolio remained significant at 39%, despite the substantial Southwark disposal. The share of other assets increased with acquisitions, while the retail warehouse and retail assets declined with negative revaluation, including the impact of retailer CVAs.

Acquisition activity since the end of H119 significantly comprises two assets within the retail warehouse subsector, as well as one smaller mixed use asset, acquired at a significant discount to recent market pricing, and an additional motor showroom (other) asset.

Given CREI’s desire to maintain a highly diversified portfolio, and given the fact that obsolescence risk means that much of the office sector does not meet its investment criteria, it is natural that it should continue to seek opportunities within the broad retail sector. Its approach is highly selective, and focused on out-of-town retail warehouse assets, modest, targeted high street exposure, and no shopping centre exposure.

The investment manager believes that well located retail warehouse properties that either do not compete with online retailing or are complementary, through offering easy click-and-collect services, will remain in demand despite the current restructuring of the retail market. Despite the investment market's current aversion to the retail sector, CREI believes that the recently acquired retail warehouse properties are well placed to prosper as a result of their strong locations, good quality tenant base and long lease lengths.

The recent mixed use investment in Stratford is driven by the strength of the location (following the London 2012 Olympics, Stratford is now well established as East London's most significant retail and leisure destination, with completion of the Crossrail project due in December 2019 set to further enhance the area), and the strength and commitment of the tenants. Both have recently renewed their leases at higher rents and the resulting weighted average unexpired lease term to first break of over eight years adds secure income to the portfolio.

Our estimates are updated to incorporate the financial detail provided by the interim results release, as well as the most recent property acquisitions and equity issuance. The changes are relatively modest with virtually no change to EPRA EPS or DPS estimates. Recent acquisition activity is reflected in higher net rental income and, as we do not assume future equity issuance although it is highly likely, in a slightly higher LTV estimate. As discussed below, we are slightly more cautious on the growth in property rental and capital values, reflected in a slightly reduced EPRA NAV per share forecast.

Our main forecasting assumptions are:

As an income-oriented REIT, CREI’s focus is on generating a secure and growing income stream that can support the progressive and sustainable dividend objectives, while delivering capital value growth over the long term. As a result, the shares combine an attractive dividend yield, with a good level of dividend cover, and conservative gearing. NAV total return since listing in March 2014 (a compound average annual 7.3%) has been further enhanced by growth in EPRA NAV per share (Exhibit 8).

Exhibit 9 shows a valuation and share price performance comparison of CREI with a group of close peers with a similar income focus and diversified investment strategy. For the group as a whole, across all periods shown, the focus on income returns has generated a stronger average share price performance than for the broad UK property index as well as for the FTSE All-Share Index. Over the past 12 months, CREI’s performance has been stronger than the group average. Despite this performance, its trailing 12-month dividend yield remains slightly above the average, with the dividend well covered by earnings. EPRA EPS covered DPS by 1.08x in the year ended 31 March 2018 and we estimate that the increased FY19 DPS will be 1.1x covered on the same basis. The share price premium to EPRA NAV has reduced slightly in recent months but has been relatively robust and the gap versus the peer group average has widened somewhat.