Picton Property Income — Organic growth accelerating

Across most of the commercial property market, occupier demand has remained resilient and rents have continued to increase, despite economic challenges. The short technical UK recession of end-2023 reversed in the opening months of 2024. With inflation significantly reduced and interest rates expected to soon decline, property valuations appear to be stabilising at levels that are well below the peak of 2022. Meanwhile, increased building costs are a headwind to new construction. Against this background, Picton has significant opportunities to grow income and create value, and we highlight the key elements of the investment case as:

FY24 EPRA earnings of £21.7m was well ahead of our forecast £20.5m, with the beat driven by net property income while higher-than-forecast expenses offset lower net financing costs. Expenses included £0.6m of non-recurring items. The stronger-than-forecast net property income was split between higher dilapidation fees (‘other income’) and lower property expenses. The increase in DPS, with effect from Q424, was both earlier and greater than we had expected. The FY24 financial performance is shown in detail later in this report.

Our FY25 and FY26 EPRA earnings forecast are each increased by £1.0m, with portfolio repositioning having a noticeable impact. As a result, higher DPS growth than we had expected remains well-covered by EPRA earnings. The completed sale of Angel Gate, around 50% vacant, reduces net property income by £0.7m pa, but with the proceeds partly utilised to repay more expensive, floating rate debt in full, the foregone income is more than made up by reduced borrowing costs of c £1.1m, even before redeployment of the balance of proceeds of more than £13m. With vacant possession obtained on Longcross in Cardiff, the sale completion, expected later this year, will have a positive impact on net property income, driven by the property costs eliminated.

The NAV growth that we forecast is mostly driven by increased rental income. For FY25 we assume no change in the end-FY24 net initial yield of 5.4% but allow for a 10bp yield tightening in FY26, reflecting the anticipation of declining interest rates.

We estimate that each 5bp increase or decrease in the net initial yield is equivalent to c 1% of portfolio value and c 1.3p per share of NAV.

Picton aims to provide an attractive total return with an income focus, proactively managing its portfolio with a focus on assets where it has identified opportunities to enhance income and/or value. Its dividend policy is to distribute most of the recurring income earnings to shareholders via quarterly dividends, maintaining full cover and generating surplus cash for reinvestment back into the portfolio. Despite challenging market conditions in FY23 and FY24, the cumulative 10-year NAV total return,2 calculated without assuming any reinvestment of dividends, has been 129.1%, or an average 8.7% pa. Reflecting the total return investment strategy, dividends paid have provided 46% of the 10-year total return and capital growth 56%. We expect dividends to represent an increased share of total return in the next two years. In common with the sector, the across-the-cycle income return has been much more stable than the capital return.

The key driver of Picton’s NAV total return performance has been the consistently strong property portfolio return, measured before the impact of gearing or the company running costs. The company has outperformed the MSCI Quarterly Property Index in each of the past 11 years, with upper-quartile performances over three, five and 10 years and since launch in 2005. In FY24, Picton’s portfolio total return was 1.6% compared with -1.0% for the index. This comprised a capital return of -3.5% (-5.7% for the index) and an income return of 5.1% (4.7% for the index). Since launch, Picton’s property income return is c 20% ahead of the index.

Among the factors supporting this strong performance, we note Picton’s successful record of proactive asset management and its diversified, unconstrained investment strategy.

Active asset management is core to Picton’s strong performance. Underpinned by the group’s occupier focus, Picton seeks to work closely with tenants to understand their needs, enhance tenant retention and occupancy, maximise income and support capital values. The strong portfolio performance in FY24 included progress in the following areas:

The pattern of office use, post-pandemic, remains unclear, particularly with respect to the long-term adoption of remote and hybrid working arrangements. Combined with economic uncertainties this has created some general occupier hesitancy, but with interest focused increasingly on well-located, good quality and sustainable space. Similarly, in the investment market, secondary space, in need of capital expenditure to meet occupier demands and regulatory requirements for energy efficiency, rents and capital values face a significant headwind.

Picton has responded proactively to these changes in the office market by adapting some of its assets to alternative use, with key projects at Angel Gate in London EC1, Longcross in Cardiff and Charlotte Terrace in London W14.

The sale of Angel Gate completed shortly after the period end, for a consideration of £29.6m, a 5% premium to the 31 December 2023 (Q324) independent valuation. It followed significant work undertaken by the company during 2023, when it identified an opportunity to secure planning consent for conversion of part-vacant office property to residential use. As Picton worked through the process, it was able to maintain occupancy at around 50%, but the property still represented the largest single void in the portfolio, accounting for 19% of the end-FY24 total.

At Longcross, contracts have been exchanged for its sale to an experienced purpose-built student accommodation developer. Picton has been securing vacant possession ahead of the sale and at end-FY24, Longcross represented 12% of the total portfolio void. The transaction is conditional on planning permission, for which the purchaser has now submitted an application. Picton hopes that permission will be secured in the fourth quarter of 2024. The final sale price is dependent on the exact planning consent obtained and, in particular, upon the number of rooms secured, subject to a collar and cap. The planning application is for 706 units, which Picton says will trigger an overage payment if successfully completed, with an expected sales price of c 20% of the end-FY24 valuation The potential gain on sale is c £1m or c 0.2p per share.

Charlotte Terrace (13% of the portfolio void) comprises four adjoining buildings, with total 28,500 sq ft of office space and 4,400 sq ft of retail space, arranged over five floors. It is located close to Olympia, which is currently undergoing a £1bn redevelopment, delivering a new creative district with a new theatre, entertainment venue, hotel, office, retail and leisure space that is expected to enhance the surrounding area. Having achieved vacant possession in one of the four buildings, planning permission has now been secured for alternative use, allowing Picton to convert the void space into six residential units.

Picton has an unconstrained, opportunistic and primarily asset-driven approach to portfolio construction, while nonetheless maintaining a diversified portfolio. This provides the flexibility to adjust the portfolio to changing market conditions while also investing with conviction. It is an approach that is especially suited to investors that are unable or disinclined to choose between the broad range of single-sector, in many cases higher-risk, funds. Picton’s portfolio of 49 properties is significantly weighted towards industrial and logistics assets (59% by value at end-FY24), reflecting the depth of opportunities in the sector, which benefits from positive demand-supply fundamentals and continuing rental growth. Industrial and logistics assets have significantly contributed to Picton’s performance in recent periods and continued to do so through FY24. Conversely, traditional retail has for some time offered only selective opportunities in the face of over-supply and falling rents, and two-thirds of sector exposure is to retail warehouses, which are better supported by trend changes in consumer spending habits and are underpinned by value-led retailers. Repositioning of selected office assets will see exposure to that sector decline further.

Passing rent for the industrial assets continued to increase strongly in FY24, by 12% (FY23: 13%), while the ERV also increased, albeit at a more moderate pace than previously (by 3% on a like-for-like basis in FY24 versus 18% in FY23). Capital values showed a modestly positive movement.

Despite the pressures on the office market, ERV increased by 4% for Picton’s assets in FY24, particularly within the central London assets (in Farringdon and Covent Garden). Passing rent decreased by 7%, some of which was related to obtaining vacant possession for alternative uses, while capital values decreased by 8%.

Encouragingly, for Picton’s retail & leisure assets, passing rent increased by 2% and ERV by 1% while capital values were 2% lower.

The choice of sector-diversified commercial property REITS, and the list of peers that we show in the valuation section of this note, has reduced drastically in the past three years, as a result of merger and acquisition activity and corporate wind-downs. The catalyst for this has been a challenging market environment since interest rates began to increase, leading to most companies trading at persistent discounts to NAV.

Alongside the benefits of increased scale, the opportunity to increase exposure to industrial and logistic assets has in many cases been highlighted by acquirers.

Picton recognises the merits of consolidation and the opportunity to leverage its strong performance record and the significantly fixed costs of its internal management structure. The disclosed extensive discussions with UK Commercial Property REIT (UKCM) about a possible combination were one of multiple consolidation opportunities that the company has considered over the past year. However, its belief in the merits of a diversified approach remains a point of focus. Subsequent to discussions with Picton ending, UKCM was acquired by Tritax. CT Property Trust (UKCPT) had earlier been acquired by LondonMetric. In both cases the buyers were particularly attracted by the opportunity to increase their industrial logistics exposure. With similar motivations, Urban Logistics (SHED) made an indicative proposal to abrdn Property Income Trust (API) after it had agreed a merger with Custodian REIT (CREI). SHED withdrew but the merger with CREI, recommended by both boards, failed to gain sufficient shareholder approval, by a very narrow margin. API is now pursuing a strategy of managed wind-down. Balanced Commercial Property Trust is undertaking a strategic review and could well go the same way. Other companies that have been removed from the peer group in the past two to three years through completed or ongoing wind-down include Circle Property, Palace Capital and Ediston Property.

The end-FY24 ERV of £57.6m was £12.9m, or 29%, ahead of passing rent of £44.7m, providing a strong opportunity to organically increase income. Excluding the two office assets held for sale, the income upside potential included £3.7m from void reduction and a further £3.7m from increasing rents to market levels at lease expiry/regear. The balance included lease incentive run-off and stepped up rents (c £3.9m).

Within Picton’s portfolio, there is significant further potential to increase industrial rents and reduce office voids. For its industrial assets, the upside from passing rents to ERV is £6.1m, of which £4.2m represents upside to market rents. The end-FY24 industrial voids was low, at just £0.7m of ERV, most of which was either under offer or under refurbishment. Lettings have been completed in Bracknell and Warrington which estimate has roughly halved the void.

Excluding Angel Gate and Longcross, there was £5.9m of remaining reversionary potential in the office sector, of which £2.9m relates to voids (79% of the total portfolio void), with £0.8m upside to estimated market rents. Key voids included Tower Wharf were in Bristol (£0.7m) and Colchester Business Park (£0.6m), both undergoing refurbishment, in addition to Charlotte Terrace (£0.7m). At Tower Wharf, has since let 13,000 sq ft, with an existing occupier relocating within the building, and taking 140% more floorspace. We estimate this has broadly halved the void at this property.

For the retail & leisure assets, occupancy is high while rents are above estimated market levels (by £0.8m of ERV). Positively, passing rent increased in FY24 (by 2%), as did ERV (by 1%).

Lease maturities provide an opportunity to rebase rents and capture reversionary upside. Across the portfolio, the average length of leases to first termination is 4.2 years and the company expects to capture around 20% of the reversion to market level rents annually, providing a positive tailwind for income growth over coming years.

At end-FY24, EPRA occupancy was 91% but has since increased to c 93%, including the post-FY24 lettings and completion of the sale of Angel Gate. This is in line with the 10-year average but below pre-pandemic levels. We would expect a combination of further portfolio repositioning away from the office sector and the leasing of better quality, refurbished space to be the key drivers of further occupancy improvement.

Total drawn debt at end-FY24 was £227.5m, comprising long-term, fixed-rate borrowing of £211.1m and £16.4m drawn on a short-term floating rate revolving credit facility (RCF), since repaid in full. The fixed-rate debt has a blended cost of 3.69% with no maturity until 2031.

Adjusting for the Angel Gate disposal and repayment of the RCF, the end-FY24 net loan to value ratio (gross debt net of cash of £19.8m) of 27.9% was c 25% on a pro-forma basis. Picton is weighing options for the balance of proceeds of the Angel Gate disposal. This will certainly include investment in the existing portfolio to support rental growth and capital values and may also include opportunistic acquisitions, where these are accretive. Share repurchases are also an option, although any immediate accretion would at least in part be offset by the diseconomies of reduced scale. We would favour a patient approach to deployment of the proceeds as market conditions move in favour of acquisitions.

The Canada Life facility can only be repaid at maturity. The Aviva facility is amortising, but only at a rate of c £1.4m pa. The undrawn RCF expires in May 2025 and the company is already considering options for refinancing that will cost-efficiently maintain its balance sheet flexibility.

Although we expect the attractively priced long-term borrowing to be held to maturity, its value can be seen in the c £25m difference between the nominal value of borrowings and their fair value at end-FY24 of £202.8m. This is reflected in the EPRA net disposal value per share of 101p, above EPRA net tangible assets per share of 96p.

The increased level of quarterly DPS (0.925p) represents an annualised rate of 3.7p or a 5.7% yield. We forecast further increases in quarterly DPS in FY25 and FY26.

The shares trade at c 0.70x the 96p end-FY24 NAV3 per share, well below the 10-year average of 0.9x and a high of c 1.1x. In common with the UK REIT sector, Picton shares have de-rated as interest rates have risen and the current valuation is broadly in line with its level at the height of pandemic uncertainty in early 2020.

The table below compares Picton with a selected group of peers, all targeting income from diversified portfolios. The list has narrowed considerably in the past two years as a result of the corporate activity referred to above and looks likely to narrow further. Corporate activity has had an impact on relative share price performances and valuations, and continues to do so. Picton shares trade on a lower yield than the group average, primarily reflecting its strategy of balancing sustainable fully covered4 dividends with the capital requirements of active management. Its P/NAV ratio is slightly below the average. The company’s strong track record of property level performance, the future income and valuation growth potential embedded in its portfolio, and its strong balance sheet are all positive indicators for a share price re-rating.

Against a challenging market backdrop, the FY24 performance was robust. EPRA earnings was maintained and, as discussed above, the property portfolio performed ahead of the index.

Key features included:

At 31 March 2024 (end-FY24), the externally assessed fair value of the investment portfolio was £745m (the balance sheet value includes an adjustment for lease incentives and finance leases), reflecting an EPRA net initial yield of 5.4% and a reversionary yield of 7.0%.

The portfolio comprises 49 assets, let to more than 400 individual occupiers, of which the top 10 account for 23.6% and the largest (3.6%) is various public sector entities.

Exhibit 15 shows the split of the portfolio in greater detail.

The company was launched in October 2005 as the ING UK Real Estate Income Trust in an offshore structure, listed on the Channel Islands Stock Exchange and the London Stock Exchange. In 2011, the company name was changed to Picton Property Income and in January 2012, management was internalised, giving the company greater flexibility to manage costs and benefit fully from the growth in assets. In 2018 it became a UK-domiciled REIT and changed its technical listing status from an investment company to a commercial company, bringing it more in line with other internally managed property company peers. Throughout this period, there has been no change in the company’s diversified, actively managed total return investment strategy.

The board comprises six members: four non-executive and two executive directors, chaired by Lena Wilson CBE. Collectively, the non-executive directors bring considerable experience from across the real estate, real estate financing and financial services sectors. Ms Wilson serves on a number of boards in a non-executive capacity, including NatWest Group, and is also chair of Chiene + Tait LLP and AGS Group. Previously she was chief executive of Scottish Enterprise from 2009 until 2017 and, prior to that, was a senior investment adviser at The World Bank. The other non-executives are Mark Batten (chair of the audit and risk committee and the senior independent director), formerly a partner at PricewaterhouseCoopers for over 25 years, Maria Bentley (chair of the remuneration and nominations committees), with over 35 years of experience in the financial services sector, and Richard Jones (chair of the property and valuation committee), a highly experienced real estate professional with over 30 years’ experience.

The executive board members are CEO Michael Morris and CFO Saira Johnston. Mr Morris has more than 25 years’ experience in the UK commercial property sector and has worked with the group since it was launched in 2005. Ms Johnston joined Picton in March 2024, replacing Andrew Dewhirst upon his retirement, and has over 20 years’ experience in the real estate and financial services sector.

Brief biographies of the key members of the leadership team are listed below and detailed board biographies may be found on the company website.

Including the CEO and CFO, the broader Picton management team comprises 11 individuals, of whom five are property professionals.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. From a sector viewpoint we also highlight the increased risks and uncertainties that attach to development activity, including planning consents, timing, construction risks and the long lead times to completion and eventual occupation. Picton is not a developer, but is exposed to similar but lesser uncertainties, as it actively invests in improvements to existing assets with the aim of enhancing long-term income growth and returns. More generally we note the sensitivity to: