Regional REIT — Progress with capital raise deployment

In this note we review recent progress with RGL’s active management of its existing portfolio as well as its deployment of the July 2019 equity raise. We also discuss RGL’s delivery on the investment strategy that it laid out at the time of its IPO (November 2015) and on its long-term return targets. Capital recycling is an important element of RGL’s active management strategy. In FY18, while locking in the value created by mature asset management plans to reinvest in new opportunities, RGL was also a net seller of assets. It tactically sold nearly half of its industrial portfolio into what management had identified as an overheating investment market and increased its focus on regional offices where the risk-return balance appeared more favourable. With lingering Brexit uncertainty having a dampening impact on the investment market (while the office and industrial occupational markets remain robust), RGL has found an increasing number of investment opportunities that meet its return criteria and we expect the company to swiftly complete the full deployment of the proceeds from the July equity raise.

With H119 contracted rental income of £57.8m and an estimated rental value (ERV) at full occupancy of £71.4m there is a significant opportunity for active asset management to drive rental growth from the existing portfolio. Management has continued to report leasing progress at rents in excess of ERV. Our forecasts also allow for £90m of acquisitions between H119 and early 2020, of which c £56m has already been completed or agreed. Earnings will be further supported by significant refinancing in the past year, which has lowered the average cost of borrowing while extending maturity. We have slightly reduced our FY19 adjusted earnings forecast due to the timing of lease maturities at end-H119 and modestly slower acquisitions than we had assumed. However, the acquisition yields are ahead of our assumptions and our FY20 and FY21 forecasts increase a little. We continue to forecast ongoing DPS growth, with full cover by adjusted earnings in FY20.

RGL targets a total return of more than 10% pa, with a strong focus on income supported by the potential for additional capital growth. Since listing, RGL has generated an accounting total return (change in NAV plus DPS paid) of 41%, equivalent to a compound 9.8% pa, effectively meeting its target. Income returns (DPS paid) accounted for two-thirds of the total. We would view RGL’s target return as a medium-term target that will be difficult to achieve in all market conditions and given our cautious assumptions for capital returns over the next couple of years, our forecasts imply a total accounting return over the FY19–21 period of 7.1%, effectively all generated by dividend payments. In the context of a continuing low return environment we think this is attractive, supported by a c 8% discount to H119 EPRA NAV per share.

We discuss the sensitivities on page 12. In summary, the commercial property sector is cyclical; occupier demand is sensitive to economic growth, while valuation yield and capital values are affected by investment flows and monetary conditions. The diversity of RGL’s portfolio and tenant base mitigate the cyclical income risks. Near-term interest rate risk is also well-managed, with all of RGL’s debt either fixed or hedged with an average maturity of 7.8 years (at H119). Gearing has reduced to c 40%, in line with the company’s target, from a peak of c 49% immediately after the Conygar asset purchase in 2017.

Regional REIT (RGL) is a UK-based real estate investment trust (REIT) that aims to provide an attractive total return to shareholders, targeting a total return of more than 10% pa, with a strong focus on income supported by the potential for additional capital growth. The company’s investment portfolio is comprised wholly of UK commercial property assets, predominantly offices and light industrial units located in the regional centres of the UK outside of the M25 motorway.

Since listing on the Main Market of the London Stock Exchange (LSE) in November 2015, RGL has been committed to an opportunistic acquisitive growth strategy, seeking to generate operational and financial economies through increased scale and further diversifying the portfolio to mitigate cyclical and tenant-specific risks to income. The portfolio value has almost doubled since the IPO with a diversification by region, property and tenants. In addition to the focus on regional property assets, the managers seek under-managed properties where there are opportunities to create additional value through lease renewals and rent increases, minimising voids through effective marketing of vacant space, enhancing the tenant mix and covenant strength, and through refurbishment, extension, or change of use. When properties have met their return objectives they are assessed for sale (or to hold if their income and capital growth outlook looks strong), allowing the recycling of resources into new value-creating opportunities.

At 30 June 2019 (H119) the investment portfolio was valued at £721.7m with a gross rental income of £57.8m reflected in a net initial yield (NIY) of 6.5%. An ERV of £71.4m, reflected in a reversionary yield of 9.0%, represented a significant opportunity to grow income from the existing portfolio through void reduction (EPRA occupancy was 87.5% at H119) and other lease events. The company is also targeting accretive acquisitions through further deployment of the £62.5m (gross) proceeds of its July 2019 equity raise.

Ahead of its listing, RGL was formed by the combination of two UK commercial property investment funds previously created by the external asset and investment managers. London & Scottish Property Investment Management (LSPIM) is the asset manager, responsible for the day to day management of the asset and debt portfolios. Toscafund Management (Toscafund) is the investment manager, responsible for management functions of the company.

LSPIM is a privately-owned co-investing asset management and property development business with assets under management of more than £1bn, of which c £750m relates to RGL, based in Glasgow with offices in Leeds, Manchester and London. The senior management team has worked together for a long time and has experience of managing portfolios for cash in down cycles.

Both the asset and investment management contracts initially run for five years from launch, at which point 12 months’ notice could be given; beyond five years the contract has a three-year term subject to 12 months’ notice being given at any point. The management fee is set at 1.1% of net assets up to £500m and 0.9% above £500m, split equally between LSPIM and Tosca. In addition, a property management fee of 4% of annual gross rental income is payable to LSI. An additional incentive is provided to the managers by way of a performance fee, set at 15% of total EPRA NAV per share return (EPRA NAV growth plus dividends declared) above an 8% hurdle, subject to a high-water mark (the greater of the highest year-end NAV per share in prior periods or the IPO price of 100p).

After an initial three-year performance fee calculation period, from the beginning of FY19 the performance fee is calculated annually and is expected to be paid one-third in cash and two-thirds in shares.

After the initial five-year term of the asset and investment management contracts, subject to EPRA net assets having reached £750m, the board and managers may decide to internalise the management of Regional REIT, subject to approval by independent shareholders.

Regional REIT has a six-member board and is chaired by Kevin McGrath (biography on page 15). There are five non-executive directors, three of whom RGL considers independent (William Eason, Daniel Taylor, and Frances Daley), plus Stephen Inglis (representing LSPIM) and Tim Bee (representing Toscafund).

Since listing, RGL has significantly grown the scale of its portfolio, adding further diversification and repositioning its sector and geographic balance. At H119 RGL’s portfolio comprised 149 properties valued at £722m compared with 128 properties valued at £386m at the time of the IPO. It has since completed the acquisition of a six-asset regional office portfolio for £25.9m. While growing the portfolio the company has also increased the share of assets in the more prosperous south-east and reduced the weighting to Scotland, while the focus on regional office and light industrial assets has been sharpened, both in line with the strategy expressed at the time of the IPO.

A summary of the overall portfolio is shown in Exhibit 1. There is a material gap between the H119 annualised contracted rent of £57.8m and the ERV at full occupancy of £71.4m, representing the income growth opportunity from the existing portfolio. We estimate that c £9m of this potential relates to void reduction (primarily in the office portfolio) and the balance from moving rents towards market levels. The progress that RGL continues to make with leasing is not always apparent from published occupancy figures as properties are likely to be sold, and capital recycled, when successful asset management plans are complete. End-H119 occupancy of 87.5% (EPRA basis) was lower than at the end of FY18 due to the timing of lease maturities, but was consistent with the reported trend since IPO.

The rental growth that RGL has achieved over the past 18 months continued in H119. It undertook 39 new lettings over c 240k sq ft, achieving rental income of c £1.6m and reflecting an uplift of 5.2% over ERV. Additionally, 18 leases were renewed over c 70k sq ft, achieving rental income of c £0.6m, a 19.5% uplift from previous rents and 12% above ERV.

In August, RGL announced a string of successful lettings amounting to £1.3m pa, which represented a significant uplift to income as it mostly related to previously vacant properties. Further progress was reported in October with leases representing an annualised c £850k of income renewed at an average c 10.9% uplift to ERV.

RGL has demonstrated its ability to source and execute on ‘value add’ acquisitions since IPO, growing the portfolio through a string of portfolio acquisitions, primarily off-market, funded by new equity issuance, borrowings and capital recycling. The most significant portfolio acquisitions have been:

Not reflected in Exhibit 2, in August RGL completed the £25.9m acquisition (before costs) of a portfolio of six office assets located in Birmingham, Bristol, Cardiff, Chester, Glasgow and Manchester. The assets total c 172k sq ft of gross lettable space and are expected to provide a net income of c £2.36m per annum, equating to a net initial yield of 8.9% and an anticipated reversionary yield of 9.5%. The 27 tenants are diversified by industry type and geography, with no crossover to the existing tenant base. Also not included is the four-asset office portfolio acquisition on which the exchange of contracts was announced on 18 October 2019. The portfolio comprises multi-let offices in Redhill, Harefield, Bristol and High Wycombe with an aggregate c 131k sq ft of space, let to 24 tenants and which are expected to provide net income of c £2.6m pa. The agreed consideration of £27.7m (before costs) reflects a net initial yield of 8.7% and an anticipated reversionary yield of 9.7%.

Opportunistic acquisition activity, net of disposals, significantly drove portfolio growth during FY16 and FY17, enabling RGL to benefit from strong tenant demand and growing rents. To fund these transactions, gearing was allowed to increase, reaching a high of c 49% post the Conygar transaction in 2017.

Subsequently, acquisitions and disposals have been more evenly balanced with RGL taking advantage of the strong investment market in 2018, especially for industrial assets, to dispose of properties where its asset management plans were complete or where plans were yet to reach maturity but where the managers had identified a better risk-adjusted return by selling at the prevailing market prices, well above valuations. This included the strategic decision to sell almost half of the industrial portfolio during FY18 into what the company appears to have correctly identified as an overheating investment market at the time.

In H119 RGL continued to recycle capital, realising value from mature asset management plans and opening new opportunities, reflected in a continuing positive yield arbitrage. Two properties were sold for £19.7m (after costs), reflecting a blended net initial yield of c 6.7%, and generating a £1.7m uplift over the end-FY18 valuation. Norfolk House, an office property in central Birmingham, was acquired for £20m at a net initial yield of 7.9%.

Looking forward, capital recycling will continue to be at the heart of RGL’s strategy to invest in, actively manage, and dispose of properties where asset management plans are mature. Additionally, now that the investment market has cooled (see page 7) while the occupier market for regional office and light industrial assets remains robust, RGL is finding an increasing number of acquisition opportunities that meet its investment criteria. It recently identified a broad pipeline of identified opportunities amounting to c £500m and in this context we expect the proceeds of the July 2019 equity raise to be swiftly deployed.

RGL’s sector strategy since its IPO has been to focus on regional office and light industrial property and to reduce legacy retail and other exposures. Office and industrial assets represented 92.5% of the total at H119, up from 83.7% at the time of its IPO. With the industrial weighting being significantly reduced in the last year, the office weighting at H119 had reached 78.2%. Given continuing solid occupier fundamentals we would view the industrial weighting as more tactical in nature and would not be surprised to see some reversal if the investment market for industrial assets continues to cool.

The shift in geographic positioning since IPO can be seen in Exhibits 6 and 7 with the main changes being the planned reduction in the relatively large historical weighting towards Scotland and increased exposure to the more affluent south-east of the UK. The Scottish weighting has halved to 17.5% since IPO towards a long-term target of c 15%. Exposure to the south-east has more than doubled to 29.1%.

A large tenant base (more than 800 individual tenants), that can fairly be said to be representative of the UK economy as a whole, supports a highly diversified income stream. The largest tenant at H119 represented 2.8% of gross rent roll and the top 15 tenants represented just 27.1%. RGL closely monitors the industry exposure of its tenants (and prospective tenants when assessing acquisitions) not just at the broad sector level but using detailed analysis based on Standard Industrial Classification (SIC) codes.

In the regional office and light industrial markets that are the focus of the RGL portfolio, occupier demand appears to have remained robust despite the continuing uncertainty of the Brexit process and some weakening in overall economic growth prospects. In the investment market, UK-wide commercial real estate investment volumes weakened in H119, although there are some signs that the impact in the regions was more muted than for London. Overall UK volumes fell by 29% compared with H118 and were 26% below the half-yearly average. Although it is difficult to be certain, most commentators believe that the slowdown in investment activity reflects a delay in decision making that may reverse when the Brexit outcome becomes clearer.

Research by Avison Young indicates that take-up of office space across the big nine regional office markets continued to be above the long-term average through Q219 and that against a backdrop of limited supply this has continued to put upward pressure on rents.

Occupier demand in the industrial market appears to have softened slightly but remains positive. Cushman and Wakefield estimate that occupier take-up in the industrial market was lower in H119 than in the same period of 2018, but that it remains slightly above the 10-year average. Similarly, rental growth appears to be continuing but at a slightly slower pace.

Looking forwards, the most recent quarterly market forecasts by the Investment Property Forum (IPF, canvassing a group of fund managers and surveyors under the IPF Research Programme) were published in September and point to an expectation of positive total returns in the industrial and office sectors through to 2023. In the past quarter, the expectation for both rental and capital growth in the office sector has increased, while the expectation for industrial rent growth has weakened very slightly with a more noticeable dip in the capital growth expectation for 2019.

We present the market consensus data as a guide to expected overall market direction and returns but would caution against a direct read across to RGL’s, or any other, portfolio. The market consensus is formed of a wide range of differing expectations and at the individual portfolio level much depends on the performance of individual assets as well as the timing and effectiveness of asset management initiatives.

Since we last updated our forecasts on 9 August 2019, RGL has:

The H119 results showed continued strong income generation, supporting RGL’s target of declaring aggregate DPS for the year of 8.25p (+3% versus FY18), barring unforeseen circumstances.

H119 net rental income was slightly lower than in H118, primarily reflecting the timing of purchases and sales and a lower investment property portfolio in the period. At the adjusted earnings level there was no change, with the lower net rental income and higher admin costs offset by lower financing costs (lower average debt and reduced average cost of debt). Gross contracted rent and occupancy at end-H119 were both a little lower than was reflected in our modelling as a result of the timing of lease expiries and planned asset management/refurbishment. As discussed below, this has a small impact on our H219 net rental income and adjusted earnings, but we expect this to be made up in future periods as the properties are re-let.

Although ahead of H118, EPRA NAV per share of 114.3p was lower than the 115.5p at end-FY18 with £3.9m of H119 asset management related capex yet to be reflected in the valuation

RGL has made good progress with the deployment of the proceeds of the July equity raise (£62.5m gross). Our forecasts incorporate full deployment by early 2020, along with cash resources and some additional debt capital, while maintaining a c 40% LTV, in line with RGL’s medium-term targets. For acquisitions we continue to forecast:

More broadly, our key forecasting assumptions are:

Significant refinancing activity, particularly over the past year, has increased the amount of available funding, while rationalising the number of facilities has increased average debt maturity and lowered the average cost. From a peak of c 49% in 2017 immediately after the Conygar acquisition, loan to value (LTV) has been steadily reduced in line with the group’s medium-term target of c 40%.

At 30 June 2019 (H119), RGL had debt facilities of c £372m (including unamortised debt arrangement costs), of which c £342m was drawn and outstanding. Allowing for c £54m of cash, net debt was c £288m and the LTV was 39.9%. The weighted average term to maturity was 7.8 years.

In February 2019, £39.5m of 6.5% zero dividend preference shares were repaid at maturity and in June 2019 two of the existing bank facilities were extended and increased in size. Santander increased by £22m to c £66m and the term was extended from November 2022 to June 2029. The RBS facility was increased by c £28m to c £55m and the term was extended from December 2021 to June 2024. At the same time, a small £19m facility with HSBC was repaid.

The end-H119 weighted average interest rate payable was 3.4% and the average cost of debt including hedging costs was 3.5%. RGL has a target that at least 90% of the loan portfolio is hedged using fixed rate facilities or interest rate swaps, and at end-H119 the portfolio was more than 100% hedged.

Allowing for the unsecured Retail Eligible Bond debt, the LTV ratios on the secured debt facilities were all comfortable and the group indicated that at H119 it had c 25% headroom within the required debt service coverage ratios, implying an ability to withstand a reduction of about one-third in asset values.

RGL aims to provide an attractive total return to shareholders, targeting a total return of more than 10% pa, with a strong focus on income supported by the potential for additional capital growth. Up to end-H119 the cumulative accounting total return (the change in EPRA NAV per share plus dividends paid out) was 40.8% or a compound average annual return of 9.8%, very close to the target. Dividend payments have accounted for 65% of the total return over this period. Given our cautious assumptions for capital returns over the next couple of years, outlined above, our forecasts imply a total accounting return over the FY19–21 period of 7.1%, effectively all generated by dividend payments. Although lower than historical returns, and below the 10% target, we think this represents an attractive return in the context of generally low interest rates. By way of a risk-free benchmark, the 10-year gilt has recently been traded at a yield of c 0.75%. We would also view RGL’s target return as a medium-term target, which will be difficult to achieve in all market conditions given the historical volatility of commercial property capital values.

RGL’s high dividend yield continues to be at the very top end of the broad UK property sector. For FY19 the group has indicated that it will declare aggregate quarterly dividends of 8.25p per share, barring unforeseen circumstances, representing a prospective yield of 7.8%.

In Exhibit 14 we show a comparison with a narrow group of peers that are similarly focused on regional commercial property. To ease comparison, this data is based on 12-month trailing DPS declared and last published NAV. Compared with this narrower group, RGL’s yield is also well above the average. Its c 8% share price discount to NAV is lower than the average for the peer group, within which those companies with an income focus, like RGL, tend to have the higher P/NAV ratings. This reflects the greater stability of income returns across the cycle and the recently increased level of uncertainty regarding future capital value movements.

Across the broader UK commercial property sector, over the past 12 months share price performance has polarised between perceived low risk (most industrial focused companies and predominantly specialist sectors where assets are let on lease leases, often with inflation indexation of rents) and higher risk assets (of which the most notable casualty has been the retail sector). RGL has performed in line with the broader market and ahead of the narrow peer group shown in Exhibit 14. We attribute this positive performance to its attractive yield, commitment to a progressive dividend policy, reduced LTV, and ability to demonstrate asset management driven capital returns.

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. The last major sector downturn came to an end in early 2009. 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. RGL is not a developer but is exposed to similar but lesser uncertainties as it actively invests in improvements to existing assets with the aim of enhancing long-term income growth and returns. We consider the main sensitivities to include: