Custodian REIT — Robust FY21 with improving outlook

CREI seeks to appeal to both retail and institutional investors in the UK real estate investment trust (REIT) sector by targeting attractive and stable dividend returns, with the potential for capital growth, from a well-diversified portfolio of UK commercial real estate with conservative levels of gearing (c 25% target with a maximum 35%). Although diversified, portfolio positioning is actively managed, with the industrial/logistics and retail warehouse sectors favoured by the manager, and an expanding exposure to ‘drive-thru’ restaurants. CREI’s investment strategy is differentiated by a principal focus on properties with smaller individual values (‘lot sizes’) of less than £10m at the point of investment. On average, properties of this size provide a yield premium over larger assets, in part the result of a broader range of potential occupiers while attracting less competition from larger institutional investors. Combined with active asset management and a relatively low cost base (FY21 ongoing cost ratio or OCR of 1.12%), this yield premium has delivered attractive total returns since IPO, consistently positive on an annual basis (including FY21) and driven by dividends paid.

Although UK commercial property market returns have historically shown significant cyclicality, the income component has been much less volatile than capital values. CREI’s income-focused strategy has consistently generated positive annual total returns despite more recent volatility in capital values, first in relation to Brexit and political uncertainty and then the pandemic. From listing in March 2014 to March 2021 (the end of FY21), CREI generated an EPRA net asset value (NAV) total return (without assuming reinvestment of dividends paid) of 41.1%, or a compound annual average return of 5.9% pa. This total return has been entirely generated by the income component, dividends paid to shareholders, and more so in FY21 (income return of 4.8% versus total return of 0.9%). During FY21, although the sharp pandemic-related fall in capital values generated a negative total return in Q121 (4.2%), the subsequent quarters each generated positive returns, reaching 2.5% in Q421.

Our forecasts for FY22 and FY23 are unchanged. The growth that we forecast for FY22 is driven by our expectation of a significant (c £3.0m) decline in net receivables charges, supported by a good level of end-FY21 provisions and the expectation of an improved collection outlook, including a part of the rent outstanding although tenant failures remain a risk. We expect occupancy to improve modestly in FY22 and more so in FY23. FY22e reported rent income is held back by the lower opening rent roll compared with FY21 but increases in FY23e. Our NAV forecasts benefit from relatively low but positive capital return assumptions, driven by modest blended growth in estimated rental values (ERV) with no implied change in valuation yields. The company seeks to leverage its strong balance sheet for accretive acquisitions but these are not included in our forecasts.

We review the main sensitivities below. The greatest uncertainties relate to the continuing impact of the COVID-19 pandemic on economic growth and the way real estate may be used in future. The commercial property market is cyclical and property values have historically displayed significant volatility across the cycle; income returns have been significantly more stable although the level of income fluctuates with occupier demand and rent levels. Yields on well-let property compare favourably with short-term interest rates and long-term risk-free rates.

Many of the FY21 headline financial numbers contained in the FY21 results release were previously disclosed in the unaudited Q421 release in May and were in line with our forecasts at the time. However, the annual report includes additional details on the robust performance in FY21 and prospects.

As CREI’s rent recovery (91% for the year, adjusted for contractual rent deferrals) and market-wide property valuations steadied in H2, EPRA earnings showed a strong improvement, DPS increased, and EPRA NTA made a partial recovery, generating a positive total return for the year of 0.9%.

The board has been monitoring whether COVID-19 guidance limiting public gatherings and travel will be in place when the company holds its AGM on 25 August 2021. To provide certainty and encourage interaction and engagement with shareholders, the company has arranged an online investor presentation at 2:00pm on 6 July 2021 at which shareholders will receive updates from the Chairman and Investment Manager with the opportunity for an interactive question and answer session. For those wishing to participate, the registration link is bigmarker.com.

Exhibit 1 provides a summary of the FY21 financial results.

The key highlights of the financial performance include:

The £19.6m aggregate valuation decrease comprised a £9.4m uplift from successful asset management initiatives and £29.0m of general valuation decreases, primarily due to decreases in the ERV of high street retail properties, negative market sentiment for retail assets and the impact of the COVID-19 pandemic. Lower valuations in retail, other1 and the office sector were partly offset by a 4.6% (£12.0m) increase in industrial and logistics. Significant net portfolio valuation weakness in Q121 began to stabilise with net gains registered in each of the past two quarters.

The strong performance of CREI’s industrial assets mirrors the market-wide trend but also benefited from asset management initiatives. The ‘out-of-town’ retail warehouse sector performed significantly more strongly than high street retail and CREI notes recent strong competition for assets in the sector. The ‘other’ sector contains a number of tenant exposures that would ordinarily be defensive in terms of the economic cycle but have proved less resilient to the pandemic in the past year, although capital values have increased in each of the past two quarters.

Of the £36.8m of contracted cash rental income for FY21 (ie rental income adjusted for non-cash IFRS smoothing adjustments of £1.9m), 91% has been collected, net of contractual rent deferrals, and 89% before contractual rent deferrals.2 Applied to the sector mix of the portfolio (Exhibit 3) we consider this a good performance, which CREI notes has benefited from it collecting rents directly (ie not through a third-party agent), allowing better engagement for payments and facilitating an improved outcome, in some cases agreeing to monthly rather than quarterly rent payments or providing rent concessions. Concessions were offered as a last resort, amounting to less than 1% of contracted rents, and where possible longer lease commitments were sought in return as part of a lease re-gear.

Around £3.1m of FY21 rent remains outstanding and is the subject of continuing discussions with tenants. Some of this remains at risk of nonrecovery due to the recent national lockdown and particularly from CVAs and Administrations,3 but we suspect that not all outstanding rent represents an inability to pay on the part of tenants and some will have been influenced by the government’s moratorium on the eviction of tenants for non-payment of rent (now further extended to March 2022). To cover the estimated risk of non-recovery of outstanding and deferred rents, the end-FY21 doubtful debt provision stood at £3.0m, up from £0.3m at end-FY20.

In addition to the provision, £0.9m was written off in respect in respect of the rent provisions granted (c £0.25m) and tenant CVAs and Administrations.

Since end-FY21, CREI has received 90% of rents due relating to the April to June 2021 quarter.4

Including both the Q421 DPS of 1.25p declared for payment on 28 May 2021 and the fifth interim DPS of 0.5p declared for payment on 30 June 2021, aggregate DPS declared for FY21 was 5.0p (FY20: 6.65p). Aggregate DPS was 113% covered by EPRA EPS of 5.6p (FY20: 7.0p) and fully covered by net cash receipts, in line with the current policy of paying dividends at a level that is broadly linked to net rental receipts. For FY22, the board has set a target for aggregate dividends of not less than 5.0p, primarily subject to rent collection remaining in line with expectations. On a longer-term basis, the policy remains to grow dividends on a sustainable basis, at a rate that is fully covered by projected net rental income while maintaining investment flexibility. We continue to forecast aggregate FY22 DPS of 5.6p, above the targeted minimum.

CREI is a UK REIT listed on the Premium Segment of the Main Market of the London Stock Exchange since March 2014. Its diversified portfolio targets regional commercial properties (outside London), predominantly let to institutional-grade tenants throughout the UK. It is externally managed by the experienced property management team of Custodian Capital, a property management and investment business wholly owned by Mattioli Woods, the specialist wealth management and employee benefits consultants, managing total client assets of £13.6bn including recent acquisitions. It aims to appeal to both retail and institutional investors in the UK REIT sector by targeting attractive and stable dividend returns, with the potential for capital growth, from a well-diversified portfolio of UK commercial real estate with conservative levels of gearing (c 25% target with a maximum 35%).5 CREI’s investment strategy is differentiated by a principal focus on properties with smaller individual values (‘lot sizes’) of less than £10m at the point of investment. On average, properties of this size provide a yield premium over larger assets, in part the result of a broader range of potential occupiers while attracting less competition from larger institutional investors. Combined with active asset management and a relatively low cost base (FY21 OCR of 1.12%), this yield premium has delivered attractive total returns since IPO, consistently positive on an annual basis (including FY21) and driven by dividends paid.

Although diversified, portfolio positioning is active with the industrial/logistics and retail warehouse sectors favoured by the manager, and an expanding exposure to ‘drive-thru’ restaurants. The portfolio has grown strongly since IPO but has been more stable in the past three years as CREI has taken a more cautious approach to acquisitions and reflecting weaker market valuations due to the pandemic. However, CREI continues to seek opportunities for further growth, recognising the potential for further economies of scale.

Dividend policy aims to maximise fully covered DPS at a level that is sustainable and does not conflict with investment policy and dividends had increased each year until the pandemic. From a reduced level, uninterrupted quarterly DPS was increased twice during FY21, maximising distributions while tracking cash receipts as the prospects for rent collection improved. The aggregate FY21 DPS of 5.0p was well ahead of the minimum 3.0p target set by the board at the beginning of the year. The board has set a target of no less than 5.0p for FY22 although we forecast a fully covered 5.6p.

Although UK commercial property market returns have historically shown significant cyclicality, the income component has been much less volatile than capital values. CREI’s income-focused strategy has consistently generated positive annual total returns despite more recent volatility in capital values, first in relation to Brexit and political uncertainty, and then the pandemic. From listing in March 2014 to March 2021 (FY21), CREI generated an EPRA NAV total return (without assuming reinvestment of dividends paid) of 41.1%, or a compound annual average return of 5.9% pa, all of which has been generated by dividend payments. The income return for investors from dividends paid has generated all of this return and more so in FY21 (income return of 4.8% versus total return of 0.9%). During FY21, although the sharp pandemic-related fall in capital values generated a negative total return in Q121 (4.2%), the subsequent quarters each generated positive returns, reaching 2.5% in Q421.

Smaller lot size yield premium

Using market-wide data, Exhibit 7 compares the transaction yields on assets with a value of less than £10m with those that have a value of more than £10m. Due to pandemic delays, only data to end-2019 are currently available but the consistent small-lot premium is evident and CREI’s manager believe this remains the case.

Smaller properties are generally considered to be higher risk and will typically have a higher cost of management relative to income. In our view, the main risk is related to lower liquidity, which may be an issue if the property must be sold, but smaller size does not in itself determine the quality of the property, its appeal to tenants, or the quality of tenant. Asset selection and a long-term approach to investment are key to managing risk and of CREI’s strategy for producing an attractive risk adjusted income return, more than sufficient to offset the additional administrative complexity. Other key elements of this strategy include:

Portfolio diversification provides a mitigation to risk in uncertain times such as these and CREI’s portfolio is well spread across the main commercial property sectors and by location, tenant and lease term.

At 31 March 2021 (end-FY21) the portfolio was externally valued at £551.9m (FY20: £559.8m) with a rent roll of £38.7m pa reflected in a net initial yield of 6.6%. The weighted average unexpired lease term at end-FY21 was 5.0 years, fairly evenly distributed, with income ‘at risk’ from tenant lease expiry or the exercise of a lease break options of c 11% over one year and c 31% over three years. While a significant proportion of tenants do not exit at break or expiry, this could be negatively affected by the pandemic and economic weakness.

Tenant business failures and tenants exiting at lease expiry contributed to a decrease in occupancy to 91.6% at end-FY21 from 95.9% at end-FY20. More than half of CREI’s end-FY21 vacant space is now let or under offer. While contracted rent roll was 5.0% lower during the year the externally ERV at full occupancy was just 0.4% lower at £42.6m. The c £3.9m or c 10% gap between ERV and contracted rents indicates additional income potential in the portfolio, the majority of which (c £3.6m) represents the potential from letting vacant space, although in some cases it may be necessary and sensible to accept rents below ERV to maintain occupancy and long-term income.

Of the more than 260 individual tenancies, the top 10 tenants represent a little under 24% of overall rent roll, little changed in composition or aggregate share over the past year.6 Menzies Distribution is the largest tenant at just over 4% of total rent roll, spread over eight individual assets. Menzies is one of the UK's leading urban logistics businesses.

Exhibits 10 and 11 show the sector and geographic spread of the portfolio.7 Geographically, the portfolio has minimal exposure to London, but exposure to every other region. It is split between the main property sectors, in line with the company’s objective of maintaining a suitably balanced portfolio, with relatively high exposures to the industrial, retail warehouse and alternative sectors (‘other’, including car showrooms, petrol filling stations, children’s day nurseries, gymnasiums, hotels, healthcare units, and drive-thru), with relatively low exposure to office and high street retail.

Although the portfolio is diversified to manage risk the investment strategy provides flexibility for active sector positioning, enabling CREI to make strategic adaptations in response to changing market conditions. As a long-term investor, changes to the overall portfolio positioning have been evolutionary rather than revolutionary but we highlight the following:

Of course, active asset management goes much further than portfolio positioning. CREI estimates that lease renewals and re-gears, rent reviews, new lettings, and acquisitions and disposals positively added at least c £9.4m to valuations in FY21 and more than £10m if the mitigating impact on valuation declines is also included.

CREI targets further accretive growth in the portfolio to benefit from attractively priced assets as well as scale efficiencies, spreading fixed costs over a wider income producing asset base and ultimately reducing the marginal rate of asset management charges (on a rise in net assets above £500m). The portfolio grew strongly in the three to four years from listing (initial portfolio c £95m), funded by significant equity raises. Net acquisition activity has continued but slowed noticeably in FY20, as attractive opportunities that met CREI’s investment criteria were more difficult to identify, With demand for the shares maintaining a consistent premium to NAV, acquisitions were funded by capital recycling and by share issuance under the company’s tap issue facility. Due mainly to the pandemic, activity slowed further in FY21 but CREI nevertheless made three acquisitions for an aggregate £11.4m and sold properties for an aggregate headline consideration of £4.4m.

The FY21 acquisitions included properties in the industrial, office and other (land and development of a drive-thru coffee outlet pre-let to Starbucks) sectors at a blended net initial yield of almost 6.5%. The disposals included a mature industrial asset (net initial yield of 4.5%), generating a gain of £0.5m, and four retail properties, acquired as part of larger transactions in 2014/15, some of which were let on short-term leases and some of which were vacant, for an aggregate £1.6m, and in line with FY21 valuation.

The pandemic has created new opportunities for growth and with low gearing and undrawn debt facilities CREI has the financial flexibility to take advantage of opportunities as they arise. The recovery in the share price and closing of the discount to NAV that opened during the pandemic has also allowed CREI to recently recommence modest share issuance, at a premium to NAV, under its tap facility.

So far in FY22, CREI has acquired an industrial asset in Knowsley for £3.5m at a net initial yield of 5.74% and has further reduced retail exposure with the sale of a property in Nottingham for £0.7m, in line with valuation. The manager continues to monitor further opportunities for growth.

CREI preference is for selective individual property acquisitions although strategic portfolio acquisitions have historically also been undertaken; in the most recent portfolio acquisition, in October 2019 CREI acquired a portfolio of eight ‘last mile’ distribution units, well spread across the UK and let to Menzies Distribution on new 10-year leases for c £25m (before costs) reflecting a net initial yield of 6.4%. CREI also sees the potential for acquisitions from investors more negatively affected by the pandemic, including smaller corporate vehicles and open-ended funds.

Strategic disposals, particularly of mature assets, may provide capital recycling opportunities but, given the company’s desire to grow while maintaining a moderate level of gearing, larger acquisitions would likely require equity funding beyond the scope of the tap issuance facility. This may have the added advantage of broadening the shareholder base.

CREI’s board of directors comprises six members, all of whom are non-executive and responsible for the overall management of the company’s activities. The board has appointed Custodian Capital (www.custodiancapital.com), a wholly owned subsidiary of Mattioli Woods (www.mattioliwoods.com), as investment manager to provide investment and property management, and administrative services to the company. Custodian Capital is authorised and regulated by the Financial Conduct Authority (FCA) and, in addition to acting as fund manager to CREI, provides a structure that enables investors to purchase business premises and/or other commercial property in a tax-efficient and flexible manner.

Five board members are independent of the investment manager, including the non-executive chairman, David Hunter, a professional strategic adviser focused principally on UK and international real estate, who sits on the boards of a number of listed and unlisted companies, as well as holding corporate advisory roles. The independent non-executive directors are Matthew Thorne, an experienced former finance director in the UK quoted sector and non-executive director of Bankers Investment Trust for nine years until 2018; Hazel Adam, who joined the board in December 2019 bringing a range of experience including the buy-side and sell-side investment industry, strategies and markets; Elizabeth McMeikan, a former Tesco executive and experienced board member, who joined the board in March 2021; and Chris Ireland, a former CEO of JLL UK and former chair of the Investment Property Forum, who also joined the board in March 2021. Ian Mattioli, chief executive officer of Mattioli Woods and a board member of the investment manager, is the sixth CREI non-executive director. Ed Moore, finance director of Custodian Capital is company secretary to CREI. Full details of the board can be found at www.custodianreit.com.

Custodian Capital was appointed investment manager at the IPO, an arrangement that is subject to regular board review. Richard Shepherd-Cross is the managing director of Custodian Capital and the fund manager of CREI. He is a former director of Jones Lang LaSalle in London, where he led the portfolio investment team before joining Mattioli Woods in 2009, with responsibility for its syndicated property initiative, the precursor to Custodian. In total, the Custodian Capital team that is dedicated to the management of CREI’s assets consists of 18 members, including six property professionals.

Management and administration fees are paid to the manager on a sliding scale that allows shareholders to benefit from growth NAV. The fees on continued growth in NAV above £500m were reduced during the year.

We have updated our forecasts, published in May after the Q421 NAV update, for the details provided in the FY21 results but have made no changes to the key financial numbers, including EPRA EPS, EPRA NTA and DPS.

We forecast an increase in FY22 EPRA earnings and EPS to £25.8m (FY21: £23.7m) and 6.1p (FY21: 5.6p) respectively, driven by lower receivables provisions/write-offs, with further growth in FY23, driven by reversionary capture/void reductions.

The key forecasting uncertainties relate to rental income and collection and our assumptions include:

Our NAV forecasts benefit from relatively low but positive capital return assumptions that we estimate on a sector-by-sector basis, driven by modest forecast growth in ERV and implying no change in valuation yields. For FY22, we expect a blended gross increase of c 1% before adjustment for capex, again driven by industrial assets. For FY23 we expect a blended c 1.5% as the recovery in capital values broadens across sectors. As always, there is much uncertainty about this. Each 1% increase/decrease in the value of the investment portfolio compared with our forecast would increase/decrease NAV per share by c 1.3%.

Custodian operates with moderate gearing and mostly fixed rate debt, much of which is long term, mitigating interest rate risk.

Custodian operates with four loan facilities amounting to £150m in aggregate (with the option to increase to £165m with lender agreement), comprising:

At end-FY21, £140m of the debt facilities were drawn and, including unrestricted cash of £2.7m, net debt was £137.3m with an LTV ratio of 24.9%. The weighted average cost of the debt facilities was 3.0%, 77% fixed rate, and the weighted average maturity was 7.4 years.

Each of the facilities has its own discrete security pool comprising individual properties over which the relevant lender has security and covenants. The facilities contain market-standard cross guarantees such that a default on an individual facility results in all facilities falling into default. The covenants include:

With unencumbered property assets (ie assets not within the discrete security pools) of c £165.0m (30% of the property portfolio) LTV covenants are not a concern in current market conditions. Although pre-emptive interest covers were agreed with lenders earlier in FY21, providing flexibility to collect rents in the most advantageous way, these were not required.

The company’s minimum target for aggregate FY22 DPS of 5.0p, represents a prospective yield of 5.1%, and our forecast 5.6p DPS represents a yield of 5.7%. The shares are trading at around NAV, below the average c 8% premium since IPO in March 2014.

In Exhibit 14, we show a summary performance and valuation comparison of Custodian and what we consider to be its closest diversified income-oriented peers. CREI’s share price performance is below the peer group average over 12 months, reflecting the fact that it was more stable during the pandemic sell-off in early 2020 and has therefore shown a lesser rebound. For comparative purposes, the valuation data are shown on a trailing basis so do not capture the prospective increase in CREI’s DPS from 4.5p to at least 5.0p (our forecast 5.6p) for FY22. CREI trades on a higher P/NAV than the average of the group, as it has done for most of the period since IPO in 2014, while its trailing yield is slightly below average. Factors supporting CREI’s valuation include uninterrupted quarterly DPS during the pandemic (albeit at a reduced level), moderate gearing and a focus on smaller lot size properties with a yield premium that has historically supported risk-adjusted income 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. 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. Custodian is not a developer but is exposed to similar but lesser uncertainties through modest forward funding of pre-let development on fixed price contracts and through investment in improvements to existing assets with the aim of enhancing long-term income growth and returns. More generally we note the sensitivity to: