Standard Life Inv. Property Income Trust — UK REIT generates net income surplus in FY16

Exhibit 2 (right-hand side) suggests that the yield on the UK commercial property market remains attractive relative to gilts, even as gilt yields have risen from their lows. For a non-sterling based international investor, the yield on UK property appears more attractive than it did in June 2016, when sterling was significantly stronger relative to the major currencies than today. Thus, on the one hand, Brexit has encouraged overseas corporates to delay UK investment due to uncertainty, while, on the other hand, the compensating effect of the weaker pound is proving too hard for some property investors to resist – witness the recent sale of the City of London’s tallest tower, known as the Cheesegrater, to China’s CC Land.

While global economic and political uncertainty reign, however, tenants are unlikely to want to move premises since this would incur additional risk, distraction and expense. This can be viewed as positive for actively managed direct property funds, enabling them to keep a lid on transaction costs and maximise asset management potential to enhance and improve the sustainability of rental income for shareholders.

In the UK, rising inflation is potentially negative for UK consumer confidence but it seems unlikely to result in higher UK interest rates in the short term, given wages have stayed flat (save for the legislated rise in the minimum wage). This means that UK deposit rates are likely to stay low, encouraging UK savers to look elsewhere for income. A well selected portfolio of UK commercial property assets might be of interest to investors seeking a stable income return with some protection against rising inflation.

Launched in December 2003, SLI is a Guernsey-registered, closed-end UK REIT listed on the London Stock Exchange. SLI aims to provide shareholders with an attractive level of income, together with the prospect of income and capital growth through investing in a diversified portfolio of UK commercial properties. The portfolio principally invests directly within the three main commercial property sectors of retail, office and industrial. Although it does have the flexibility to invest in other commercial property such as hotels, nursing homes and student housing, but to date, has chosen not to. The board reviews SLI’s property income and total return performance against the quarterly version of the IPD Monthly Index Funds. Jason Baggaley, the investment manager, respects the broad collective experience and expertise of the board, seeing them as an additional layer of due diligence, and consults them before making new investments. A typical initial purchase lot size is £5-10m, an area of the market seen as under-researched with greater potential to find hidden gems. Standard Life Investments has been SLI’s investment manager since its launch in 2003, with Jason Baggaley acting as lead fund manager since September 2006. Baggaley, a qualified chartered surveyor, joined Standard Life Investments in 1996 and has over 26 years of real estate fund management experience. Baggaley is supported by portfolio managers Alex Thompson and Cameron MacKay, while an additional portfolio manager, Andrew Roberts, has recently joined the team on a full-time basis, providing further dedicated resource. Baggaley can also draw on the investment manager’s wider real estate team.

While the amount of annual rental income the manager seeks to generate to finance SLI’s attractive dividend payout remains relatively stable over the course of the cycle, the factors that affect the stability of that income tend to vary. Yields have compressed significantly in certain locations and sectors in recent years, affected by supply, tenant demand, tenant quality, availability of domestic and international capital, and the relative attractiveness of other asset classes. Baggaley notes that there are times in the cycle when he has the flexibility to invest across all sectors and locations without jeopardising SLI’s income requirement, since yields are high across the board. However, this is not the case in the current environment – yield compression in certain hotspots and falling demand for poor secondary and tertiary locations mean that Baggaley needs to be a little more canny, avoid the yield traps as well as the fashionable assets, and look to invest in undiscovered early cyclical plays where there is reversionary yield and asset management upside potential.

To generate SLI’s annual income requirement, Baggaley must be highly selective about where he invests: a tertiary retail property, offering a yield of 9% with two years of unexpired lease, may look attractive on the surface, he argues, but once that lease comes to an end or if the tenant defaults, and a void emerges, retail properties in poor locations can be hard to fill, meaning that “the 9% yield, rather than compressing to 8%, could as likely be zero within a short space of time”. The portfolio is then potentially stuck with a long-term void, something that Baggaley strives to avoid, since voids generate zero income and the capital value of that asset may fall. At the other end of the yield spectrum are the prime retail and office hotspots in central London, where yields have compressed so severely that there would need to be a precipitous fall in London property values before Baggaley would consider buying there again.

Currently, the manager is seeing the most attractive opportunities in the industrials sector, but even here value has become harder to find. As regards the outlook, Baggaley expects economic fundamentals to weaken as Brexit evolves. He shares Standard Life’s house view that UK inflation will continue to pick up in 2017/18, but sees that as an advantage for his asset class, since unlike conventional bonds, a property portfolio can provide a measure of inflation protection. The uncertain times through which businesses are currently navigating encourages tenants to remain where they are rather than look for alternative accommodation. This is positive from the manager’s perspective since it enables portfolio management costs to be kept down (fewer transactions and fewer voids).

The manager is focused on investing in good-quality, albeit not necessarily prime, UK commercial real estate assets situated in sound locations, where there is perceived to be sustainable tenant demand. Properties are selected that the manager believes will appeal to occupiers, where there is seen to be high reversionary yield potential, especially as a result of asset management activity. SLI’s income objective can influence both sector and geographic weightings, on the basis of relative yields. While being contra-cyclical is perceived as a potentially risky strategy, the manager’s purchase philosophy is to be ‘early’ cyclical: to acquire attractively priced assets whose future income return prospects are not yet appreciated. Once a trade becomes popular, it generally ceases to be attractive. Baggaley tends to focus on smaller lot sizes of c £5m. SLI collects its own rent and has a 99% record of collecting rent within 21 days. At end-March 2017, voids were at 3.2%, c 50% lower than the market average, although there is potential for this to tick up somewhat.

The portfolio reflects Standard Life’s current property strategy, while taking into account SLI’s income objective. In terms of portfolio activity, after the acquisition of 22 properties from Pearl in December 2015, a period of consolidation followed in 2016, during which no further purchases were made. Recent sales include the Quadrangle in Cheltenham and Interplex in Bristol in January 2017 – both required capital investment, while the latter was partially void. The most recent sale was White Bear Yard, an office in Farringdon (previously SLI’s largest holding). Profits were finally taken on this long-held property ahead of a lease expiry in 2019. This reduced SLI’s City of London office exposure to zero, having been gradually reduced in recent years as yields contracted and expectations of potential oversupply rose. The proceeds of the aforementioned sales were used to pay down debt and to make two new investments – an industrial unit in Sunderland adjacent to the Nissan plant and occupied by one of its suppliers, and a multi-let industrial scheme in Bristol fully let to seven tenants, providing the opportunity for asset management over the next three years.

SLI has an average unexpired lease term to the earliest of lease end or tenant break of 5.5 years. The benchmark has a slightly longer average of 7.4 years (excluding leases over 35 years). While some may be wary of shorter lease terms, Baggaley argues that so long as the building is in a good location, has an attractive initial yield, has reliable tenants and is of sound quality, then a short unexpired lease term is not an issue and is possibly an advantage. While the location of a property cannot be altered or easily improved, the lease has the potential to be regeared.

While the share prices of direct property funds fluctuated in 2016, SLI’s net rental income proved stable and contributed to both income and capital return. Offsetting this positive, capital values fell as the yield curve steepened following the Brexit vote. The marking to market of SLI’s swap liability (£3.6m) and its gearing also detracted. However, over one, three and five years, SLI’s NAV total return has outperformed the benchmark, as well as being strongly positive in absolute terms.

SLI has traded at a premium to NAV for most of the last five years but in June 2016, following the Brexit vote, and in common with all other direct property trusts, SLI’s share price moved to a discount, as retail investors sought to withdraw funds from the market. Shortly thereafter the discount narrowed sharply and moved back to a premium as the year drew to a close. In a low deposit rate world, demand for income remains strong and the current share price premium to NAV of 8.7% arguably reflects SLI’s income generation and real income growth potential. Regular issuance of new shares at a premium to NAV in 2017 (see Exhibit 1) has been accretive to existing shareholders.

SLI is a conventional investment trust with one class of share; following regular issuance in 2017, the ordinary share capital has increased and there are now 388.8m ordinary shares outstanding. SLI refinanced its debt facilities in April 2016: a new £110m seven-year facility and a £35m revolving credit facility were taken out, and a swap agreement was entered into. At the year end, having used sales proceeds to pay down debt, SLI had a net LTV of 26.0% (as compared with 28.1% at the prior year end) and an all-in rate of financing of 2.6% (2.7%). The annual management fee is tiered: 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. The ongoing charge was 1.7% for FY16, compared with 1.5% the previous year, reflecting the fall in capital value.

For FY16, the dividend was 4.76p, an increase of 2.5% on the prior year. In addition to retained earnings, there are substantial distributable reserves, and in conjunction with the outlook for future portfolio rental income, this makes the manager reasonably optimistic about future dividend prospects. At the December year-end, the dividend yield equated to 5.5%, comparing favourably to the end-December dividend yields of 3.7% for the FTSE All-Share REIT and 3.5% for the FTSE All-Share indices. Based on its current share price, SLI has a dividend yield of 5.4%.

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. In spite of its portfolio acquisition in 2015, SLI remains one of the smaller trusts in the peer group, enabling it to maintain its focus on smaller lot sizes without encountering liquidity issues. In terms of NAV total return, SLI has lagged the peer group over one and 10 years, but has outperformed the sector average over three and five years.

SLI has five independent non-executive directors following 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 over 30 years’ investment management experience. Sally Ann Farnon was appointed in July 2010 and Huw Evans in April 2013.