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GBP392m
Research: Real Estate
In Q323, Custodian Property Income REIT (CREI) continued to capture occupational demand, lease vacant space across all sectors and grow rental income. This underpins fully covered dividends and provided a partial offset to strong market-wide pressure on property valuations. Moderate gearing mitigated the impact on NAV, while income is protected by 80% of drawn debt having a fixed cost.
Custodian REIT |
Positive income indicators in a challenging market |
Q323 update |
Real estate |
23 February 2023 |
Share price performance
Business description
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Analyst
Custodian Property Income REIT is a research client of Edison Investment Research Limited |
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In Q323, Custodian Property Income REIT (CREI) continued to capture occupational demand, lease vacant space across all sectors and grow rental income. This underpins fully covered dividends and provided a partial offset to strong market-wide pressure on property valuations. Moderate gearing mitigated the impact on NAV, while income is protected by 80% of drawn debt having a fixed cost.
Year end |
Net rental |
EPRA |
EPRA |
NAV**/ |
DPS |
P/NAV** |
Yield |
03/21 |
33.1 |
23.7 |
5.6 |
97.6 |
5.00 |
0.93 |
5.5 |
03/22 |
35.6 |
25.3 |
5.9 |
119.7 |
5.25 |
0.76 |
5.8 |
03/23e |
37.9 |
25.2 |
5.7 |
98.5 |
5.50 |
0.93 |
6.0 |
03/24e |
39.3 |
26.1 |
5.9 |
98.9 |
5.60 |
0.92 |
6.1 |
Note: *EPRA earnings exclude revaluation gains/losses and other exceptional items. **Defined as EPRA net tangible assets per share (EPRA NTA).
Letting progress has continued
Custodian has paid/declared 4.1p of DPS in FY23 to date, 1.02x covered by EPRA earnings, leaving the company on track to meet its annual DPS target of at least 5.5p. Driven by acquisitions and asset management, EPRA earnings increased 7% during Q323 to 1.5p. New lettings, which have continued into Q423, are a positive indicator for income development, as is like-for-like growth in estimated rental value (ERV) and rent roll and an increase in EPRA occupancy. This all had a positive impact on property valuations, mitigating the negative effects of yield widening. As a result, the 9.1% like-for-like decline in Custodian’s property portfolio valuations compares favourably with MSCI data that indicates a market-wide decline in capital values of almost 13%. NAV per share declined to 99.8p, or by c 12%. The market-wide decline in property valuations slowed in the December quarter, which is consistent with our unchanged estimates, which assume some further Q423 weakness and flat in FY24.
Income at the core of strategy
CREI’s prime strategy for delivering returns is the generation of attractive and stable dividend returns from an actively managed, well-diversified portfolio of UK commercial real estate. Within this, it is differentiated by a principal focus on properties with smaller individual values (‘lot sizes’) of less than £15m at the point of investment. These typically provide a yield premium over larger assets, recently widened, partly the result of a broader range of potential occupiers, while attracting less competition from larger institutional investors. The average annual NAV total returns since the company listed in 2014 is 5.0%, with unbroken dividend payments accounting for 97% of this.
Valuation: Consistent income returns
The minimum 5.50p DPS targeted by CREI for FY23 represents an attractive yield of a 6.0%, which we expect to be fully covered. The discount to NAV has closed to 7%, versus c 20% for close peers, but is still below the average 3% premium since its initial public offering and appears to anticipate further asset price weakening.
Strong capital growth with increasing income
Positive income developments
The 1.4% growth in like-for-like rent roll in Q322 reflected positive leasing events, which, together with the 0.6% increase in ERV, provides evidence of the depth of the occupational market for space in high-quality, well-located and affordable assets. Together with the opportunity to continue vacancy reduction, these are positive indicators for future income development.
During Q323, 10 new lease agreements were signed across a range of property sectors at an aggregate 7% ahead of ERV, adding £1.2m of annual rent for a weighted average of 7.3 years to first break (Q223: five new leases adding £0.4m of annual rent for 6.3 years). There were two rent reviews settled in the period, generating an aggregate 18% increase on the previous rents, or £0.4m pa. Lettings progress has continued into Q423, with a further four new leases completed, adding £0.8m of annual rental income for a weighted average 12 years to first break.
EPRA occupancy improved to 89.9% (end-Q223: 89.3%), resulting from the letting of five vacant properties. 48% of current vacancy is subject to refurbishment or redevelopment, 8% was let post end-Q323 and a further 8% has been put under offer for sale or lease.
Consistent dividend return
NAV total return for the first three quarters of FY23 was negative 13.2%, with capital losses more than offsetting the 3.4% return from fully covered dividends.
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Exhibit 1: NAV total return year to date |
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Source: Custodian Property Income REIT |
Since listing in 2015, dividend returns have been consistently positive, even throughout the pandemic, generating 97% of the aggregate total return of 5.0% pa. This reflects Custodian’s income focus, supported by its strategy of investing in higher yielding, smaller lot properties.
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Exhibit 2: Long-term accounting total return |
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Source: Custodian Property Income REIT data, Edison Investment Research |
Income is less volatile than capital values
Current market conditions demonstrate the cyclicality of the commercial property market, a feature of which is the relative stability of income return versus the volatility of property valuations and capital returns.
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Exhibit 3: The relative stability of income return versus the volatility of capital return |
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Source: Custodian Property Income REIT data, Edison Investment Research |
Negative property revaluation movements, commencing in Q223 and accelerating in Q323 and directionally following market-wide trends, have been a negative 19.2 pence per share, comprising 22.9p of general valuation movement, partly offset by gains on asset management initiatives (primarily lease renewals, new lets and lease regears), and gains on disposal of 1.1p.
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Exhibit 4: NAV movement year to date |
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Source: Custodian Property Income REIT |
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Property valuation yields have been sharply adjusting
After a long period of rising property values, interrupted for a time during the pandemic, the trend has very sharply reversed. This is due to a combination of rising bond yields, economic and political uncertainty, a sharp reduction in investment demand for UK commercial property, and eager selling by some open-ended funds and even insurance companies this has spectacularly reversed. This is despite many areas of the market continuing to report robust levels of occupier demand and increasing rents.
While property values are declining across the market, there has been a tendency for sectors where yields had been lowest to adjust more than average. Mirroring this trend, Custodian’s industrial/logistics assets have seen the largest pull back in valuations after exceptionally strong past growth, despite continuing firm occupier demand, constrained supply and rising rents. High street retail, where Custodian has focused on prime locations, has been the strongest performer, despite the obvious pressures on consumer disposable incomes and continuing modest declines in rents. In such an environment, the benefits of a diversified investment approach are clear.
Custodian’s Q323 like-for-like decline in portfolio valuations of 9.1% followed a Q223 decline of 5.4%, a six-month like-for-like decline of 15.3%. This reflected an increase in the blended net initial portfolio yield from 5.5% at end-Q123 to 5.9% at end-Q2 and 6.5% at end-Q3.
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Exhibit 5: Q323 valuation movements by sector |
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Source: Custodian Property Income REIT. Note: *Net initial yield or passing rent divided by property valuation plus purchasers’ costs. **Other comprises drive-through restaurants, car showrooms, trade counters, gymnasiums, restaurants and leisure units. |
Money market interest rate expectations remain volatile and have recently moved in the direction of higher for longer, but 10-year government gilt yields have been moving in a lower, tighter range (c 3.6% currently) since peaking at c 4.5% last autumn. Alongside this, MSCI data indicate that the occupier market remains robust, with estimated rental values continuing to increase (1.6% in the industrial sector in the three months to December and 0.3% in offices). It may be that yield widening is in the process of stabilising.
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Exhibit 6: Financial summary |
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Source: Custodian Property Income REIT historical data, Edison Investment Research forecasts |
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Research: Healthcare
Ultimovacs’ Q422 and FY22 results reflected another busy period marked by continued development of its lead cancer vaccine, UV1, across multiple indications. Top-line results from the Phase II clinical trials INITIUM (in metastatic malignant melanoma) and NIPU (in metastatic pleural mesothelioma) are expected in H123 and are key catalysts for a potential licensing deal, should data be positive. Another clinical milestone will be the readout from the Phase I TENDU trial (prostate cancer), expected in H223. However, data readouts for the other Phase II trials have been adjusted due to the delayed initiation of DOVACC, change in standard of care for LUNGVAC and a minor delay in FOCUS (end FY23 to H124). We roll forward our model and adjust our estimates, resulting in a valuation of NOK7.4bn or NOK216/share (NOK7.9bn or NOK231/share previously). Our estimates do not include consideration for preclinical assets, which may offer upside on successful clinical progress. The end-FY22 cash position stood at NOK425.3m, which should provide funding to mid-2024, according to management.
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