Regional REIT — Update 4 October 2016

Regional REIT (RGL) has delivered its first set of interim results since listing on the Main Market of the London Stock Exchange (LSE) in November 2015. It is a UK-based real estate investment trust (REIT) that aims to deliver an attractive return to investors through investments in commercial property (predominantly office and light industrial property) in the main regional centres of the UK, effectively outside the M25 motorway. RGL was formed from the combination of two existing, privately owned, limited life property funds that had previously been created by the investment manager, Toscafund Asset Management (Tosca) and the external asset manager, London & Scottish Investments (LSI), and was thus able to come to market with an established and diversified portfolio of high-yielding properties. H116 has seen the £128.1m acquisition of additional property assets, including two substantial portfolios, and disposals of non-core assets have further progressed portfolio refocusing, both towards office and industrial property and across the regions. Refinancing has lowered the cost of debt.

RGL has an active asset management strategy, built off detailed plans for each property and targeting a 10-15% pa return to shareholders, including a 7-8% pa dividend return on the IPO price of 100p. The prospective dividend is fully covered and offers a sector-leading yield of 7.3%. LSI brings a well-resourced, dedicated team, with cross-cycle experience, and targets occupancy and rent increases to drive income and capital growth from existing assets. Regional commercial rents have been increasing against a background of improving occupational demand (including structural drivers such as business relocation) with declining availability, and are coming from a lower point in the cycle than London offices or the retail sector. The yield spread on secondary assets versus prime assets remains historically wide with the opportunity for RGL to benefit from further narrowing. While Brexit has increased uncertainty about longer-term economic prospects, the asset manager observes that regional demand has so far remained resilient and anticipates higher rental income with targeted improvements to occupancy through the second half of the year and into 2017. We recently wrote at length about RGL, its strategy and the investment opportunity in our initiation note, and provide an update here.

RGL’s target of a 10-15% pa return is based on targeting underexploited properties and managing them actively to improve occupancy and rents. Providing context for this, our views on the UK commercial property sector and the regional property opportunity were discussed at length in our initiation note and are briefly summarised here:

RGL’s strategy is fundamentally different from peers, which may be more London-focused or targeting long leases. RGL seeks to add additional value by targeting underexploited properties and managing them actively to improve occupancy, rents and capital value over time. The diversification of the portfolio is an important element of balancing the risk of this strategy (whether it be market conditions or operational delivery), with the potential for enhanced rewards. At 30 June 2016, the RGL portfolio comprised 128 properties made of 974 individual units let to 719 tenants. It is also diversified by geography and increasingly focused (91.6% by value) on the targeted sectors of office and light industrial property. An appraisal of the top 15 tenants shows a broad mix across a wide variety of business sectors, and no excessive concentrations, in particular with respect to financial services companies. The largest tenant represents 5.3% of gross rental income and the largest property represents 6.6% of portfolio value. Selective acquisitions and non-core disposals since IPO, and continuing through H116, have contributed towards a rebalancing of the portfolio away from Scotland to more closely match the general regional economy and population (England and Wales now 73.5% by value versus 64.6% at IPO).

Occupancy at 30 June 2016 was 81.8%, which was lower than at the end of 2015, primarily due to the acquisition of the Wing and Rainbow portfolios at lower occupancy than the portfolio average, so as to be able to benefit from planned active asset management improvements. The manager indicates that leasing activity since the half year has taken occupancy to c 83%, and that at least 85% by year currently appears to be a reasonable objective. Assuming no change in the portfolio, no further acquisition of properties with low occupancy and the active asset management potential, the manager believes that c 90% occupancy is a reasonable level for long-term structural occupancy. The weighted average unexpired lease term to first break is 3.6 years, again a little lower than at year end (3.8% excluding the non-core, fully occupied Blytheswood House where the sale was announced in April, or 4.4 years including it), but not an unreasonable length when compared with current new lease terms. For the office and light industrial properties targeted by RGL, leases at inception tend to be in the region of 10 years with a five-year break clause or a straight five years with no break. Exhibit 4 shows that there is a noticeable pick-up in lease maturities in 2017 and 2018 and this represents both a key challenge for the manager and a key opportunity to benefit from its active asset management strategy.

Our forecasts assume that all maturing leases are extended or re-let on terms that are similar to the portfolio average expected rental value (ERV). We assume that ERV grows at 2% pa.

Very usefully the interim results contain information about the manager’s asset management and strategy and progress with respect to the Wing and Rainbow portfolios. We review this in the next section.

The Wing portfolio was acquired in March of this year for £37.5m, representing an 8.5% net initial yield. The portfolio includes four office properties (Manchester, Leeds, Leicester and Basingstoke) and a light industrial site in Beverley. The portfolio provides a solid income base immediately, with the potential to add additional value from letting space already refurbished by the previous owner, refurbishing existing unlet space, restructuring existing leases and securing alternative uses. The letting of already refurbished space has increased occupancy from 78.2% at acquisition to 85.2% as of September 2016. Refurbishment has continued and a number of lease extensions are under negotiation.

The Rainbow portfolio was also acquired in March 2016 for £80m, representing a net initial yield of 8.2%. The investment plan looks to create additional value on the five office buildings and seven industrial sites by restructuring existing leases, and refurbishment and lettings of space. The portfolio is split c 45% industrial/55% office by rental income and is spread throughout the UK in major urban areas including Bristol, Manchester, Cardiff, Sheffield and the West Midlands. Occupancy of 77.2% on acquisition is now (as of September 2016) 78.2%. The portfolio includes two office buildings in Aylesbury, one of which is occupied by Lloyds Banking Group until 2021. At the other, RGL has secured a new 10-year lease with the anchor tenant Equitable Life over two floors and has agreed break terms with the tenant (LBG, which had served notice) on the other two. This will allow refurbishment of the vacant two floors and re-letting. The building is modern and attractive in a town centre location and the manager is optimistic of the re-letting potential. At the Aztec 800 office building, seven miles north-west of the Bristol city centre with good links to the M4 and M5, refurbishment is being finalised and potential occupier interest from more than one party seems strong. The manager believes that the go-ahead for the Hinkley Point C nuclear power station provides positive support for stronger local demand.

Our medium-term forecasting framework is covered in detail in our initiation note. Following the interim results, we have made the following adjustments:

As discussed above, RGL is targeting a total return of 10-15% pa to shareholders, including a 7-8% pa dividend return on the IPO price of 100p, with additional capital appreciation driven by specific asset management initiatives in the portfolio. The continued strengthening of the regional property market more generally would additionally support overall returns. Our forecasts indicate a dividend yield on the current share price of 105p of 7.3% (7.7% on the IPO price), very much towards the top of the range of prospective dividend yields for the UK REIT sector, while trading at a discount to 2016e of c 5%, slightly wider than the median.

As explored in detail in our initiation note, RGL seeks to engage in selective acquisitions to grow the portfolio on terms that are immediately accretive to EPRA EPS and dividend-paying capacity.