Standard Life Investments Property Income Trust — Strong track record in UK commercial property

As shown in Exhibit 2 (left-hand side), total returns from UK property are higher than total returns from both UK equities and UK government bonds over the last three and five years, while lagging over 10 years. There is a general level of uncertainty in the UK commercial property market due to the ongoing Brexit negotiations and while there are currently few signs of stress, a broad economic downturn could lead to lower demand for commercial property, putting pressure on yields and asset values. However, closed-end property funds are at a distinct advantage versus open ended-funds as they do not face the same liquidity issues, which allows them to take a longer-term view.

Launched in December 2003, SLI is registered in Guernsey and listed on the London Stock Exchange. The trust converted to a REIT status in January 2015, which means it does not pay UK corporation tax on rental profits or chargeable gains and must distribute at least 90% of its real estate profits. Lead manager Jason Baggaley, who is able to draw on the well-resourced real estate team at Aberdeen Standard Investments, aims to generate an attractive level of income, with the prospect of income and capital growth from a diversified portfolio of UK commercial properties. SLI is currently invested directly in the three main industry sectors of retail, office and industrial, but investment in alternative areas such as hotels and student housing may also be considered, and a maximum of 10% of the portfolio may be invested in co-investments and property development. Baggaley focuses on quality assets in good – but not necessarily prime – locations, with good tenant demand and the potential to enhance returns through asset management. No single property may be more than 15% of total assets and no single tenant, excluding the government, can represent more than 20% of the rent roll. Gearing of up to 65% of gross assets is permitted and the loan-to-value ratio is capped at 45% (calculated as net debt as a proportion of the property portfolio’s market value). At end-September 2017, SLI’s loan-to-value was 21.6%. SLI is benchmarked against the IPD Monthly Index Funds (quarterly version).

Baggaley says that the outlook for the UK commercial property market is difficult to forecast. He says that in terms of pricing, activity levels and behaviour, it seems to be late in the investment cycle although, even after a multi-year period of strong UK commercial property returns, he is unsure what will cause the cycle to end. There is a macro overhang due to Brexit uncertainty; however, property yields remain attractive versus those available from a variety of other asset classes, such as government bonds and cash. UK commercial property supply and demand are generally well balanced, although there are pockets of higher supply, such as in central London. There are also areas where demand is more robust, such as in the Thames Valley and areas around key infrastructure projects such as the planned High Speed 2 rail line and the expansion of Heathrow Airport.

Commenting on uncertainty caused by Brexit, the manager says that tenants are delaying moving where possible, with some tenants requesting breaks in their new lease agreements. However, Baggaley suggests that there has been similar uncertainty for the last ten years, due to a variety of factors. As part of its ongoing asset management initiatives, SLI structures its contracts with tenants to ‘offer rewards for staying and penalties for leaving’, although it is willing to negotiate with tenants to provide a mutually beneficial outcome. Baggaley notes that if a building has been refurbished, there is a good chance that a tenant will not exercise a break clause in its contract, as this is often a significant investment for the tenant, maybe costing two-to-three years in rent payments.

Of the three major property sectors, Baggaley is more optimistic in general on the outlook for industrial, than office and retail, as industrial valuations are increasing in aggregate. However, he cautions that the valuations of some low-quality industrial assets are unrealistically high, which he cites as evidence that it is late in the UK commercial property investment cycle. On the positive side, there is very strong rental growth in industrial warehouses within the M25. This is led by retail companies, which are building out their online operations and limited supply is leading to higher rents.

Lead manager, Baggaley says he focuses on “good-quality properties, with good tenants, in good locations”. Typical initial purchase lot sizes are £5-15m, which can be under-researched, offering the potential for revaluation. SLI’s portfolio is actively managed in order to maximise asset values and rental growth. This primarily involves renegotiating new (generally higher) leases with new or existing tenants, and refurbishments, which can attract new tenants and enhance the value of a property. During H117 (six months ending 30 June), there were a number of asset management initiatives, including seven new lettings securing £519k of rent, and seven rent reviews generating an additional £111k per annum. Unusually within the property industry, SLI collects its own rent, which builds stronger relationships with tenants and can provide advance warning if a client is in financial difficulty. The trust’s record of collecting rent within 21 days is now back up to 100%. At end-September 2017, SLI’s voids were up to 7.9% versus 6.7% at end-June 2017 and 3.3% at end-2016. However, the manager says that the void level has declined since end-September and is currently broadly in line with the industry and a small level of voids is unavoidable. Recent asset purchases have generally had multi-let tenants, which reduces the risk of large voids; SLI now has c 250 individual tenants, with the top 10 accounting for 34.3% of total rent (Exhibit 3).

The structure of SLI’s portfolio at end-September 2017 remains similar to end-March 2017, which was included in our last published May 2017 report, with a significant overweight exposure to industrial property versus the benchmark, a modest underweight in offices and meaningful underweight exposure to the retail sector (Exhibit 4). As shown in Exhibit 5, SLI’s portfolio is diversified by region, with less than 50% invested in London and the South East.

Baggaley comments that recently there have been an above-average number of transactions announced. He suggests that he would like to slow the pace of transactions, but is working hard to ensure that SLI has a resilient portfolio in the event of a slowdown in the UK commercial property market. The manager comments that the majority of sales have been agreed at above the property’s last valuation level. Recent transactions include:

As shown in Exhibit 6, SLI’s one year to end-September 2017 NAV and share price total returns of 15.2% and 18.1% respectively are meaningfully ahead of the benchmark’s 9.6% total return.

SLI’s relative total returns are shown in Exhibit 7; the trust has outperformed the benchmark in NAV and share price terms over one, three, and five years, and also over 10 years in share price terms. Baggaley suggests that the reasons for SLI’s strong relative performance are: 1) active portfolio management – he is happy to take profits and reinvest when more attractive opportunities are identified; 2) the manager seeks to invest in areas of the market where there is less competition, such as smaller lot sizes, which are selling at attractive prices; and 3) Baggaley has a flexible approach – he is currently looking at c £12m purchases versus a more typical £5m, as the larger lot size is where he is finding greater value.

Having traded at a discount due to a period of uncertainty following the Brexit vote, when a number of open-ended property funds suspended trading and/or introduced dilution discounts, SLI has returned to trading consistently at a premium. The current 5.5% premium to NAV compares to the range of premiums of 4.7% to 13.6% over the last 12 months, and is broadly similar to the 8.0%, 6.6% and 7.7% average premiums of the last one, three and five years respectively. SLI has been issuing equity in response to investor demand, aiming to limit the size of the premium. However, activity has been relatively modest: so far in 2017, 13.2m shares (3.5% of shares in issue at end-2016) have been issued raising £11.6m, with proceeds used as working capital and for property refurbishments.

SLI is a conventional investment trust with one class of share; there are currently 394.4m ordinary shares outstanding. On 28 April 2016, the trust entered into a £145m debt facility with Royal Bank of Scotland, comprising a £110m seven-year term loan at three-month Libor plus 1.375% and a £35m revolving credit facility (RCF) at Libor plus 1.2%. The cost of the term loan was subsequently hedged and is fixed at 2.725%. At end-September 2017, the RCF was undrawn and the portfolio’s loan-to-value was 21.6%, which compares to 26.0% at end-2016. Baggaley says that if he was to utilise the RCF to finance an attractive investment opportunity, he would look to repay this debt as soon as possible. Given this caution on the outlook for the UK commercial property industry, he would like to keep the loan-to-value around its current level, which is towards the low end of the historical range.

A tiered annual management fee has been in place since 2014; 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. There are no performance fees. In FY16, the ongoing charge was 1.7%, which was 20bp higher than in FY15 (which was reduced by a one-off £400k contribution to costs from the investment manager following the major portfolio purchase in December 2015).

In FY16, the 4.76p annual dividend was 2.5% higher than in FY15, and was more than covered by income. As at 30 September 2017, SLI had a dividend yield of 5.3%, which compared favourably to the 3.6% yield on the FTSE All-Share REIT index and the 3.7% yield on the FTSE All Share index. The 1.19p Q317 dividend was only 97% covered by income, but the 3.57p 9M17 dividends were 106% covered. SLI’s board is confident that dividend cover will be maintained in the future. Based on the current share price, SLI has a dividend yield of 5.2%.

In Exhibit 10, we highlight the trusts in the AIC Property Direct – UK sector with a market cap above £100m, which have been trading for more than one year. SLI’s NAV total returns are ahead of the peer group average over one and five years, ranking second out of 12 and 7 funds respectively, while lagging over three and 10 years. The trust is one of eight funds that are trading at a premium. SLI has a lower than average ongoing charge and no performance fee is payable. Reflecting the manager’s level of caution, the trust has lower gearing versus the peer group average, while its dividend yield is fourth highest out of 12.

There are five directors on the board of SLI, all of whom are non-executive and independent of the manager. Chairman Robert Peto was appointed in May 2014 and assumed his current role in June 2016. The other four directors and their dates of appointment are: Sally Ann Farnon (July 2010), Huw Evans (April 2013), Mike Balfour (March 2016) and James Clifton-Brown (August 2016).