Town Centre Securities — Positive trading update and innovative refinancing

Town Centre Securities (TCS) is a UK Real Estate Investment Trust (REIT) operating across the UK, but with a regional focus, primarily in Leeds and Manchester, where management is able to exploit its strong and detailed knowledge of the local markets, Scotland and (mainly suburban) London. The company is a family-run business with strong income focus and a 57-year record of increased or maintained DPS. It owns a mixed-use portfolio, valued at c £384m as at 31 December 2017, including more than 900,000 sq ft of retail space, more than 360,000 sq ft of mostly prime office space, and key development sites in Leeds and Manchester. It also has a car parking operation (CitiPark), which provides a growing and complementary revenue and earnings stream, while monetising what would in some cases be empty, non-income producing development assets. Intensive asset management and active capital recycling are used to drive income growth and capital returns, and the company has a substantial pipeline of continuing development opportunities. For an in-depth overview of TCS, please see our April 2018 initiation note.

TCS has recently updated on company developments, including trading for the 12 months to 30 June 2018 (FY18), and will publish full year results on 26 September 2018. The year ended positively and overall trading was in line with the board’s expectations, with good levels of occupancy, an increase in like-for-like property rental income, and continued growth in car parking revenues and profits. In addition to refinancing its existing bank debt facilities, TCS has also now completed a formal agreement with Leeds City Council (LCC) for the refinancing of Merrion House in Leeds, a jointly owned office redevelopment that completed in February 2018. The refinancing will provide additional financial flexibility as the company enters a new phase in its strategy of intensive asset management and capital recycling to drive income growth and capital returns. The key features of the trading update are:

Merrion House is a 175k sq ft office building within the Merrion Centre, let on a 25-year lease with capped RPI increases to Leeds City Council (LCC) from its completion in February 2018. It was developed by a 50:50 joint venture (MH LLP) with LCC, with TCS contributing the existing building that it previously owned 100%, with a pre-development value of £20m, and then investing an addition £5m. TCS continued to receive £700k of rental income during the development phase and this increased to c £1.66m at completion. MH LLP, of which TCS owns 50%, is left with an asset that management expects to be valued at c £68m (TCS share £34m). Forming part of the Merrion Centre, this remains a core asset for TCS, but the joint venture ownership limited the options available to TCS to refinance its share of the asset and release capital for reinvestment. In an innovative financing solution, MH LLP has reached agreement for LCC to advance all of the base rent that would be due to it from 1 October 2018 until the end of the lease on 11 February 2043, discounted at an equivalent rate of 3.5% plus costs. As a result, TCS will receive £26.4m in cash. From an accounting perspective, the transaction will be treated as a financing agreement undertaken in MH LLP, which in turn is equity accounted within TCS. MH LLP will continue to recognise the contracted rent with LLC on a quarterly basis, but this will be partly offset by an interest charge calculated on an effective interest rate basis. TCS will continue to recognise its 50% share of MH LLP net income on an equity accounted basis.

The net asset value of TCS will be unaffected. Its cash resources will increase, while the value of its investment in MH LLP will reduce. The MH LLP balance sheet will reflect the full value of the property, less the deferred income balance, which will gradually reduce to zero by the maturity of the lease.

In addition to the base rent, the lease allows for capped RPI increases every five years. These will continue to apply but will flow as normal rental payments through MH LLP.

The agreement is made possible by the close working relationship between TCS and LCC. From the TCS perspective there is no risk attached other than to ensure that the building remains fully insured and capable of meeting the lease commitments until lease expiry.

In the short term the proceeds will be used to reduce debt but, more strategically, the transaction creates additional flexibility for TCS to invest in its acquisition and development programme for future growth.

Our multi-year forecasts for the period ending June 2020 were set out in detail in our initiation note, and we are not changing these on the back of the trading statement and recent developments. The trading update appears consistent with our FY18 forecast and we will review the future year forecasts with the full year results, when we expect management to provide and update on development, capital recycling and funding plans.

With the interim results, management provided details of a substantial pipeline of continuing development opportunities with an estimated developed value of up to £600m. In addition to the Burlington House development, to capture some of the potential that is available to TCS from this wide range of opportunities, we have assumed three further development projects in our current forecasts (from a pipeline that numbers 16). However, there is inevitably some uncertainty as to which projects will proceed, the timing of these projects, and the choices over funding between new debt/equity capital and/or recycling of capital from mature assets. The projects that we have assumed thus far are:

For modelling purposes, our forecasts currently assume an increase in debt funding, although asset disposals remain likely and we have made no specific adjustment for the acquisitions and disposal noted above. The Merrion House refinancing has a similar economic impact to the debt that is currently assumed in our forecasts.

Although TCS has a strong focus on growing portfolio income to support its long-term progressive dividend policy, its active asset management strategy, aimed at enhancing long-term total return, means it is not focused on yield maximisation over the shorter term. For this reason we think it useful to look at NAV total return performance (the change in NAV per share plus dividends paid), and in the five years ending June 2017 we calculate an aggregate return of 52.7%, or a compound annual return of 8.8% pa. Dividends contributed an aggregate 20% over the period and the growth in NAV per share the balance. The H118 NAV total return was 6.6% over the six-month period.

Although the continuing investment in and redevelopment of the portfolio is a limiting factor on immediate dividend distributions, TCS has a long and consistent track record of dividend payments, increasing or at least maintaining DPS in each of the past 57 years. Our forecast for the final dividend in respect of the year that ended 30 June 2018 puts the shares on a yield of 4.0%, slightly below the median level for the broad group of property companies and REITs shown in Exhibit 4, but in line with yields on the FTSE All-Share Index and the UK property index.

In terms of historic P/NAV, TCS shares sit well below the median which, when viewed in combination with the yield, would suggest that investors are factoring in little capital return potential relative to the broader group, despite TCS having a strong pipeline of development opportunities.

The broad group of companies shown in Exhibits 4 and 5 includes a wide variety of property companies, REITs and non-REITs, and specialist vehicles (healthcare property, student accommodation), and covers a wide range of strategies, from a pure focus on income and collecting rents to varying degrees of asset management and capital growth, extending to property development. In Exhibit 6 we show a summary valuation comparison of TCS with what we consider to be a closer group of peers, including companies focused on regional property and those with retail exposure.

The TCS share price performance has been similar to that of this narrower group of peers over the past year. However, in terms of valuation, TCS similarly shows a noticeably lower P/NAV than the median and slightly lower yield. Despite a more diversified portfolio, the TCS P/NAV valuation more closely resemble the retail property focused companies (Capital & Regional, Hammerson), where investor sentiment has been weakened by signs of stress among some retailers, and this again suggests that the TCS valuation is not challenging in a sector context.