Standard Life Inv. Property Income Trust — Update 2 September 2016

Exhibit 2 (left-hand side) shows the attractive relative returns generated from investment in property over the last three and five years in a low interest rate environment, versus both UK equities and UK government bonds; although annual returns have lagged over 10 years. Over three years, the annual outperformance has been 8.6pp and 6.4pp respectively (4.1pp and 2.7pp over five years). In addition, since the financial crisis the yield on UK property has remained considerably higher than the UK 10-year government bond yield (5.28% versus 1.02% at 30 June, Exhibit 2 right-hand side).

Following the Brexit vote and faced with a slew of redemption requests, a number of open-ended property funds were forced to suspend dealing in their units or apply a dilution discount. While the situation appears to be improving, with trading in some funds resumed and/or dilution discounts reduced, recent events highlight liquidity issues faced by open-ended property funds. By virtue of their closed-end structures, property investment trusts do not face the same liquidity issues. However, the Brexit vote has introduced a degree of uncertainty over the outlook for commercial property. General levels of risk aversion may lead to a reduction in demand, resulting in a market supply/demand imbalance, which could affect property prices. Nevertheless, it is too early to assess the Brexit vote’s full effect on asset prices in a class that by its nature is a long-term investment.

SLI was launched in December 2003. It is a Guernsey-registered, closed-end fund listed on the London Stock Exchange. In January 2015 it became a REIT, which means it does not pay UK corporation tax on rental profits or chargeable gains and it must distribute at least 90% of its real estate profits. SLI aims to provide an attractive income with the potential for income and capital growth via direct investment in a diversified portfolio of UK commercial properties. The portfolio is currently invested in retail, office and industrial property, but hotels, nursing homes and student housing may also be considered. There is a quality bias to the portfolio, poor secondary and tertiary locations are avoided. The focus is on good, but not necessarily prime, locations with good tenant demand and the potential to enhance returns through asset management.

SLI is benchmarked against the Investment Property Databank (IPD) Balanced Monthly Funds index. There are broad investment limits in place: no single property can account for more than 15% of total assets; no single tenant, excluding the government, can represent more than 20% of the rent roll; and a maximum of 10% of the portfolio may be invested in co-investments and property development. Gearing is permitted up to 65% of gross assets, with the loan-to-value ratio capped at 45% (calculated as net debt as a proportion of the property portfolio’s market value).

Following the UK’s decision to leave the EU, there is short-term uncertainty in the commercial property sector, which is likely to lead to a fall in capital values. This will probably occur over the next 12 months and have the largest impact on central London office prices. Until there is greater clarity on the performance of the UK economy and the likely structure of the UK’s future relationship with the EU, it is hard to predict how the commercial property market will be affected. The manager takes comfort that the fall in the value of sterling has helped to make the UK property market appear more attractive to overseas investors, and that real estate remains attractively priced compared to other asset classes. A functioning banking system, low levels of property supply and government stimulus all help support the asset class. To date, tenant demand has held up reasonably well; the manager believes that SLI’s focus on income means that it will weather the storm relatively well with limited voids, and a diverse tenant base.

The manager sees more opportunity to retain tenants currently than during the financial crisis, when the occupier market was depressed and many companies, especially smaller operations, were looking to move premises. However, Baggaley points out that moving premises is a costly and time-consuming exercise and good quality accommodation is still highly in demand. If a lease can be extended, this provides certainty of income for the owner, leaving scope for any financial benefit to be shared with the tenant, who requires certainty over their outgoings. Given the timing of the Brexit vote, any movement in SLI’s asset values due to a change in market conditions will not be apparent until the September NAV is released. The manager is optimistic that occupiers will retain a positive outlook and suggests that the search for yield from investments will continue if government bond yields remain low. He notes that transaction volumes ahead of the referendum were low after two to three years of strong activity driven by a high level of liquidity and the search for yield. Comparing the current environment to the global financial crisis, the manager observes that leverage is lower and rents more affordable due to low interest rates, while void rates are still very low and speculative investment has been limited.

SLI runs a balanced portfolio of property in good, but not necessarily prime locations, where high tenant demand is expected. The portfolio is actively managed to maximise asset values and rental growth. This primarily involves negotiating new leases with existing or new tenants and can involve refurbishment before re-letting, which is an important factor in attracting new tenants. New leases are historically at a higher rent, which can enhance the value of the property as well as generating higher income. Asset management initiatives in FY15 included: five new lettings generating £0.8m pa in new rent; nine lease extensions with existing tenants generating £2.2m pa and lease renewals and lettings at the largest asset, White Bear Yard (office development in central London). SLI collects its own rent, which is unusual within the industry. This builds stronger relationships with tenants and can provide advance warning that a client may be struggling. SLI has a 100% record of collecting rent within 21 days. At end June 2016, SLI’s voids were 3.8%; c 50% lower than for its IPD index benchmark.

In December 2015, SLI purchased a portfolio of 22 commercial properties for £165m, which increased SLI’s portfolio value by more than 50%. The acquired assets were diversified by sector, tenant and region and complementary to SLI’s existing properties; the deal was funded by a mixture of new equity and debt. The manager comments that he was delighted with the acquisition as the portfolio had plenty of asset management opportunities with a number of short leases and an initial yield of 5.9%, giving scope to increase rents in the short term. During FY15, £217m of assets were acquired (including the 22-asset portfolio) compared to sales of £55m. As shown in Exhibits 1 and 3, the December 2015 acquisition significantly increased diversification within the portfolio. At end-June 2016, the top 10 properties accounted for 33.9% of the portfolio versus 48.2% a year earlier, with the top 10 tenants generating 33.0% of total passing rent versus 44.7%. The average lease length is 5.8 years, which compares with 7.2 years before the December 2015 acquisition.

SLI is invested in the three main commercial property segments: office, retail and industrial. At 30 June 2016, versus the benchmark it was overweight industrial and office exposure and underweight retail exposure. Industry data for 2015 showed that the UK office sector provided the highest total return, 17.2%, followed by the industrial sector at 16.6% and retail at 8.1%. Exhibit 5 shows the portfolio’s regional diversification, with less than 50% exposure to London and the South East.

On 13 July 2016, SLI announced that it had completed three separate property transactions, sales of a small industrial asset in Witham, an office property in Teddington that was part of the portfolio acquired in December 2015 and a small retail parade in Kingston upon Thames. Total proceeds of £12.4m were in aggregate 3% higher than the March 2016 valuations and used to repay debt. SLI also announced that it had completed four lease renewals with two tenants on its multi-let industrial estate in Aberdeen, in line with March 2016 estimated rental values (ERVs), which ensures that the estate remains fully let.

As shown in Exhibit 6, SLI’s share price has been volatile following the Brexit vote, but having bottomed on 6 July 2016, has started to appreciate. This follows resumption of trading in some of the open-ended funds that were forced to suspend trading following investor redemption requests.

SLI’s NAV total return has outperformed the benchmark IPD UK Monthly index over one, three and five years and its share price has outperformed over three and five years. As a reference to UK investors, there has been outperformance over the same periods versus the FTSE All-Share index.

Exhibit 8 illustrates SLI’s relative performance over 10 years. The substantial underperformance versus the benchmark during the global financial crisis has been followed by a more benign period, with steady outperformance over the last three years.

Having traded at a premium for most of the last five years, SLI’s share price moved to a discount to its NAV following the Brexit vote, with investor uncertainty increasing after a number of open-ended property funds suspended trading and/or introduced dilution discounts. SLI’s current share price discount to NAV of 1.6% compares to an average premium of 3.3% over the last 12 months. During this period, the shares ranged from an 11.2% premium in late-September 2015 to a 16.6% discount on 6 July 2016 due to the reasons highlighted above. The average premiums of the last three and five years are 8.7% and 5.7% respectively. Although SLI has authority to purchase up to 14.99% of its issued share capital, no shares have been repurchased in recent years.

SLI is a conventional investment trust with one class of share; there are currently 380.7m ordinary shares outstanding, an increase of c 150% from 155.0m at the end of 2013. During FY15, borrowings were increased to fund the December 2015 property portfolio acquisition. At end-2015, the loan to value was 28.1% versus 29.2% at the prior year end and the weighted average interest rate was 2.70% (3.66% at end-2014). On 28 April 2016, SLI announced a £145m debt refinancing with Royal Bank of Scotland, comprising a £110m seven-year loan at Libor plus 1.375% matched with an interest rate swap, which had an all-in cost of 2.5% at end-June 2016; and a £35m five-year revolving credit facility (RCF) at Libor plus 1.2%. £141.5m was drawn at end-June 2016, with £11.5m repaid in July, reducing the drawn amount on the RCF to £20m. The loan to value at end-June 2016 was 28.4%. The movement in the interest rate curve following the Brexit vote led to a negative movement in the swap, resulting in a £5.5m swap liability at end-June 2016.

A tiered annual management fee has been in place since 2014. The fees are 0.75% of total assets up to £200m; 0.70% of total assets between £200m and £300m; and 0.65% of total assets in excess of £300m. No performance fee is paid. The FY15 ongoing charge of 1.1% of net assets was 50 basis points lower than the prior year, reflecting a higher NAV coupled with effective cost control.

In FY15, the dividend was held steady at 4.64p; in line with prior year, it was fully covered by rental income. In the absence of unforeseen events, the board has announced its intention to increase the dividend by 2.5% to 4.76p in FY16; equating to a prospective yield of 5.9%. This compares to the end-July dividend yields of 3.5% for both the FTSE All-Share REIT and the FTSE All-Share indices.

Exhibit 10 shows the AIC Property Direct – UK sector excluding funds with a market cap of less than £100m or that have been trading for less than one year. SLI’s NAV total return is ahead of the peer-group average over one and five years, ranking third out of 12 and second out of eight funds respectively. Although lower than the peer-group average for both periods, SLI’s NAV total return is at or close to the median over three and 10 years. In terms of risk-adjusted returns, SLI’s Sharpe ratio is modestly below the average over one and three years. In contrast to the predominant share price premiums seen before the Brexit vote, most of the trusts in the sector are now trading at a discount to NAV; SLI is broadly in line with the average. SLI’s ongoing charge is below the peer-group average and no performance fee is payable. The trust’s gearing is modestly higher than the average and, reflecting its income bias, it has the joint-highest dividend yield in the sector.

SLI has five independent non-executive directors after the appointment on 17 August 2016 of James Clifton-Brown, who has served as UK CIO of CBRE Global Investors since 1996. Chairman, Robert Peto succeeded Richard Barfield at the June 2016 AGM, having joined the board in May 2014. Mike Balfour was appointed in March 2016; he has more than 30 years’ of investment management experience and is currently also a director of Martin Currie Global Portfolio Trust and Murray Income Trust. Sally Ann Farnon was appointed in July 2010 and Huw Evans in April 2013.