Picton Property Income — Portfolio outperformance continuing

Picton had a good half year, maintaining a high level of occupancy and income, generating year-on-year growth in EPRA earnings and dividends and reducing gearing further.

The period also saw shareholders overwhelmingly support the company in joining the UK REIT regime, effective from 1 October 2018, and change its listing status to that of a commercial company, from an investment company. The former will avoid negative effects from recent UK tax law changes, while the latter improves administrative flexibility.

The outlook statement is cautiously optimistic, with management noting that the economy and property markets have remained resilient despite Brexit uncertainties. There is £6.4m of reversionary potential within the existing portfolio, primarily within the industrial and office sectors that account for nearly 80% of the portfolio by value. Management expects the supply and demand imbalance, combined with a lack of development, to drive further rental growth in the industrial sector and it sees continuing strong demand in the regional office sector.

The external appraisal value of the portfolio at 30 September was c £683m, little changed from the 31 March 2018 valuation, with net valuation gains and disposals (at book value) broadly offsetting each other. With an annualised contracted rental income of £40.3m the valuation reflects a net initial yield of 5.4%. The weighted average unexpired lease term (WAULT) was 5.2 years (5.0 years to first break), slightly reduced from March 2018 but by less than the time elapsed. Occupancy remained at a good level of 94%, which compares with 92% in the MSCI IPD Quarterly Digest. The reduction from 96% at 31 March substantially reflecting planned asset management actions at Stanford House in London WC2, discussed below.

Although Picton owns a diversified portfolio, the portfolio is currently deliberately focused on the better-performing industrial and office sectors, with a clear underweighting in retail and leisure. The rental stream is earned from a broad range of c 350 occupiers, with the largest representing c 4% and the ten largest c 27%. The top 10 assets represent c 50% of the portfolio by value and during H119 the average lot size increased further to £13.9m. For acquisitions, management targets a lot size of £10-30m, believing this provides a good balance between the efficiency/lower management complexity that larger assets bring and the added competition amongst potential buyers that they typically attract.

The income opportunity in the existing portfolio is reflected in the higher annualised reversionary income (estimated rental value or ERV) of £46.7m, reflected in a net reversionary yield of 6.4%. Of the £6.4m reversionary potential in the portfolio, £2.9m is from the opportunity to let additional space, with the remainder from lease renewals, rent reviews and contracted uplifts.

The industrial weighting of 43.7% at end-H119 compares with 24% for the MSCI IPD Quarterly Benchmark with a particular overweighting in the South-east where rental growth and capital values were noticeably strong in H119. The 34.5% weighting in office properties is also ahead of the Benchmark weight of 27%, while the 21.8% exposure to retail/leisure assets is nearly half the index level of 47%, with no exposure to shopping centres.

Exhibit 3 shows the portfolio positioning as at 30 September 2018, as well as the like-for-like change in valuations during the six months. The portfolio industrial valuations grew strongly, office valuations increased and retail and leisure valuations declined. Overall, the portfolio saw 1.5% capital growth, with the positive effects of asset allocation and asset management offsetting the negatives. For the six-month period, on an ungeared basis and including income, the portfolio returned 4.4%, outperforming the MSCI IPD Quarterly Benchmark return of 3.2%. The income return of 2.9% was 0.4% ahead of the benchmark income return. Picton has now outperformed the benchmark on both a total return and income return basis over one, three, five and 10 years, consistent with its aim of being one of the consistently best-performing, diversified, UK-focused property companies listed on the Main Market of the London Stock Exchange.

Management remains alert for new investment opportunities but no acquisitions were made during H119, which in part reflects the seasonal summer slowdown in market activity but also the failure of those assets reviewed to meet the company’s acquisition criteria. Two non-core assets were sold, both office properties – Ricoh House in Northampton and Merchants House in Chester – and both sold to local authority investors. Ricoh House was sold for £8.0m, a 13% premium to the March valuation, but a more significant 54% uplift on the June 2017 valuation. Similarly, the £3.9m (plus £150k top-up) disposal of Merchants House was modestly ahead of the £3.9m March valuation, but 35% up on the June 2017 valuation.

Stanford House is Picton’s flagship store in Covent Garden, taking its name from the Stanfords map and travel shop that currently occupies three floors, with three office and one residential floor above. Picton is in the process of securing vacant possession, which it expects to achieve by early next year. This will be the first time in over 100 years that the building as a whole has been available to lease, and early discussions are underway with interested parties. We estimate that vacation of office space had a c £500k impact on contracted rent roll in H119, although £170k was received by the occupiers to secure an early exit, and we would expect an additional c £1.0m impact on annualised rent roll between now and early 2019 when full vacant possession is expected.

The H119 like-for-like increases in annualised contracted rent roll show a similar pattern to the valuation data above. Like-for-like growth for the industrial portfolio was 3.8% and for the office portfolio it was 1.9%, with both sectors continuing to benefit from occupier demand and tight supply in many areas. Occupancy of the industrial portfolio is a high 99% and the focus remains on capturing the c £2.2m of reversionary potential through lease events. In the office sector, the regional assets are performing well due to the continued demand for space and the potential for rents to increase from relatively low levels. Within the City of London, 50 Farringdon Road benefitted from the letting of the final suite, to an existing occupier, at 5% ahead of ERV, and is now fully let. Overall occupancy in the office portfolio is 91% providing further letting opportunities to capture more of the £3.7m reversionary potential.

As has been widely reported, the situation in the retail and leisure sector is rather different, with retailers facing a continuing trend shift towards online, increased labour costs and business rates. Struggling operators are showing a greater propensity to aggressively use Company Voluntary Arrangements (or CVAs). Although significantly underweight in retail and leisure, Picton saw a 9.5% reduction in H119 contracted rental income from the sector. Around half of this (47%) was deliberate, reflecting the planned asset management activity at Stanford House where the company is in the process of securing vacant possession. Retail failures accounted for 37% of the reduction, and the remainder reflects lease events. The softness in market rents can be seen in the retail and leisure estimated rental value (ERV), now £10.2m, which is slightly lower than contracted rent would be on a full occupancy basis (£10.2m/89% or £10.9m). As a result of the New Look CVA, Picton will take back its retail unit in Peterborough, which is already under offer from a replacement tenant. The Homebase CVA and Poundworld administration will see Picton taking back two units on the same retail park in Swansea. Picton reports good early interest in the Homebase unit.

We expect Picton to broadly maintain its current portfolio balance for the time being. The prospects for industrial assets and regional offices are good and although retail assets may suffer further, capital values have been weak for some time and yields are at a premium.

Although we do not publish half-yearly financial estimates, the H119 EPRA earnings and NAV were both a little ahead of the levels reflected in our forecasts. However, the group annualised contracted rent roll of £40.3m at 30 September, and carried forward into H219, is a little lower than we had expected (£40.7m), due entirely to the retail and leisure segment of the portfolio. This, and a small increase in forecast management expenses, has a small negative impact on our forecasts, most notably in FY20. Despite this, we make no change to our forecast DPS growth and expect FY20 DPS cover to remain a healthy 1.15x. It is also worth noting that our forecasts assume an unchanged portfolio, although management remains alert for new investment opportunities and has the financial resources to pursue these, with c £26m available from the revolving credit facilities.

Taking our forecasts for changes in EPRA NAV and DPS together, the implied EPRA NAV total return is 6.4% in FY19 (after the refinancing impact) and 6.7% in FY20.

The like-for-like increases in annualised contracted rent roll in the industrial and office portfolios were both stronger than we had anticipated, but the reduction in retail and leisure more than offset this. As noted above, around half of the reduction in retail and leisure rent roll was due to planned asset management activity, and we have adjusted our forecasts to include this, although the benefits are likely to fall outside of the forecast period. Most of the balance of the retail and leisure rent roll reduction resulted from retailer failure that we had not anticipated. Taking all of these factors together, rent roll was slightly (c £0.4m) lower than we had expected at 30 September.

Our forecasts continue to reflect growth in like-for-like occupancy in the industrial portfolio, and to a lesser extent within the office portfolio, although for both we prudently assume a slowdown, as previously. For industrial, we assume 2% growth in H219 and a further 2% for FY20 as a whole. For office, we assume 1% growth in H219 and 1% growth for FY20 as a whole. In retail and leisure, we have allowed for some (c £300k) of the recent income loss relating to retail failures to be recovered but this is more than offset in the near term by the asset management at Stanford House, where we have allowed for full vacant possession to temporarily reduce contracted rents by an additional c £1m. We have prudently assumed that only around £1m of the c £1.5m contracted income forgone (including the H119 impact) is recovered by end FY20, with no material impact on revenue in the period. For the group as a whole, our forecasts reflect an end FY19 contracted rent roll of £39.8m, with £41.5m at end FY20.

Our forecasts include modest revaluation gains driven by expected rental growth. We assume no change in market yields, either up or down, but estimate that a 0.25% increase in market yields would reduce FY20 NAV per share by c 5p per share, while a 0.25% reduction would increase it by c 7p per share.

Finance costs are based on the current 4.0% average cost of debt (95% fixed) and no change in drawn debt (£194.2m at 30 September). Given the forecast modest growth in portfolio value and positive net cash flow, we expect net LTV to drift lower, below 25% by end FY20.

With its strong income focus, Picton pays quarterly dividends that currently annualise at 3.5p per share, a prospective yield of 4.3% at the current share price. The dividend is well covered by EPRA earnings, providing management with the flexibility to reinvest into the portfolio in ways designed to support occupancy and income growth, with the specific goal of enhancing total return over the long run. As a REIT (from 1 October 2018) Picton will continue to pay dividends quarterly, primarily in the form of Property Income Distributions (PIDs). The quarterly dividend that is expected to be paid in February 2019 (in respect of the three months ending December 2018) will be the first payment under the REIT regime. Before then, the board will review the company’s dividend in the light of REIT distribution requirements (a minimum of 90% of the income profits from property rental business, which differs slightly from reported income earnings) and market conditions, although we do not expect significant changes to distribution policy and have not changed our DPS forecasts.

In Exhibit 6 we show a summary performance and valuation comparison of Picton and what we consider to be its closest income-oriented peers. The valuation comparison is based on last reported EPRA NAV per share and trailing 12 month DPS declared. Over the past year Picton shares have performed slightly better than the peer group average and the FTSE All-Share Index. As a result of its strong dividend cover, the Picton yield is below the average for the group while its P/NAV per share is slightly below the average.

Bringing together dividend distributions and the impact of reinvesting for growth, in Exhibit 7 we show the trend in EPRA NAV per share in the five years ended FY18 ie total return of 117% over the period or a compound annual return of 16.8% pa. As noted above, NAV total return for the first six months of FY19 was 3.9% including the impact of the refinancing; we estimate c 4.6% excluding it.