Custodian Property Income REIT — Organic growth paying dividends

This outlook note focuses on CREI’s long-term performance and strategy for continued growth in earnings and fully covered dividends. It also includes a review of the detailed FY24 financial report and an update on our forecasts. In summary, the investment case for the company is as follows:

CREI has long sought to appeal to a broad base of institutional and private shareholders by providing a diversified and differentiated portfolio, with a strong income focus and low-risk balance sheet. This strategy is especially suited to investors unable or disinclined to choose between the broad range of single-sector, and in many cases higher-risk, funds.

The choice of sector-diversified commercial property real estate investment trusts (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.

CREI recognises the merits of consolidation as a route to accelerating growth, increasing scale and liquidity while reducing cost ratios, and was disappointed that its proposed merger with abrdn Property Income Trust (API), agreed by both boards, failed to win sufficient shareholder backing by a very narrow margin. The merger would have created a larger, stronger, diversified REIT but API is now pursuing a strategy of managed wind-down.

Alongside the benefits of increased scale, several recent transactions have been driven by acquirers seeking to expand their presence in the industrial and logistics sectors, where structural demand factors and limited supply continue to drive above-average rental growth and capital value performance, areas in which CREI’s portfolio is well represented.

This was the motivation behind Urban Logistics’ (SHED’s) indicative proposal to API, rejected by the board, during the merger discussions with CREI. Similarly, subsequent to the discontinuation of discussions with Picton Property Income (PCTN), UK Commercial Property REIT (UKCM) was acquired by Tritax Big Box (BBOX). CT Property Trust (UKCPT) had earlier been acquired by LondonMetric (LMP). In both cases the buyers were also particularly attracted by the opportunity to increase their industrial logistics exposure.

CREI’s income-focused strategy has generated positive income returns, from fully covered dividends, each year since listing in March 2014. Without assuming reinvestment of dividends, the aggregate return from listing to end-FY24 is 54%, or 4.4% pa, effectively all accounted for by dividends paid. Including dividend reinvestment, CREI calculates a 5.5% pa average total return. The prospective dividend yield is significantly higher than the income return on NAV as a result of the discount to NAV at which the shares are trading.

For FY24, CREI declared four quarterly dividends of 1.375p, meeting its annual target of at least 5.5p. To reflect a continuing strong leasing performance, earnings-accretive disposals and the company’s confidence in the outlook, a special dividend of 0.3p took the total distribution for the year to 5.8p. The FY25 DPS target was increased to 6.0p, a 9% uplift on the FY24 target, excluding the special dividend.

In line with the broad sector, capital returns have been significantly affected by the adjustments of property values across the UK commercial property sector to increased bond yields and economic uncertainty. With DPS growth accelerating, income should continue to drive total return, even though capital values show increasing signs of stabilisation and may well benefit from the expected decline in interest rates.

The greater stability of CREI’s income return as a percentage of NAV compared with more volatile capital returns is consistent with across-the-cycle sector returns, but the contribution from income to CREI’s returns is above the sector average, which we estimate to be c 70%.

While capital returns are volatile, we note that in FY24 the like-for-like valuation decline on the CREI portfolio of 4.0% compared favourably to the 5.7% decline indicated by MSCI quarterly data. The 11.8% like-for-like capital value decline was also less than the broad market decline of c 17%.

CREI’s NAV decreased by 5.9% during the year but, in step with property valuations, at an increasingly slower rate quarter-on-quarter, as the impact of higher interest rates and investor sentiment became fully reflected in valuations. Including the benefit of disposal gains, Q424 NAV per share showed a marginal increase. The company expects the first move down in interest rates to provide a catalyst for a positive shift in sentiment towards real estate investment and a potential turning point in the market.

Our last published forecasts followed the company’s Q424 update in early May and reflected the FY24 special dividend and increase in FY25 DPS target. The published data for EPRA earnings, net assets and dividends show no material differences to the unaudited Q4 data, nor to our forecasts. In aggregate there is little change to our FY25 forecasts, although the composition has shifted, with slightly slower growth in net rental income offset by lower administrative costs. Our newly introduced FY26 forecasts show modest further advances in earnings and fully covered DPS.

During Q4 and in the year to date, CREI has sold five assets for an aggregate consideration of £29.5m, on average 21% ahead of book value. This will limit the growth of rental income in the current year but will reduce void property costs, and the repayment of more expensive variable rate borrowing from the proceeds will reduce interest expense. We estimate a blended gross yield (before property costs) on the disposals of less than 4%, well below the c 7% marginal cost of debt.

Aside from the impact of disposals, we have only assumed modest growth in underlying contracted rents. This could prove conservative compared with the significant rent reversion opportunity in the portfolio, discussed in more detail later in this report. The end-FY24 estimated rental value (ERV) of £49.4m was £6.3m, or 15%, above passing contracted rent of £43.1m.

Our previous forecast had assumed flat property valuations through H224 and a higher NAV than reported. Looking forward, we have assumed some modest valuation upside, driven by leasing progress and a broadly unchanged net initial yield.

Since IPO, CREI has sought to provide enhanced income returns from UK real estate by following a smaller lot-sized, regional property strategy. Its portfolio is built on a balance of core and core-plus strategies, or core/core-plus. The core strategy is expected to deliver stable, long-term income from well-let, good-quality, predominantly smaller regional properties in attractive locations. The core-plus strategy provides the opportunity to enhance income through asset management initiatives such as lease renewals, regears and new lets and refurbishment. Taken together, CREI aims to generate better risk-adjusted returns than would be possible from a core strategy alone, without a material increase in the volatility of underlying asset values.

The investment strategy does not target value-add acquisitions, often requiring significant improvement and void reduction measures, although the company will invest to reposition existing assets when there is the potential for attractive risk-adjusted returns. The investment policy allows for the redevelopment of properties already owned to a limit of 10% of gross assets. To be clear, CREI will not acquire land assets or properties with the intention of development or redevelopment. The purpose is to provide additional flexibility to enhance asset quality, including environmental performance, to better meet the demands of tenants and drive income growth.

Comparing the transaction net initial yields for properties below £10m with the transaction net initial yields for properties above £10m on a 12-month rolling basis, over the past 20 years or so the yield spread of sub-£10m transactions over those of more than £10m has averaged c 1.1%.

The higher yield on smaller properties is often considered to reflect higher risk and, typically, a higher cost of management relative to income. However, smaller size does not in itself determine the quality of the property, its appeal to tenants or the quality of tenant. While there may be less competition for smaller assets from investors, there is an active owner-occupier market that supports vacant possession values and mitigates valuation risk. Asset selection and a long-term approach to investment are key to managing risk and hence CREI’s strategy for producing an attractive risk-adjusted income return, more than sufficient to offset the additional administrative complexity. Other key elements of CREI’s investment strategy for achieving above-average, risk-adjusted returns include:

Portfolio diversification provides a mitigation to income risk and CREI’s portfolio is well spread across the main commercial property sectors and by geographic location, as well as by the number of properties and tenants.

There were 155 properties in the portfolio at end-FY24, let to 335 individual tenants. The top 10 tenants represented c 23% of the total. Although the properties are smaller, the list of tenants includes many well-known and well-established businesses and the overall tenant risk rating is strong.

Although CREI’s portfolio is split between the main property sectors, in line with the company’s objective of maintaining a suitably balanced portfolio, it is actively weighted, with a high level of exposure to the industrial, retail warehouse and alternative sectors (‘other’, including pubs and restaurants, gymnasiums, drive-through restaurants, car showrooms, leisure, units and trade counters), with relatively low exposure to offices and high street retail.

The key themes to CREI’s portfolio positioning include:

The Investment Property Forum’s second quarterly survey of the year, based on data received from 19 organisations, the forecasts for which were generated between the start of March and mid-May 2024, shows a consensus expectation that the industrial and retail warehouse sectors will continue to show the strongest rental and capital growth and lead overall performance. Nonetheless, positive total returns are expected across all sectors during the period.

In an inflationary environment and with a lack of supply of modern, smaller regional properties, the company expects to see continued rental growth over the year ahead, especially for properties with strong environmental credentials. Additionally, the portfolio contains significant reversionary potential while rents continue to grow.

During FY24, on a like-for-like basis, contractual rental income increased 5.6% and the externally estimated portfolio rental value increased by 3.6%. Growth continued through Q424 with like-for-like growth of 1.7% in contracted rents and ERV increasing 0.8%. EPRA occupancy increased to 91.7% in FY24, from 90.3% at end-FY23. The 15 rent reviews completed in the year were in aggregate at an average 23% premium to the previous passing rent, supporting income and capital values.

Providing a strong opportunity to organically increase income, the end-FY24 ERV of £49.4m was £7.7m or c 18% ahead of cash passing rent of £41.7m and £6.3m or 15% ahead of contracted rent of £43.1m, which included c £1.4m of lease incentives. Void reduction represented £4.1m of the potential upside to income with a further £2.1m of latent rental growth, which will be unlocked at rent review and lease renewal.

The reversionary potential of the portfolio by sector can be seen by comparing EPRA topped-up net initial yield (NIY) to the equivalent yield, which factors in expected rental growth and the letting of vacant units. The significant upside in industrial assets primarily reflects rental potential. For office assets, including those undergoing refurbishment, there is a strong opportunity to reduce voids. High street retail assets are yet to fully reflect the declines in market rents of recent years. For retail warehouse assets, the lower equivalent yield versus the NIY relates primarily to two assets, which were acquired with above market-level rents. The assets, combined with a longer-than-average remaining lease term and strong tenant covenant, compensates for the potential rebasing of rents at lease maturity.

Although having increased over the past year, EPRA occupancy remains below the average of 95% since listing, primarily due to the level of refurbishment activity seen in the past two years. It is, nonetheless, in line with close peers. While the level of structural vacancy was lower than 8.3% reported, allowing for c 2% of ERV that was under offer to let or sell and the c 1% of ERV subject to refurbishment, timing factors are fairly typical, such that a material opportunity to increase income remains.

The sustainability credentials of the assets in the portfolio have increasingly become ever more important for occupiers and investors and are now central to the asset management. 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 valuations of the assets and, once let, increase rents to give a yield on cost of at least 7%.

In FY24, capex amounted to £19.0m, including £2.0m of investment in solar panels primarily and electrical vehicle charging points, spread across a range of assets in different sectors. As a result of improvements embedded in refurbishment programmes, as well as asset disposals, the weighted average share of properties EPC rated A to C increased to 79% in FY24 from 70% in FY23.2The portfolio weighted average EPC score improved to 53 (C) from 58 (C). CREI expects all remaining EPC E-rated properties to be improved by December 2025, and for the two properties containing EPC F-rated units, asset management plans are underway. Where the risk-return balance of investing in properties is unfavourable, they will continue to be sold, often for alternative use.

More broadly, CREI’s approach and strategic objectives are set out in its June 2024 Asset Management and Sustainability report and its 2023 Environmental, Social and Governance report.

The end-FY24 loan to value (LTV) ratio was 29.2% and on a pro-forma basis, adjusted for subsequent property sales,3 it was c 28%.

End-FY24 borrowings were £179m, from total facilities of £190m, or £215m including an accordion option at the discretion of the lender. Drawn borrowings comprised £140m (78% of the total) of long-term fixed-rate debt, at a blended interest cost of 3.4%, with a six-year average maturity and £39m of floating rate debt drawn from the company’s revolving credit facility (RCF). Although relatively more expensive, the RCF provides funding flexibility, and its usage has continued to reduce as a result of disposals. In all, the weighted average cost of aggregate borrowings at end-FY24 was 4.1%.

With the RCF facility extended by three years during FY24, the first debt maturity, the £20m Scottish Widows facility, is not until August 2025. The £50m RCF facility can be increased to £75m under an accordion facility, subject to lender approval, and CREI has an option to extend the maturity of the facility by a up to two years, from November 2026 to November 2028. We see no obstacles to refinancing the 2025 debt maturity, albeit it is likely to be at a higher cost than the current 3.9%. However, if interest rates decline in line with the market consensus, given the modest size of the facility, the impact on CREI’s borrowing costs would be minimal. At the time of writing the UK five-year swap rate is c 4%, providing a benchmark for refinancing at current market levels, to which a lending margin of perhaps 2% should be added.

Gearing is ahead of its medium-term target of 25%, but there is significant headroom against debt covenants.4 With a substantial pool of assets unencumbered by borrowings (£105m at end-FY24), property valuations would need to decrease by 17% from the end-FY24 level to risk breaching the overall LTV covenant.

The rate of loss or deferral of contractual rent on the borrowing facility with least headroom would need to deteriorate by 10%5 to breach interest cover covenants, assuming no unencumbered assets were charged. This is the Scottish Widows £20m facility that expires in August 2025. To breach the interest cover covenant on the facility with the second-least headroom would require a 22% loss of rental income.

CREI’s 6.0p target DPS for FY25 represents a prospective yield of 7.8%. Meanwhile, the shares trade at an 18% discount to the FY24 NAV per share of 93.4p.

The table below compares CREI 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.

CREI trades on a slightly higher P/NAV than the average of the group but less so than has been the case for most of the period since listing. Its trailing yield is broadly in line with peers, not yet reflecting the targeted dividend growth on a fully covered basis6 and the company’s focus on smaller lot-size properties, with a premium yield, has historically supported risk-adjusted income returns.

FY24 results were published in June 2024, although a number of key financial and operational performance metrics were available in the four quarterly reports published through the year. For the year as a whole, growth in rental income and lower costs more than offset the drag of higher borrowing costs such that dividend growth, including the special dividend, was fully covered by EPRA earnings.

Exhibit 20 shows a summary of the FY24 results. We highlight the following:

Although CREI’s smaller lot-size strategy has remained constant, the pool of suitable properties for investment has evolved over time, in step with market changes, and the stated investment policy has been adjusted to match. This primarily relates to the specified maximum lot size and the minimum weighted average unexpired lease term (WAULT).

At the AGM held in 2023, shareholders approved a change in the company’s target portfolio characteristics from ‘properties with individual values of less than £15m at acquisition’ to ‘smaller, regional, core/core plus properties that provide enhanced income returns’. The £15m limit had been approved by shareholders in 2022, an increase from the £10m in place since 2016 and £7.5m prior to that. Irrespective of this change, the company says that smaller properties will remain the overwhelming focus of its strategy, allowing it to operate below the general level of institutional demand. The portfolio average lot size is just under £4m. During FY24, CREI made no acquisitions and was focused on capital recycling, using disposal proceeds to invest in the existing portfolio and reduce borrowings. In FY23, acquisitions amounted to c £53m, with an average consideration of a little under £7m, within a range of £15.0m (a retail park in Nottingham) and £3m (two drive-through restaurants in York).

To reflect market shifts, including increasing tenant demand for shorter and more flexible leases,7 the 2020 AGM removed the restriction that all new investments should have a minimum WAULT of five years. This allows CREI to focus on asset quality and opportunities to create value on a sustainable basis through re-lettings and lease re-gears. Leases representing approximately one-third of gross contracted rents, or c £14m, mature over the next three years. The end-FY24 WAULT was 4.9 years, a similar level to that of the past five years. At 31 March 2024 (end-FY24), the externally assessed fair value of the investment portfolio was £589m (the balance sheet value includes an adjustment for lease incentives and finance leases), reflecting an EPRA topped-up net initial yield of 6.6% and an equivalent yield of 7.5%.

During FY24, no properties were acquired, and five properties were sold, for an aggregate consideration of £18.2m, a weighted average premium of 12% to the end-FY23 valuation. Since period-end, CREI has sold a vacant industrial unit in Warrington for £9.0m and a vacant former car showroom in Redhill for £2.3m, which had an aggregate year-end value of £11.3m.

At end-FY24, the top 10 tenants represented c 23% of overall rent roll, with rents from the largest tenant, Menzies Distribution, spread over eight individual assets. Menzies is one of the UK’s leading urban logistics businesses.

Custodian Property Income REIT is an externally managed UK REIT, listed on the Main Market of the London Stock Exchange. Its stated purpose is to offer investors the opportunity to access a diversified portfolio of UK commercial real estate, with strong environmental credentials, which can provide an attractive level of income and the potential for capital growth. It aims to be the REIT of choice for private and institutional investors seeking high and stable dividends from well diversified UK real estate.

CREI’s board of directors comprises six members, all of whom are non-executive and five of whom are deemed independent. The board is chaired by David MacLellan, who joined the board in May 2023, taking over from David Hunter as chair on his retirement from the board at the 2023 AGM after nine years of service. David has more than 35 years’ experience in private equity and fund management and has an established track record as chair and as a non-executive director of public and private companies.

The other directors are Hazel Adam, who joined the board in December 2019, bringing a range of experience including in the buy-side and sell-side investment industry, strategies and markets; Elizabeth McMeikan, a former Tesco executive and experienced board member, appointed in March 2021; Chris Ireland, a former CEO of JLL UK and former chair of the Investment Property Forum, who also joined the board in March 2021; Malcolm Cooper, who has extensive board experience and a background in corporate finance, infrastructure and property, and who joined the board in June 2022; and Ian Mattioli, who as CEO of Mattioli Woods and a board member of the investment manager, is deemed not to be independent. Ed Moore, finance director of Custodian Capital, is company secretary to CREI. Full details of the board can be found on the company’s website.

The company is externally managed by Custodian Capital, a wholly owned subsidiary of Mattioli Woods. Custodian Capital was appointed investment manager at the IPO, an arrangement that is subject to regular board review. Richard Shepherd-Cross is the managing director of Custodian Capital and the fund manager of CREI. He is a former director of Jones Lang LaSalle in London, where he led the portfolio investment team before joining Mattioli Woods in 2009, with responsibility for its syndicated property initiative, the precursor to Custodian. Richard is supported by Custodian Capital’s other key personnel, including Ed Moore (finance director), Alex Nix (assistant investment manager) and Tom Donnachie (portfolio manager), along with a team of five other surveyors and four accountants

Management and administration fees are paid to the manager on a sliding scale that allows shareholders to benefit from growth in NAV.

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. CREI’s development exposure is modest and limited to the improvement of existing properties. In this respect, it may best be seen as an extension of its refurbishment activity, aimed at enhancing long-term income growth and returns. Forward-funded development activity is likewise modest and, in our view, very low risk. More generally, we note the sensitivity to: