Palace Capital — Update 31 January 2017

Palace is building a diversified and well-located commercial property portfolio let to financially sound tenants with the aim of providing investors with attractive income and capital returns. The portfolio’s diversity helps mitigate sector-specific risks and the regional focus brings higher yields and less exposure to Brexit-related risks than investment in London. The policy of investing outside London can provide opportunities overlooked by other investors. Palace has an active asset management strategy with specific plans for each property, which may include full redevelopment. Asset management plans for each unit are developed by an experienced in-house team, which aims to acquire assets in good locations near transport hubs, enabling them to refurbish or redevelop them to provide high-quality alternatives to prime commercial real estate. In this way Palace seeks to increase rents and capital values while still offering an economic alternative to its tenants; examples are given in the portfolio section (page 8).

We forecast steady NAV per share growth from 419p at 30 September 2016 to 429p at the end of FY19, without building any structural valuation uplift into our model and only accounting for higher rents at two properties where refurbishment is complete and there is reasonable expectation that these increases will lead to capital value growth in the near term. We similarly forecast modest EPRA earnings growth as new leases begin with rent holidays and some leases at properties that may be refurbished or redeveloped are not immediately replaced, taking occupancy from 89% at 30 September 2016 to 88% in FY18, before rising again to a long-term rate of 90%. While these effects reduce rental income slightly from £13.8m forecast in FY17 to £13.4m in FY18 and £13.5m in FY19, we also expect direct property costs to fall from £2.3m in FY17 to £1.5m in FY19 with disposals of vacant properties and as asset management initiatives mitigate other vacancy costs.

We have not allowed for any new acquisitions or borrowings, which means our revenue and earnings forecasts are sensitive to the upside should Palace invest further, and also that we forecast debt reduction in line with the existing maturity schedule. As a result, finance costs are reduced in our forecast period, and EPRA earnings rise on a per share basis from 18.4p (net of a one-off gain from a lease surrender) in FY16 to 20.0p in FY17, 20.8p in FY18 and 23.1p in FY19. Assuming the dividend remains at 9p every half-year, we forecast that cover will rise from 1.2x to 1.3x over the forecast period. Further detail is given in the financials section on page 10.

Palace aims to increase capital values as well as earnings and we consider our forecasts to be conservative, with only two specific valuation gains expected in the forecast period, a slight decline in occupancy and no rental growth assumed elsewhere. The company also has the least expensive debt portfolio of its peers and a 5% prospective dividend yield. In that context, the c 15% discount to NAV appears high compared with an average of c 3% for the peer group of diversified regional property companies.

Occupier demand is sensitive to wider economic conditions and capital values are affected by investment flows and macroeconomic factors such as the value of sterling. Regional properties are likely to be less sensitive to these than London ones. Palace has relatively high-yielding assets with scope for rent growth, low-cost debt, a well-covered dividend and capacity to make further acquisitions of a similar scale to other recent ones.

Palace Capital is a property investment company listed on the Alternative Investment Market (AIM) of the London Stock Exchange (LSE) and registered in the UK. The company invests in UK commercial property outside London and is sector agnostic, with offices making up the largest portion of the portfolio at 42%, followed by leisure at 24%. The current portfolio of 50 assets is valued at £184.8m (30 September 2016) and has net annual rents of £11.7m. Further detail is on page 8. Palace seeks to enhance capital values and provide a sustainable and growing income stream by acquiring assets with potential for rent increases through the reduction of void costs, refurbishment and in some cases redevelopment or refurbishment. Most properties are held for long-term rental income, but the company also realises capital value through selective disposals where opportunities arise.

On a spectrum with very low-risk, buy-and-hold REITs at one end and speculative developers at the other, Palace is in the middle: it has the flexibility to invest earnings in capital-enhancing asset management projects, unconstrained by the REIT property income distribution requirement (albeit the payout ratio is currently similar to a REIT’s), and is willing to assume some development risk where the potential returns are attractive, but also has a stable core portfolio producing sustainable rental income as well as providing opportunities for capital growth.

The company was given its current form in July 2010 when Neil Sinclair (the current CEO), Stanley Davis (non-executive chairman) and Andrew Perloff acquired 29.9% of AIM-quoted Leo Insurance Services. Leo’s insurance interests were sold to Safeland as part of the deal, and the company’s investment policy was changed to take advantage of a regional property market which the new management and directors believed was significantly undervalued following the financial crisis. The crisis left many landlords with distressed assets and without the resources, or access to funding, to invest in them as a means to enhance income. It had also increased the number of private landlords seeking to sell assets.

The portfolio has been built since October 2011 through the acquisitions shown in Exhibit 1 below.

The first acquisition was the Hockenhull Estates portfolio of nine properties in Cheshire in September 2011 for £1.8m at a net initial yield of 10%. Funding came from a small equity issue and a debt facility from Close Brothers. This was followed in October 2013 by the acquisition of the Sequel Portfolio from Quintain plc and Buckingham Properties. The latter was a more significant investment of £39.25m and added 24 office, industrial and retail properties generating net rents of £5.2m for a net initial yield of 13.2%. This was funded by a larger equity fund raise of £23.5m and a £20m facility from Nationwide. Not only did Sequel substantially increase the scale of the portfolio, but it also added opportunities to increase capital value through active management of properties in a variety of regional hubs with attractive growth prospects. Since then the company has continued to grow the portfolio with a focus on the potential for value growth through active asset management and the aim of building stable and sustainable long-term income streams.

The six-member board is chaired by Stanley Davis, who holds 6.07% of Palace’s shares and was a founding shareholder, as noted above. The two non-executive directors, Anthony Dove and Kim Taylor-Smith, are both independent and chair the remuneration and audit committees respectively.

The executive management team is led by Neil Sinclair, a chartered surveyor, as CEO, bringing over 50 years’ experience in the UK property market to the executive team. The company has recently been adding depth to the team, with the CFO, Stephen Silvester, joining in July 2015, and executive director Richard Starr becoming a full-time executive in July 2016, having joined the board in 2013. A new investment manager, Andrew Thomas, also joined in 2016. Mr Starr and Mr Thomas are chartered surveyors and Mr Silvester is a chartered accountant. The team has considerable experience in the commercial property sector. Palace outsources day-to-day project and property management, saving costs and freeing its own team to concentrate on asset management. Including the directors and company secretary, it has 11 members of staff. Brief biographies of the board members are on page 16.

Palace is not a REIT, meaning that although it has to pay corporation tax (see page 11) it does not have to pay out 90% of rental income as Property Income Distributions (PIDs) (there are also differences in the tax implications for shareholders, who will typically pay less tax on company dividends than on PIDs from REITs). Because it can retain more of its earnings, the company is better able to recycle capital. Partly for that reason, Palace has been able to increase NAV per share by over 90% in the three years to 30 September 2016 (Exhibit 2).

The management team’s experience is central to establishing a pipeline of potential acquisitions on which it can bring its asset management expertise to bear. Acquisitions are generally opportunistic and the company aims to make them off-market to achieve the best price. The company’s first major deal, the acquisition of the Sequel Portfolio from Quintain in 2013, is a good example: the portfolio had fallen over 16% in value in the year to March 2013, when a price was agreed with Quintain, and was weighing on the company’s overall performance. Quintain wanted to reduce debt levels and refocus on London. The lender, Nationwide, was also keen to reduce its exposure from 71% LTV to nearer 50%. With £23.5m of equity and £20m of debt from Nationwide, Palace was able to acquire the portfolio at a 13.2% yield with the prospect of being able to reduce vacancy from the 14% at which it had been running. Having acquired the Sequel Portfolio for £39.25m in October 2013 and disposed of £7.7m of properties, the rest of this portfolio was most recently valued at £70m on 30 September 2016.

Disposals are also opportunistic and may be of non-core assets acquired as part of a portfolio, or because management can crystallise a return. In several cases occupiers have bought premises they were renting. Often these are high-yielding assets where a price above book value can be achieved. In other cases, Palace’s willingness and ability to take some redevelopment risk enables it to improve the quality and rent potential of an asset to the point where larger institutional investors may be willing to invest, again at lower yields than Palace did originally.

The regional commercial real estate market differs from the more closely followed London market in several ways, which may make it attractive to investors:

We examine the regional market in more detail below and start by discussing how its performance has differed from the London market.

Following several years of strong share price performance after the low point reached in March 2009, the UK’s commercial property market, as measured by an index of listed property companies, was sharply affected by the EU referendum on 23 June 2016 (Exhibit 3) before recovering to some extent in the rest of the year (Exhibit 4).

However, the recovery in the share prices of these companies has not been even. In Exhibit 5 we show the share price performance of a basket of REITs that invest in the regional UK vs a basket of larger UK REITs with significant exposure to London. This shows that companies most exposed to London underperformed the regional basket by 16% between 21 June and 31 December 2016. A further comparison with another basket of companies that have average lease lengths over 10 years implies that the perceived security of income associated with long leases has been particularly highly valued since the referendum, outperforming the London basket by 22%. Although the basket of long lease companies has therefore outperformed the regional one over the same period, almost all of its gains occurred immediately after the referendum; in H216, regionally focused property companies outperformed both of the other baskets.

The shape of the referendum’s aftermath reflects the uncertainty cast over the property market by the Brexit vote, hence the attraction of longer leases and the regions. Part of the attraction of regional investment is its lower volatility compared with London. To illustrate this, in Exhibit 7 we compare the average reported portfolio equivalent yields for five members of our basket of London property investors and those of Schroders REIT and Mucklow (net initial yield), which are the only two regional investors to have reported portfolio yields since before the financial crisis. While individual portfolio changes and the small size of the regional basket should be borne in mind, regional yields appear to have been slower to fall than London yields and the spread between the two remains wide. There may be scope for further compression in the regions or protection from a cyclical change should London yields widen again, as they have in the last six to 12 months.

The yield gap between London and the regions, between prime and secondary and the historically low yield on government debt all make regional property relatively attractive. Because of the diversity and specialist nature of the regional markets, they also provide opportunities for companies with the right asset management skills to acquire assets at attractive prices, increase their rental value by improving the premises, and thus their attractiveness to other investors and capital value.

We would highlight several other factors which support the view that the regions are likely to outperform the capital, and potentially other subsectors, over the next one to two years while uncertainty persists:

In the longer term, devolution of some powers to city mayors, as well as infrastructure projects including HS2, are likely to be of benefit to the non-London economy as well.

However, the effects of the referendum will not be limited to London and the current positive PMI reading could be threatened if uncertainty causes companies to defer some strategic investment decisions and to exercise caution more generally. Cushman & Wakefield (one of Palace’s valuers) expects regional office and industrial yields to remain fairly steady over the next year, a view echoed by several other market participants.

The caution engendered by Brexit appears so far to have been beneficial to Palace, which has seen companies take leases in its properties such as The Forum, Exeter, rather than pay a premium to be in grade A buildings. They have also seen demand from smaller occupiers to buy industrial units (as has recently happened in Stoke-on-Trent). While the yield gap between London and regional rents remains historically high at c 1.5-2% and bond yields are historically low, opportunities to acquire regional assets with considerable scope for rental and valuation increases will remain.

Here we provide an overview of the portfolio as well as more detail on several major properties that illustrate aspects of Palace’s strategy. The charts below show the portfolio’s distribution by sector, geography, tenant and lease (Exhibits 9 to 12). The predominance of office and leisure property will be diluted to some extent as office space will be converted to residential use at two properties (York and Dartford), further enhancing the portfolio’s diversity.

The portfolio is also well-diversified by sector and location, and although Palace bears diversity in mind, it is sector agnostic. Acquisitions are chosen based on their individual merits and applications may be made for change of use in respect of existing assets (as in the case of Hudson House, page 9). Palace also has a diverse tenant base, with the biggest tenant by rent only accounting for 6.3% of net rent and the top 10 paying less than one-third of the total rent roll.

The FY17 interim results showed that the portfolio contained 50 properties totalling 1.8m sqft. Of this, excluding Hudson House in York, 89% was let through 210 leases to 160 tenants for a total gross contracted rental income of £13.7m (£11.7m net). The leases had a weighted average unexpired lease term (WAULT) to first break of 5.8 years. Exhibit 13 shows the top 12 properties by rent/area to illustrate the composition of the portfolio.

Several asset management initiatives are underway:

We examine three assets in more detail to show Palace’s asset management approach:

Hudson House was acquired as an office property in October 2013 for £3.8m and has lettable area of 103,000sqft. It is opposite York Station, near the City Council building and within the Roman walls. The council and Network Rail have plans to redevelop surplus railway land around the station over the next 20 years including commercial and residential elements, which will complement the plan proposed at Hudson House. Although the building is within a protected area, the planned redevelopment nearby gives management confidence that more efficient use of the space with a wholly new building would be possible and permissible and is therefore bearing vacancy costs of a net £0.4m pa while working on redevelopment plans. Palace has already secured permission for change of use to 139 apartments or to 82 apartments and 37,000sqft of offices, which has increased the asset’s valuation to £14.9m as at 30 September 2016.

Boulton House was bought in August 2016 for £10.6m. It is a 75,000sqft grade B office building between Manchester Piccadilly Station and the city centre and close to both. At acquisition the property generated £0.625m of rent, a yield of 5.9%, rising to £0.775m after rent-free periods come to an end, but with around 25% of the space unlet. This vacant space and the reception area have been refurbished and the company has been encouraged by interest in the space which, when fully let, would take the rent to £0.9m reflecting a yield of c 8.5%. Given the excellent location, management believes there is scope for further rental growth towards £17.25 per sqft available in Manchester from the current level of £13-15/sqft.

This was acquired as part of the Sequel portfolio as a mixed-use retail and office property and is in the centre of a major commuter town in Kent, within walking distance of the station and opposite the Priory Shopping Centre. Post-acquisition, Palace obtained permission to convert the office space to residential use in a £2.25m scheme, which was completed in December 2016. Dartford Council has recently signed a 10-year lease without breaks at an initial annual rent of £146,500 rising at a fixed rate of 2.5% a year. The lease starts with a rent-free period until April 2017 in lieu of work the tenant will carry out on the flats. The value of the asset had grown from £1.1m as a tertiary retail/office property to £4.05m as at 30 September 2016.

This section sets out the basis for our forecasts and the valuation (page 12). We have used conservative assumptions and highlight the major sensitivities at the end of each subsection.

2016 revenues were £11.4m excluding a £3.2m surrender premium from Gala Casinos for vacating Sol Central in Northampton early. We forecast £14.0m in FY17, falling slightly in FY18 as new leases we expect to be signed at Boulton House, Milton Keynes and potentially Sol Central are assumed to begin with rent-free periods and including the recent new lease at Copperfields in Dartford, and leases at Hudson House run out prior to the redevelopment of the site. We have not included any rental growth at let properties before 2019, from which time we assume that 10% of rents come up for review or re-leasing every six months (meaning that the whole portfolio will have a rent review every five years, roughly in line with the WAULT). On review we assume that the estimated rental value (ERV) can be achieved and we use a long-term occupancy rate of 90%, achieved in 2020 after a slight decrease in FY17 and FY18. We have not included Hudson House in our occupancy estimate, but do account for loss of rents and costs there.

We expect vacancy costs to fall by c £0.8m over the next two years as two vacant properties in Coventry and Stockport are sold (we assume at book value of c £3m in H217), a planning decision at Hudson House is made and asset management initiatives partially offset vacancy costs at Boulton House, Sol Central and Milton Keynes by the end of FY18. We assume head rents across the portfolio remain flat at £0.16m and that administrative costs fall to 20% of net income by FY19 from 23% in H117, in line with the three-year average.

We have not built any change in valuation yield into our model, but we have estimated the valuation uplift from new leases being signed at Boulton House and Pitfields in H118. We expect that Palace can let the vacant space at Boulton House for c £0.275m, giving headline rental income for the building of £0.9m. At a flat equivalent yield, we estimate that the uplift would be c £1m. At Solaris House we expect an uplift of c £0.5m, bringing the value per square metre in line with the adjacent Pitfields properties let to Rockwell. The revaluation characteristics of Sol Central are less certain and reconfiguration is likely to last beyond FY18, so we have not made any revaluation assumption regarding that asset beyond capitalisation of the expenditure on it. We do not assume any further valuation uplift at Hudson House within our forecast period.

Debt is covered in more detail on page 12, but we forecast a modest decrease in finance costs as some more expensive debt funding matures in H118. Palace has recently paid effective tax of c 12%, which we forecast to rise to 15% in future years as former losses are used up but capital allowances and other relief and a reduction in corporation tax rates keep the effective rate below 20%.

These assumptions mean that forecast profit after tax is sensitive to the timing and quantum of disposals and revaluation gains, which we have been conservative in modelling, but that our EPRA earnings forecast reflects the underlying progress we expect the company to make in reducing costs and managing the properties to maximise rental value. The EPS figures allow for outstanding options to be fully exercised (0.4m in FY18 and 0.12m in FY19).

Our estimates are sensitive to any change in rents on assets other than those mentioned above, either through rent reviews or new leases and, given the level of asset management ongoing, it would be unsurprising to see some rental growth ahead of our forecasts. A 1% rise in annual net rent would add 0.5p per share to EPRA earnings. Our revaluation and disposal forecasts are also conservative and we have not included any new acquisitions in the period.

Our only significant cash flow assumption, beyond those described above, is that dividends will be maintained at 9p every half-year over the forecast period. This gives a yield of c 5% on the current share price, covered 1.2x by EPRA earnings (which exclude revaluation gains) in FY17, rising to 1.3x by FY19. The company has a progressive dividend policy, so we consider this to be the most conservative reasonable assumption.

We have not assumed any new acquisitions are made, but we do allow for £2m pa of capitalised expenditure on existing properties funded from earnings. We have also assumed that the sales of the Coventry and Stockport assets will be at their current valuation, net of any disposal costs. As mentioned in the previous subsection, our forecasts include no valuation uplift except in FY18 on Boulton House in Manchester and Pitfields in Milton Keynes. This is a conservative stance given that asset management initiatives helped add £3.6m of value in FY16 and that management has completed refurbishing Copperfields, Solaris House and Boulton House and expects to let several vacant units in the current financial year. Without further major investment in our model we have also not assumed any change in borrowings other than scheduled debt repayments, although we note that Palace has £3.5m of undrawn facilities, which at 40% LTV would allow £8.75m of spending power.

Palace is moderately geared with 39.5% net LTV at 30 September 2016. We forecast this to be 40% at year end, falling to 38.3% at the end of FY18 as some debt matures and is repaid from earnings. A summary of Palace’s debt is given in Exhibit 16. Apart from a £20m revolving credit facility with NatWest (which can be extended to £30m), it is largely secured against investment properties; however, £19m of properties are unencumbered. In all cases there is ample headroom before the LTV or rental cover covenants are reached. £10m of the Nationwide loan is hedged at a margin of 0.95% and all of the debt against Broad Street Plaza is hedged at 0.7%. We have assumed three-month Libor of 0.4% throughout our forecast period. The loan from Scottish Widows replaces one from Barclays and has reduced Palace’s average cost of debt to 3%; it now has the lowest average cost of debt of its peers.

As interest costs decline with the reduction in debt and earnings are retained or paid out rather than invested, we forecast gradual NAV per share growth. We would emphasise that this is a conservative approach given the company’s strategy of recycling capital and increasing asset values. A change in valuation yields could have a substantial impact on our estimates: a yield movement of 10 basis points would alter the portfolio value by c £2.1m or 8p per share.

As well as paying dividends at a level which gives a similar payout ratio to a REIT and a yield of 5%, Palace aims to provide NAV growth. We believe our estimates of NAV are conservative as explained above, and our forecast NAV growth is largely due to likely valuation uplifts on only two assets and to earnings retention. Given the potential to beat our estimates and to deliver solid earnings and NAV growth supported by the historic performance, we believe Palace’s current discount to EPRA NAV is high, especially with higher regional yields providing a possible cushion were property yields to rise, as the market appears to expect will happen in London.

In Exhibit 17 we show Palace and 11 other regional and London-focused property investors’ prices to EPRA NAV, FY18e EPRA earnings and some risk indicators that may affect their valuation. We have excluded Shaftesbury and Town Centre Securities because of their retail focus and the fact that they were outliers from the rest of the group. All data are taken from the last trading update, interim or annual report except the share price, which is as of 26 January 2017. The table shows that while Palace ranks relatively lowly in terms of WAULT, LTV and occupancy, it has the least expensive debt and its net initial yield is middling (and could be expected to improve as asset management initiatives take effect). We have also calculated the correlation between each of the risk indicators and the current price to EPRA NAV ratio (using our own estimates for Palace and Regional REIT). Interestingly, there does appear to be a strong positive correlation between the yield-debt spread and P/NAV. This bodes well for Palace, which has a higher spread than the peer group average.

It appears that while Palace is in the middle of the pack in terms of P/E (on our conservative estimates of FY18 [not calendarised] earnings), it is undervalued compared to peers on a NAV basis. Given the business model of significantly enhancing value, we would argue that a lower discount to NAV would be justified. We would also note the sensitivity of our forecast earnings to rental growth, which we have not modelled: if we assume rental growth across the portfolio of 2% pa over the forecast period, roughly in line with inflation, our FY18 EPS forecast rises to 22.8p, reducing the earnings multiple to below 16x.

If Palace’s shares traded at the overall group average of 92.5% of NAV, the price would be 388p, and at 20x our FY18 earnings estimate they would be at 436p (ahead of H117 NAV of 419p). The same exercise using only the smaller regional sample gives a wider spread of 438p to 338p (noting that only three of those companies have FY18 estimates available). In either case, a share price closer to 400p would appear justified.

The property market is cyclical and, while the regions may be less sensitive than London, occupier demand is influenced by economic growth. Similarly, the supply of new developments is affected by the economic outlook and may be more sensitive to Brexit than demand. Positively, the UK economic recovery has so far exceeded the expectations of many commentators, especially since the referendum. Unemployment is at its lowest rate since 2005 and employment is near its highest level since records began. The Bank of England raised its GDP projections in November from 0.8% GDP growth for 2017 to 1.4%. Both the Bank and the Office for Budget Responsibility forecast growth every year to 2021. As noted above, devolution of powers to city mayors and national infrastructure projects may support regional economic growth.

A key part of Palace’s investment case is its ability to enhance capital value by improving its assets. While refurbishments are relatively straightforward, the potential replacement of Hudson House with a new building would incur some development risk. This is mitigated by the city council’s intention to undertake development itself in the same area, the Palace team’s experience of similar projects and the existing permissions for different uses of the property.

Tenant risk and vacancy risk are both inherent in the business model and mitigated by maintaining a close relationship with tenants, planning for potential vacancy and making judicious acquisitions and disposals. For example, the tenant at one of the Exeter properties went into administration in H117 and was acquired by a PE firm. By the time the half-year results were announced, the building had been re-let to the buyer on a 10-year lease, without a break and with a fixed rental uplift programme, avoiding vacancy costs and extending the income stream, albeit at a lower level.

Palace has c £3.5m of undrawn debt, which at 40% LTV would enable it to acquire assets worth £8.75m assuming equity funding was available (it had cash of £9.3m at the half-year). At an 8% net initial yield, assuming costs of 6%, this would generate £0.658m of rental income on annual interest costs of £86k for net rental income of around £0.57m or 1.7p per share of earnings, allowing for additional administrative costs. At the FY18e EPRA EPS multiple of c 17x, that could be worth 30p per share.