LXi REIT — Organic growth drivers with external opportunities

We expect a full contribution from the merger, including cost efficiencies, and contracted rental uplifts to drive further organic growth in earnings and dividends. Although not included in our forecasts, the company expects its substantial scale to additionally support ongoing asset management activity within the portfolio and provide opportunities for external growth. The existing portfolio is diversified in nature, with a focus on assets that are ‘mission critical’ to tenants, in defensive sectors, with a stable outlook and high barriers to entry. Combined with fixed-cost funding, we believe the portfolio should provide protection against a worse UK economic performance than is captured by consensus economic forecasts.

98% of contracted rents are based on inflation indexed (26% RPI/38% CPI), 60% of which are capped at an average 3.9% pa, or fixed (34%) uplifts. Annual reviews apply to 56% of leases with 44% reviewed every five years. The portfolio is fully let and all leases require full repairing and insuring by the tenant, providing protection from property cost leakage and capital expenditure requirements. In each of the next two years, LXi expects 61% of contracted rents to renew, and for this to increase in the following years as the timing of five-yearly reviews has a greater impact.

Asset management and capital recycling remain core elements of LXi’s organic growth strategy post-merger, and the company expects enhanced opportunities as a result of its increased scale. During H223 it completed two key innovative transactions, both covered in our March outlook note, in the Merlin ‘income strip’ transaction and re-gear of the Travelodge portfolio, and sees good opportunities to create further value through lease re-gears, strengthening relationships with key tenants and other asset management initiatives.

Capital recycling is a route to rebalancing portfolio exposures and optimising capital deployment towards the most promising areas. In early June, LXi completed the profitable sale of a retail park for £31m, reflecting a yield of 4.7% compared with its portfolio average of 5.4% at end-FY23. The property had been acquired as a forward funded development in 2019 for £24m and the sale crystalised an 11% internal rate of return. The proceeds will initially reduce gearing but may also be partially reinvested in a high yielding pipeline of opportunities.

The company has identified a significant pipeline of opportunities to acquire prime, long-income assets as a result of structural change within the open-ended funds sector. It also expects ‘cliff edge’ refinancing events for corporates, as existing low-cost bonds mature, to be a source of new sale and leaseback opportunities.

LXi also anticipates opportunities to participate in REIT consolidation and M&A in the long-income market, leveraging its scale and cost efficiency and taking advantage of wide discounts that have emerged with asset repricing, leaving some players with sub-scale platforms.

As at end FY23, the portfolio comprised 350 properties across 13 property subsectors with multiple underlying uses, let on very long leases, averaging 27 years, to more than 80 separate tenant operators on low and sustainable rents.

Through the merger, Merlin Entertainments (19% of passing rent) and Ramsay Healthcare (18% of passing rent), along with Travelodge (an existing LXi tenant but increased to a combined 18%) became LXi’s largest tenants. Each is performing well, with operations that have defensive qualities, but over time we expect LXi to use selective disposals as an opportunity to reduce sector and tenant concentration, repay debt and reduce leverage, and redeploy capital.

FY23 adjusted cash earnings (‘earnings’) was in line with our last published forecasts (with some composition differences) while NAV, DPS and loan-to-value (LTV) were consistent with the company’s prior announcements. In terms of composition, the main divergence of our earnings forecast from the reported FY23 results was our inclusion of the c £4.1m (£8.2m pa) lease payment resulting from the income strip transaction as a rent reduction, rather than a lease payment within finance expense.

On a similar basis, our FY24 forecast increases by c 3%, driven mostly by licence fee income on the properties under development and lower investment adviser fees, and we have extended the forecast period to FY26. We expect fully covered DPS growth of almost 4% pa beyond the 6.6p that the company targets for the current year.

With property revaluation remaining uncertain, we have assumed no change in valuation in FY24, despite continuing rental growth, equivalent to an additional 10bp increase in yield to 5.5%. In FY25 and FY26 we assume an unchanged yield with rental growth driving valuation gains.

Every 1% increase (or decrease) in portfolio value adds (or reduces) FY24e EPRA NTA per share by c 2p.

Our assumptions are slightly more conservative than the company view, which anticipates the property market repricing of FY23 will begin to slowly reverse in the second half of the calendar year as inflation stabilises and interest rate expectations peak. It expects to benefit from a tendency for properties with robust defensive qualities to rebound the quickest, particularly in tougher economic climates, with capital seeking well let, secure, long-term investments with built-in inflation protection.

Our key forecasting assumptions are:

For FY24, although we expect recent inflation to be more fully reflected in five-year rent reviews, there are fewer reviews due compared to FY23. We assume a lower uplift on annual reviews as inflation moderates. For FY25, we expect lower indexation on annual uplifts, partly offset by higher uplifts on five-year reviews, which will continue to benefit from recent high inflation. The acceleration in like-for-like rental growth in FY26 is driven by an increase in the number of five-year reviews due.

LXi has the largest board and management team stake of any UK REIT, valued at more than £100m, strongly aligning the interests of the company and its shareholders. Key members of the investment advisory team at LXi REIT Advisors,1 who execute the company’s investment strategy, have consistently increased their investments in the company in recent months.

Prior to the merger, Secure Income REIT was externally managed by Prestbury Investment Partners, and its management team held a c 12% stake in the company. Senior members of the Prestbury team are now significant investors in LXi with a 5.8% interest. This includes Nick Leslau (chairman and majority shareholder of Prestbury) and Sandy Gumm (chief operating officer of Prestbury), both of whom joined the board of LXi as non-executive directors. Meanwhile, Mike Brown (chief executive officer of Prestbury) became an advisor to LXI REIT Advisors.

The 9.6% like-for-like decline in portfolio value in FY23 reflected a 90bp widening of the valuation yield (from 5.4% from 4.5%) partly offset by 2.3% like-for-like rental growth and other asset management activity. Chief among the latter was the Travelodge lease re-gear and rent smoothing. The performance appears favourable compared with MSCI Quarterly Index data that indicate a decline of c 7% over the same period.

Aside from asset management, those sectors where strong operational fundamentals have been reflected in relatively lower yields (eg foodstores, industrials) tended to see the greatest yield shift in response to higher bond yields. Healthcare properties benefited from their highly defensive nature.

Post-merger, coming into H223, LXi had c £800m of borrowing, around half its total facilities, with relatively near-term maturities in 2023 and 2024. Refinancing this debt was a key focus and this was successfully achieved by early April 2023, despite the further rise in interest rates and considerable volatility in debt markets. The company has also received a BBB- Investment Grade credit rating with a stable outlook from Standard & Poor’s.

Prior to the year-end, LXi agreed an extension of an existing £60m facility and completed a new £148m 16-year term loan. In April a new £565m facility was completed with a syndicate of banks comprising a number of LXi’s existing lenders. The facility consists of a £200m five-year revolving credit facility, a £115m five-year term loan and a £250m three-year term loan.

End-FY23 debt was £1,250m, fully drawn and, including the new facilities agreed in April and subsequent facility repayments, total debt is now £1,298.6m. All borrowing costs are fixed or hedged to maturity at a weighted average cost of 4.7%, compared with 4.2% in September 2022.

The refinancing activity has extended the weighted average maturity of LXi’s debt to six years from three years previously and it is now well spread across a range of lenders and maturities. While the fixed cost of debt provides nearer-term certainty, the spread of maturities and hedging arrangements provide flexibility to respond to future changes in interest rates. We also expect the credit rating to increase medium-term funding flexibility, including potential access to the corporate bond market.

The partial cash alternative offered to SIR shareholders in the merger (25% or £390m) and the market-wide widening of valuation yields (reduction in property values) has increased the LTV to 37% (post refinancing) on the company’s conservative look-through basis at end-FY23.2 This is despite the positive impact on LTV of the Merlin income strip transaction. LXi remains committed to a conservative medium-term LTV target of c 30% and notes that, other things being equal, contractual rental growth would reduce LTV to 35.5% in 12 months and 33.8% in 24 months assuming yields remain flat, allowing the rental growth to be capitalised.

The end-FY23 LTV was comfortably below the company’s medium-term borrowing policy cap of 40%, while there was substantial headroom on loan facilities. It would take a 30% reduction in FY23 portfolio values to breach the most restrictive LTV covenant across LXi's secured facilities while significant unsecured assets and cash remain available. Interest cover covenants are protected by fixed/capped interest rates. We estimate that portfolio value would need to decline by a further 7% on a like-for-like basis, with no management action, before reaching an LTV of 40%.

We estimate that a 1% increase in portfolio values would lower LTV by c 40bps and that a 1% reduction in portfolio value would raise LTV by a similar amount.

Since listing in February 2017, LXi has delivered an annualised total accounting return of 56% or an average 7.5% pa. Despite the market challenges of FY23, this is close to the company’s 8% pa medium-term target. Of the total return over the period, dividends paid have represented 32% or almost 60% of the total. Our forecasts for FY24–26 (Exhibit 3 above) imply positive accounting total returns in each year, averaging 8.7% pa, of which 58% relates to our dividend assumptions and 42% to our capital assumptions.

LXi shares offer a 7.3% FY24e prospective yield and trade at a 23% discount to the FY23 EPRA NTA per share of 121.1p, well below the average 1.0x NAV at which the shares have traded since listing. The valuation is now below its level at the height of pandemic uncertainty, which quickly unwound as investor confidence improved.

In Exhibit 10 we show the key valuation and performance metrics for LXi and a group of other long-income REITs, mostly comprising subsector specialist investors. LXi’s long weighted average unexpired lease term (WAULT) of 27 years is well above the average of the group. For comparative purposes, the DPS and NTA/NAV data are shown on a trailing basis,3 taking the last 12-month DPS declared and last reported NTA/NAV.

LXi’s trailing yield is slightly below the peer group average, but does not reflect the 4.8% increase targeted for FY24, and its P/NAV is in line. LXi’s share price performance is lower than the average on a one-year basis but well above the average over three years. The range of share price performances across the group is wide, reflecting the varying fortunes of the subsectors on which most peers are focused. It is this variability that underlines the potential attraction of a diversified and actively managed vehicle such as LXi to investors who seek, but are otherwise unable to achieve, an optimal diversification of risks.

The FY23 results clearly show the impact of the merger with Secure Income REIT, which completed on 6 July 2022. While less than nine months of the merger was reflected in the income statement, significant economies of scale were achieved, with the EPRA cost ratio reduced to 9.5% (among the lowest, if not the lowest, in the UK REIT sector) and adjusted EPS increased 19%. The H223 summary in Exhibit 11 below provides a better indication of the run-rate of underlying earnings.

The end-FY23 balance sheet fully reflected the merger, with the portfolio value more than doubling to £3.4bn and the LTV increased to 37% (on the company’s look-through basis) due to the partial cash funding of the merger and property valuation declines.

In Exhibit 11, our presentation of the income statement is structured to show the breakdown of LXi’s adjusted cash earnings, the basis for dividend distributions, following through to statutory IFRS earnings.