GCP Student Living — Strong FY18 progress and positive outlook

GCP Student Living (DIGS) was the first real estate investment trust (REIT) in the UK to focus on the specialist property asset class of student residential property. It was admitted to trading on the London Stock Exchange in May 2013, initially trading on the Specialist Fund segment of the Main Market, and transferring to the Premium segment in September 2016. The investment objective is to provide shareholders with attractive total returns in the longer term through the potential for modest capital appreciation and regular sustainable dividends with RPI-inflation linked characteristics.

Gravis, the external investment manager, was established in 2008 and is privately owned by its directors and founding members. It currently manages £2.5bn in assets, including two other listed closed-end vehicles. Tom Ward and Nick Barker from Gravis have day-to-day responsibility for the provision of investment advice to DIGS. The primary asset manager is Scape Student Living, which is closely aligned with Gravis, the directors of which own 50% of Scape.

The student housing sector has attracted investor interest for its favourable risk-adjusted yields, which benefit from a positive supply-demand situation, good levels of rental growth and less exposure to the economic-led cycles that affect traditional commercial property sectors such as offices, industrial and retail property. As discussed at length in our initiation note, DIGS is differentiated by a focus on properties that are located primarily in or around London, or markets with similar supply-demand characteristics, where growing student numbers significantly outstrip the supply of student accommodation. London continues to see increasing numbers of international and post-graduate students, driving demand for purpose-built student accommodation (PBSA), while planning restrictions and competing demands limit supply. The investment manager targets high-specification, modern, purpose-built accommodation with proximity to a suitable higher education institution and/or a major transport hub. Such properties may be more likely to both appeal to students today and offer longevity of income potential.

At 30 June 2018, the portfolio comprised the 10 assets shown at the bottom of Exhibit 1 (2017: eight assets), providing c 3,600 beds (2017: c 3,000 beds), of which c 2,700 are operational and fully let for the 2017/18 academic year (c 1,900 operational and fully let in the 2016/17 academic year), with c 900 beds under refurbishment/development and expected to be completed and operational over the coming two academic years. The portfolio value was £784.4m (2017: £634.6m), 94% of which was located in and around London (2017: 96%), reflecting a net initial yield (NIY) of 5.04%.

DIGS’s results for the year to 30 June 2018 (FY18) show strong income growth, driven by an increasing number of operational beds, continuing full occupancy and good levels of rental growth. The company continues to find attractive opportunities to grow the portfolio, while maintaining its selective approach to asset selection, both by location and asset quality. Given the positive outlook, the progressive dividend policy has been maintained, and although dividend cover has been reduced in the short term by equity issuance to fund portfolio growth, the investment manager believes it would be fully covered on a fully developed and let basis.

To support the ongoing growth of the investment portfolio, in July 2017 DIGS raised c £70m (gross) in an over-subscribed equity placing. Gearing (defined as gross borrowing as a percentage of gross assets) was 28% at end-FY18, well below the fund’s 55% limit. More commonly used in the real estate sector, net loan to value or LTV (debt, net of £29.2m of cash resources, as a percentage of the property assets) was 26.2%, little changed on the year. Since end-FY18, DIGS has entered into a new £45m, three-year revolving credit facility with a margin of 1.85% over three-month Libor, supplementing its fully drawn £235m secured debt facilities at a blended fixed rate of 2.96%. DIGS indicates that the increased borrowing facilities, together with cash resources are sufficient to fund the remaining investment commitments at Scape Bloomsbury and Circus Street, as well as the cost of the land purchase for Scape Brighton. The announced placing (on 10 September 2018 and scheduled to close on 20 September 2018) of up to 38.5m shares, previously authorised by the AGM, at a price of 149.5p per share represents potential additional equity capital resources of c £55m which will be used primarily to fund the construction of Scape Brighton, due to complete during the first half of the FY20 financial year.

DIGS remains focused on building a diversified portfolio of investments capable of providing sustainable long-term dividends. The refurbishment of Scape Bloomsbury has reduced near-term income, and portfolio growth through forward-funding the development of attractive assets that may otherwise be unavailable has a similar effect, although the impact on adjusted earnings is softened by licence fees payable on funds extended. Investment decisions have been made in the expectation that dividends will be covered on a fully developed and let basis and the investment manager has provided the illustrative explanatory data contained within Exhibit 5. To support the illustrations, it has been assumed that construction is completed on time and to budget and that the properties are fully let on terms in line with the investment manager’s expectations and market conditions. Completion of Scape Bloomsbury, Circus St Brighton and Scape Brighton is expected to add between £16m and £17m to net rental income (£27.8m in FY18) on an annualised basis, with a potential enhancement to adjusted EPS (4.01p in FY18) of between 2.6p and 3.2p, depending on the mix of equity and debt capital used to fund the remaining capex. At end-FY18, the incremental capital requirement to fund the completions was c £135m and DIGS has illustrated the impact of fully debt funding the projects (3.2p enhancement) or the impact assuming a 70:30 equity debt mix of funding, similar to the current position (2.6p enhancement). The illustration shows adjusted EPS increasing above the FY18 5.95p DPS in both cases. As discussed below, the completion of these three assets should also have a positive effect on valuations and NAV. We estimate that the announced equity placing would position the actual funding mix broadly mid-way between the two outcomes illustrated by DIGS, assuming all additional funding were debt. However, we would not expect DIGS to decide on this for several months, given the gradual deployment of funds over the period of construction.

During FY18, Scape Wembley, DIGS’s first forward-funded development was completed and opened in September 2017. It was fully occupied for the 2017/18 academic year, providing 578 beds, and contributed a c £12m revaluation surplus. The two assets acquired during FY18 were Podium in Egham, and Circus Street, Brighton. Podium is a 178-bed newly developed operational asset, in the same locality as 220-bed The Pad, which was acquired through a conditional forward purchase agreement, first entered into in 2016. Circus St is DIGS’s second forward-funded development, a 450-bed development situated in the heart of Brighton city centre. It remains on track for completion in September 2019, in time for the 2019/20 academic year. The other non-operational asset at end-FY18 was Scape Bloomsbury, in the heart of London WC1, where refurbishment has subsequently been completed, allowing the property to open, offering 432 beds for the 2018/19 academic year.

Not reflected in Exhibit 1 are the conditional forward purchase agreement entered into in October 2017 in relation to Scape Canalside, and the forward funding of Scape Brighton, agreed since year end. Scape Canalside is expected to be completed and then acquired by DIGS in time for the 2019/20 academic year, providing approximately 410 beds. The property is in the same locality as the group’s existing c 590-bed Scape East asset, opposite Queen Mary University of London. Scape Brighton, the second DIGS asset in the city, will provide c 550 beds and extensive communal areas, with c 1,500 sq ft of retail space, on the primary campus of Brighton University. It is expected to be operational in September 2020, in time for the 2020/21 academic year.

DIGS is differentiated by its highly selective approach to the locations in which it invests, and the investment manager continues to review a number of investment opportunities that meet its criteria and which it believes to be attractive. The vast majority of the portfolio continues to be focused on assets in and around London. However, the investment manager has identified the student accommodation markets in cities such as Brighton, Bath, Bristol, Oxford and Cambridge as having similarly favourable supply/demand dynamics to London, with the potential to deliver long-term, sustainable rental growth and value. In practice, investment opportunities in Oxford and Cambridge are scarce, but DIGS is already invested in Bristol (Water Lane apartments) and now has two investments in Brighton, which like London has an undersupply of student accommodation perpetuated by restrictive planning guidelines. The University of Sussex (a top 20 UK university located in Brighton) and University of Brighton have c 36,000 students (c 7,500 international students), while Brighton is also home to two of the largest English language foundation course providers. There are 6,800 beds available to students in Brighton, of which only 240 are in direct-let, private PBSA. Other than the 1,000 beds that will be provided by Circus St and Scape Brighton, just 500 PBSA beds have been consented for development in Brighton.

The blended net initial yield (NIY) was 5.04% at end-FY18, an increase from 5.00% at end-FY17, with the increase driven by asset mix. Valuation gains were recorded on each individual asset, and NIY compressed for all but The Pad.

The completion and full letting of Scape Wembley during FY18 contributed a valuation uplift of c £12m, although its £90.4m year-end valuation continues to reflect an NIY of 5.25%, above the portfolio average. The investment manager expects the post year-end completion and letting of Scape Bloomsbury, a prime central London asset, to also have a positive valuation impact of between £8m and £12m.

The continuing attraction to investors in PBSA assets, particularly London-based assets, is evident from recent market transactions, and may indicate scope for further portfolio yield tightening. The investment manager notes the impact of recent transactions involving the London-focused Pure Student Living and Chapter portfolios, with an estimated aggregate value of £2.4bn, in supporting yield compression across the London market. It was reported in the media that the £870m sale of the Pure Student Living portfolio reflects a yield of just above 4%, and the investment manager believes that this was consistent with the yield on the partial sale of the Chapter portfolio of London assets. It is a common for a premium to be paid for assets acquired on a portfolio basis compared with standalone property valuations. This makes a direct read-across to the standalone property valuations that comprise the DIGS portfolio value difficult, although the positive implications of this continuing investor interest are clear. We estimate that a 50bp tightening in the blended DIGS portfolio yield would increase NAV per share by c 22p.

With demand for higher education remaining strong, there continues to be an undersupply of purpose-built student accommodation nationally, although some regional pockets of over-supply have emerged. For London and a number of other core markets with similar demand-supply characteristics, the position of undersupply remains very clear. For London in particular, increasing global demand for the world-class educational facilities that it offers, combined with a significant undersupply and substantial obstacles to new development, represents an attractive environment for investors.

The differentiating features of the London market can be summarised as:

UCAS data for applications to UK universities as at 30 June 2018 (for the 2018/19 academic year) stood at c 637k and, although down 2% on the same point in 2017, this will have no discernible impact on student numbers, with c 1.3 applicants for each student place. Within total applications, demand for international students has continued to grow. EU student applications are up 2%, and other international students up 6%. Helping to counter Brexit uncertainties, EU students entering in the 2018/19 academic year are guaranteed the same fee rates as UK students, as well as access to student finance for the duration of the course. The decline in UK-domiciled applicants seems largely driven by demographics, although the long-term decline in the number of UK 18- to 20-year-olds should begin to reverse from 2020, while the desire to go to university, measured by participation rates, remains strong with more UK 18 year olds going to university than ever before.

In the period from IPO (20 May 2013) to the last published quarterly NAV at 30 June 2018 (end-FY18), DIGS has generated an EPRA NAV total return (dividends reinvested) of 91.2% on the opening NAV per share (after issue costs) of 97p, or an annualised compound return of 13.5% pa. Over the same period, the share price total return (dividends reinvested) was an aggregate 82.3% on the IPO price of 100p, or an annualised compound return of 12.5% pa. The share price has risen since 30 June 2018, taking the aggregate return to 87.9% or 12.6% annualised (as at 10 September 2018.

Both the NAV and share price total return are well ahead of the 8–10% target for long-term shareholder returns set by DIGS at IPO, including growing dividends per share and modest long-term capital appreciation.

The DIGS NAV total return to 30 June 2018 is ahead of the broad UK commercial property sector, the FTSE All-Share Index, and UK gilt returns over one, three and five years, and since inception.

For much of the period since IPO, DIGS has traded at a premium to NAV (including income), of up to a peak of 12% (Exhibit 7). The main exception to this was in the aftermath of the mid-2016 EU referendum result, but also during the 12 months to March 2018 there was a steady de-rating, to a c 7% discount at the low point. The shares have since moved higher to trade at a modest premium of 0.6%, but still remain below the average since IPO of c 5%.

Over the same period the broad UK-listed property sector has shown a more marked reduction in P/NAV, with valuations failing to keep pace with NAV growth. The effect has been more noticeable for those companies in the mainstream commercial property segment that are more dependent on asset management/development initiatives to drive capital appreciation, and generally less so for income-focused companies, which is how we would describe DIGS.

In Exhibit 9, we focus on the three UK-listed student accommodation companies, DIGS, Unite and Empiric, showing summary valuation and share price performance data. In terms of share price performance, and unlike the broader UK-listed property sector and FTSE All-Share Index, both DIGS and Unite are trading very close to 12-month highs, and although the Empiric share price is still some way below the 12-month high, the shares have recovered from the low point following its internally driven trading problems in 2017 and reduced dividend guidance. Investor interest in the student accommodation subsector remains positive.

DIGS offers a higher dividend yield compared with Unite, the largest of the three, yet it trades on a lower P/NAV and its share price rise over the past 12 months has been less. This suggests further potential for the DIGS share price to appreciate, supported by the continuing strong fundamentals in its target areas of the market, and as additional refurbishment/development assets come on stream to support earnings, cash flow, and dividend cover.