Town Centre Securities — Delivering on strategy

Before discussing the TCS investment case in greater detail, for investors who are already familiar with the company we first provide a brief overview of the recent interim results for the six months ended 31 December 2018 (H119).

The key financial highlights of the H119 results were:

Town Centre Securities (TCS) is a UK Real Estate Investment Trust (REIT) operating a mixed use and increasingly diversified portfolio across the UK, but with a regional focus, primarily in the two strongly performing northern cities of Leeds and Manchester (77%), as well as Scotland and (mainly suburban) London. It also has a car parking operation (CitiPark) that provides a growing and complementary revenue and earnings stream while monetising what would in some cases be empty, non-income producing development assets. The value of its investment properties, developments, joint ventures and car parks at 31 December 2018 (H119) was £368.5m. It is intensively managed, exploiting a strong and detailed knowledge of the communities in which the company operates to generate increasing levels of income, long-term dividend growth and good levels of NAV total return. Over its 58-year history, TCS has established an unbroken record of increased or maintained dividend payments.

TCS was founded in 1959 by Arnold Ziff, father of the current chief executive and chairman, Edward Ziff. The company listed on the London Stock Exchange soon afterwards, in 1960, and became a UK REIT in 2007. Members of the Ziff family continue to have a substantial interest in the company, strongly aligning the interests of management and all shareholders and contributing to the company’s long-term strategic horizon, focus on dividend payments and intensive asset management of existing assets. A relationship agreement exists between the Ziff family concert party with a combined shareholding of c 52%, and whose principal shareholders are Edward, his brother, Michael Ziff, and sister, Ann.

The executive team consists of the chairman and chief executive (Edward Ziff), the group finance director (Mark Dilley), the property director (Lynda Shillaw) and the managing director for CitiPark (Ben Ziff, Edward’s son). Biographies can be found on page 17. The board of directors consists of eight members, five of whom have been appointed within the past three years. In addition to the executive members, the four non-executive members are Michael Ziff (appointed 2004), Ian Marcus (2014), Paul Huberman (2014), and Jeremy Collins (2018).

The current developed portfolio primarily consists of commercial assets, particularly retail and leisure assets and, to a lesser extent, offices, but also includes some associated residential assets. TCS has been investing to diversify the sector exposure of the portfolio and current and planned development projects will see the share of low volatility residential assets in particular increase further. Management recognises that property values and income can reach mature levels where the potential for future returns become muted, especially in a lower growth environment and a key element of the strategy for long-term value creation is the recycling of capital from such assets into new opportunities, including an exceptionally strong pipeline of development opportunities from within the existing estate.

Exhibit 5 shows a summary of the total group portfolio including the car parking assets, as at end-H119. Compared with the balance sheet presentation of the assets, the table excludes non-income generating joint ventures and some other accounting adjustments, including for finance leases and goodwill.

Completed, income generating investment properties represent 84% of the total by value (£324.2m) and 87% by estimated rental value, or ERV (£23.1m). Income is also generated by the car parking activities from dedicated car park assets as well as certain land sites earmarked for medium-term development. Investment property ERV was £2.6m (13%) ahead of the passing rent at end-H119, which represents one source of potential income growth from the current portfolio. With end-H119 occupancy already at a good level of 96% (up from 95% at end-FY18), the majority of the reversionary potential is attributable to rent reviews and lease expiry opportunities.

During H119, TCS completed the acquisition of three assets, most notably the acquisition of The Cube and also completed the sale of the Rochdale Retail Park. The Cube is a high yielding mixed use property situated opposite the Merrion Centre in Leeds. The £12m purchase price represents an immediate yield of 12.5% on the passing income and the yield is expected to remain above 9.0% after lease expiries in 2019 and 2020. TCS plans future capex of up to £5m. The £13.2m Rochdale sale, £1.0m below the end-FY19 valuation, is consistent with the company’s strategy of recycling mature assets, especially given the mounting pressures on out of town retail assets, and reduces retail income and valuation risk further.

In terms of overall portfolio positioning, retail and leisure (combining ‘retail & leisure’, ‘the Merrion Centre’ and ‘out of town retail’ in Exhibit 5) remains the single largest sector weight in the portfolio but has been actively reduced to 52% (from 70% two years ago). Geographically, the strongly performing cities of Leeds and Manchester combined represent 77% of the portfolio by value and remain core to that strategy, and home to the majority of the group’s extensive pipeline of development opportunities that should be a major driver of future growth.

The significant, and ongoing, repositioning of the portfolio, driven by capital recycling and the group’s development programme, can be clearly seen in Exhibit 6. In the two and a half years, since the end of FY16, nine properties have been sold for £46m (11% of the portfolio), including the sale of Rochdale Retail Park, and six properties have been acquired for £29m. Three of these acquisitions, amounting to £16m, occurred during H119. A further £30m has been invested into development projects (eg the recently completed ibis Styles and Premier Inn hotels in Leeds, and the Merrion House redevelopment).

TCS is not exiting retail, and while it has reduced the overall exposure it remains committed to investing the appropriate formats in the right locations. The Merrion Center, the group’s single largest asset, is well placed in the centre of Leeds. It has been transformed over the past 10 years from a shopping centre to truly mixed-use destination. Delivery of the Merrion House office development (February 2018) and the ibis Styles hotel with restaurant (April 2017) have continued the process, with reliance on traditional ‘mall’ retail falling to less than 25%. Although not immune to retail pressures, the speed with which TCS has been able to re-let vacated space on improved terms is an encouraging indicator of the robustness of the asset. TCS also plans further diversification of the centre and is developing plans that would potentially see the building of a new office tower above part of it.

More generally we would point to the diversification of the retail tenant base, with the 10 retail tenants representing more than 50% of overall retail rents. These include a number of strong tenant covenants including Waitrose and Morrisons (almost one-third of retail rents in aggregate). Rents are mostly collected a quarter in advance, and across the portfolio 97% of collections typically occur within four days of the quarter start.

On a like-for-like basis the portfolio decreased in value by c £8.1m or 2.2% during H119. Within this, the development site valuation was flat, with the valuation changes occurring in investment assets. The investment assets saw a 2.5% like-for-like decline (also £8.1m), focused on the retail assets, which saw a 4.3% reduction in value. With good levels of occupancy maintained, and like-for-like rental growth being achieved, the changes were driven by yield shifts.

The income statement revaluation movement of negative £11.2m includes c £2m of post-acquisition valuation adjustments at Ducie House and c £1m at The Cube as well as a small amount of acquisition costs. The acquisition of Ducie House for £9.0m in May 2018 included certain strategic considerations including the potential for the development of its car park as well as the ability to eliminate a right of light claim (estimated at £1.5m) by the previous owners in relation to TCS’s adjacent Eider House development. The end-H119 valuation of Ducie House reflects its investment property value without reflecting the future potential upon which its acquisition has been based.

The post-acquisition adjustment at The Cube reflects the approach of the anticipated lease expiries, and does not capture any potential benefit from TCS’s asset management plans.

In our forecasts we are not assuming future revaluation movements, either positive or negative. As a result of faltering growth and protracted Brexit uncertainty investors have become more cautious on future property returns, especially for retail assets where many tenants and locations face their own mix of structural and cyclical pressures. Whereas the regional office market continues to benefit from robust occupational demand and a lack of new supply, there is a widespread consensus that trading conditions for the retail sector will continue to be challenging. Further retail CVAs and administrations are a real prospect, and the fate of Debenhams, the largest occupier of non-food floor space in the UK, will be closely watched. However, we note that TCS has no exposure to Debenhams or other major high street retailers. For properties across the UK, the UK Consensus Forecasts published by the Investment Property Forum is pointing to weaker capital values in 2019 for all sectors other than industrial assets. After income returns, this still translates into a negative annual total return for retail assets (-5.3% capital growth and -1.1% total return; for standard retail; -8.2/-3.4% for shopping centres; and -6.5%/-1.0% for retail warehouses). Fundamentally, the picture is very mixed across the retail sector, and a strong investment case can be made for assets that are sensibly priced, trading well, and meeting the needs of their catchment areas. For this reason, we would caution against making any direct read-across from the national consensus view to TCS’s specific assets, but the potential headwind to valuations is clear, even where the assets continue to provide a robust income performance. We discuss the sensitivity of our forecasts to potential valuation movements on page 13.

TCS has a very significant pipeline of development opportunities within its current portfolio, much of it with detailed planning consent or forming part of the local strategic framework (Exhibit 9). This represents significant potential for future growth in income and capital, subject to financing. Including the Burlington House residential development that is nearing completion, the pipeline projects now represent a potential gross development value of more than £590m with income estimated by management at £34.5m. The majority of the projects by value are situated within two strategic development sites in Manchester (Piccadilly Basin) and Leeds (Whitehall Road), two strong regional markets. Other projects include further developments at the Merrion Centre. The pipeline has continued to strengthen, most recently with the addition of Ducie House in Manchester, which offers the opportunity of a development on its car park. In Leeds, TCS has also now submitted a scheme to planning for a 17-storey office development above a disused cinema at the Merrion Centre.

The projects are listed in Exhibit 9 in line with management’s current best view of the likely order in which they may proceed, although this is subject to material variation according to changes in the marketplace. Our forecasts reflect those projects that management expects to commence in the near term. Taken as a whole, the pipeline represents a significant financing requirement and management continues to explore how best to achieve this and unlock the value. Certainly we expect the TCS funding requirement will be managed by continuing to spread the developments over time, the use of joint ventures, and capital recycling (selling some assets on completion to fund ongoing investment). Notwithstanding the funding challenge, the opportunity for continued value creation from intensive asset management is clear. Working back from management’s expectations for yield on cost, the implied development profits are more than £85m.

As discussed below, in addition to completing the Burlington House private sector residential (PRS) project (expected in May 2019), our forecasts allow for a second PRS scheme at Eider House, and the George St aparthotel JV with Leeds City Council, which has now received detailed planning consent, to be completed before the end of our forecasting period (FY21), but with little income impact in the period. We also include capital expenditure (and temporary loss of car parking income) in respect of the Whitehall Rd, Leeds car park, but again completion comes too late to contribute to income.

The TCS car parking operation, known as CitiPark, is a material contributor to the group, generating c 28% of H118 net revenues and c 31% of operating profits. To support its growth, CitiPark has invested in technologies to improve its customer service, operational efficiency and marketing reach. We believe that it provides a number of benefits to the group, including:

TCS has a strategic investment (c £2m in loans and equity) in fast growing, non-listed YourParkingSpace.co.uk (YPS), in which it has a 15% stake. YPS is an on-demand parking service that connects drivers with more than 250,000 parking spaces across the UK via its website and mobile application. TCS is excited about the growth potential for YPS and the possibilities for the two businesses to work together, and says that YPS continues to deliver promising results.

In this section we provide a detailed update on our multi-year financial forecasts. A summary of our forecast revisions is shown in Exhibit 10, with reduced recurring EPRA earnings (a mix of revenue and cost factors) and NAV (the H119 revaluation moves and a more cautious outlook) in each of the years. Both are negatively affected by pushing back development activity, which defers the income and potential development benefits into FY22, outside the forecast period. However, we have not changed our DPS forecasts, which we expect to be fully covered by EPRA earnings. Moreover, we show how existing capital resources (equity and debt facilities) should be adequate to meet our development funding assumptions.

A summary of our earnings forecasts for the property rental segment is shown in Exhibit 11. Our assumptions include:

The JV contribution included within the property segment forecast includes Merrion House, the on-site development at Burlington House, and planned developments at George Street and Eider House.

Management expects the Burlington House development to complete in May 2019. We then expect the 50:50 JV to generate c £0.6m pa of rental income (TCS share) and c £270k of earnings after JV borrowing costs. Based on management’s revised £22.6m GDV, which is lower to reflect its being held as a PRS asset, we no longer forecast a development gain on completion.

The main change to our overall JV forecasts is to defer development at Eider House by around a year. TCS has confirmed that it expects to proceed as a JV but is exploring a change to the detailed planning consent, potentially increasing the number of residential units to 149 from 128. We now allow for construction work to start early in H220 (was H219), completing late in H221, too late to contribute towards FY21 income or development gains in the forecast period.

Our Merrion House forecasts reflect the refinancing that occurred early in H119 whereby it received £26.4m in cash upfront in settlement of its future contracted rental entitlement. The forecast earnings reflect the continuing accounting recognition of the TCS rent entitlement, partly offset by an interest charge on the prepayment calculated on an effective interest rate basis.

We have also slightly delayed the start date for the construction of the George Street development, by around six months, to early H120, with completion early in H221. The 50:50 JV development is expected to generate c £0.6m pa of rental income (TCS share) and assuming no debt within the JV, we expect a similar level of earnings. As the project has progressed, TCS now indicates a higher GDV at completion and our forecast development gain is now £2.1m (was £0.9m) in H221.

Exhibit 12 summarises our updated forecasts for the JV capital, income and valuation movements in respect of the developments contained in our forecasts.

The ibis Styles hotel is situated within the Merrion Centre and opened in April 2017. The hotel and restaurant incorporated within is operated under external contract. Management says that the hotel operations have traded well, exceeding expectations, but the original restaurant format struggled and has been repositioned, negatively affecting H119 performance by £0.1m. The success of competing local independent restaurants indicates there is local demand for the right offering, and positively the new format restaurant has received favourable early reviews. Our forecasts are unchanged, anticipating a rather flat year this year with performance continuing to build up to FY21.

Based on a continuing strong performance in H119, we have increased our forecasts for operating profit before valuation movements by c £0.5m pa over the forecast period. Our forecasts look for c 4% pa underlying revenue growth off a stronger than previously assumed revenue base. We expect a temporary loss of c £0.6m pa of revenue for 12 months (from the beginning of H221) while the Whitehall Road, Leeds car park site is partly decommissioned in order to construct a new multi-storey car park. The temporary closure negatively affects our FY21 forecast by c £0.3m, while revenue benefits expected from the new car park fall outside our forecasting period. Management’s revised development pipeline data suggests that the eventual uplift may be greater than the c £0.6m that we had previously assumed.

Although we have reduced both earnings and NAV expectations through FY21, our analysis indicates that post the Merrion House refinancing TCS continues to have adequate financial resources to fund the distributions and development activity that we have assumed.

Total financial liabilities at end-H119 were £187.1m, comprising a blend of £105.9m of long-term fixed-rate borrowing (5.375% First Mortgage Debenture Stock 2031), £76.8m of revolving bank credit facilities (including a £5m overdraft facility), and finance leases amounting to £4.4m. We focus on the amount (‘gross borrowing’) excluding the finance leases (£182.7m).

There are three revolving bank debt facilities, all recently extended or renewed with no material impact on the cost of borrowing. A facility with RBS was extended to 2021, Lloyds refinanced with a new three-year facility to 2021, and Handelsbanken refinanced with a new five-year facility to 2023. The aggregate of the bank facilities is £103m, and including the debenture the total existing debt facility, excluding the £5m overdraft, is c £209m.

The weighted average maturity of the debt at 31 December 2018 was 8.1 years with a weighted average cost of debt of 4.2%. Adjusting for the £13.2m cash proceeds of the Rochdale Retail Park sale that were paid in early January 2019, the LTV was 46.8% (end-FY18: 47.5%).

The £26.4m net inflow from the Merrion House refinancing had a significant impact on the H119 funding position. This is included in the ‘distributions from JV’ line in Exhibit 15. This shows a summary of our forecasts for TCS cash flow and borrowing requirements during the forecast period. Over the three-year period, we expect operational cash flow to more than cover dividends paid. Gross new direct (wholly owned) portfolio investment is forecast at £42.4m and gross investment in JVs is forecast at an aggregate £66.0m. The JV investments are shown in Exhibit 12 above and our gross direct investment includes the purchases completed in H119, recurring capex of £2.0m pa, investment in The Cube of £5.0m, and initial investment in the Whitehall Road, Leeds car park of £5.0m in H221 (we anticipate a further £5.0m in FY22, although this is outside our forecast period). Almost half of the £60.0m direct and JV investment is offset by distributions from the JVs, substantially reflecting the Merrion House refinancing, and around half of the balance is offset by the H119 disposals (we assume no others although they are quite likely). This leaves a net funding requirement of £16.6m (from end-FY18 to end-FY21), which in our forecasts is met by £14.0m of new borrowing and a £2.6m reduction in the start of period cash balance. The additional borrowing takes forecast gross borrowing, which can be seen in the group financial summary (Exhibit 19), to £207.7m by end-FY21, an increase from £193.6m at the FY18. Given that the debt facilities are secured by individual properties charged to each facility, it may be challenging for TCS to increase borrowing to this level under the existing facilities. If necessary, management could adapt by asset disposals or spreading the investment plans.

As noted above, we are not assuming any changes in property values in our forecasts but do include potential development profits, where appropriate, in respect of the development projects. This amounts to £2.1m (TCS share, in FY21 in respect of the George St development).

During H119, the like-for-like unrealised movement in the TCS portfolio value was 2.2%. As noted above, the Investment Property Forum Consensus (Autumn 2018) is for 2019 UK-wide capital values in all of the main property types, other than industrial, and especially in retail. Of course, any individual asset should be expected to vary considerably from this, particularly relating to its quality, location and tenant covenant.

By way of illustration, should valuations reduce further, each 1% decline in like-for-like portfolio valuation is equivalent to £3.6m or 6.8p per share. A similar like-for-like valuation decline in H219 to the -2.2% H119 movement would negatively affect valuations by £8.0m and NAV per share by c 15p.

In Exhibit 16 we show a range of potential outcomes, both for the impact of NAV should valuations decline further, as well as on LTV. For illustrative purposes we show the rather extreme example of a 10% decline. It is important to note that this is a static sensitivity that allows nothing for management actions.

In terms of borrowing covenants, it is disclosed by TCS that the debenture debt has a collateral requirement of 1.67x with temporary flexibility down to 1.5x, suggesting that c £185m of collateral would be a comfortable target. Excluding this from chargeable assets of, say, c £340m (we understand that there are a few that are not chargeable) would leave perhaps £155m to support the bank debt. Based on the end-H119 drawn bank debt, the LTV implied by our analysis is a comfortable c 50% compared to what we believe would be a requirement of between 60–65%. By FY21 we look for bank borrowing to increase to c £103m, which based on our current estimate of chargeable assets would imply some use of the debenture covenant flexibility. If we assume full use of the debenture flexibility down to 1.5x cover, we estimate that our c £102m FY21 bank borrowing requirement should be supportable so long as chargeable asset values fall no more than c £15m or 4–5%. Beyond that we believe management may have to consider additional asset sales, deferral of some development activity, or other measures. We estimate interest cover at c 1.7x.

TCS has a strong focus on growing portfolio income to support its long-term progressive dividend policy, although its active asset management strategy, aimed at enhancing long-term total return, means it is not focused on yield maximisation over the shorter term. In this context we think it informative to examine NAV total return performance (the change in NAV per share plus dividends paid). The aggregate NAV total return over the five and a half years to end-H119 is 58.6%, including the negative unrealised valuation effects in H119. This represents a compound annual total return of 8.7%. It is worth noting that 40% of the total return generated over the period is attributable to dividends paid.

The investment in portfolio repositioning and development required to generate these returns is a limiting factor on immediate dividend distributions, but TCS has a long and consistent track record of dividend payments, increasing or at least maintaining DPS in each of the past 58 years, including during the last downturn in 2008. The shares provide a 5.3% yield and are trading at a significant discount to NAV of c 40%.

In Exhibit 18 we show a summary valuation comparison of TCS with what we consider to be a group of peers from within the broad property sector, including companies focused on regional property and those with retail exposure.

The group as a whole trades at a very slight yield premium to TCS but also at a higher P/NAV. Over the past 12 months the TCS share price performance has been weaker than the group average, which we ascribe to weak investor sentiment towards retail exposure. That said, TCS’s performance is notably stronger than that of purer retail plays, with significant shopping centre exposure, such as Capital & Counties, Hammerson, and Intu, which we believe is entirely justified by the more diversified nature of its portfolio. TCS provides an attractive yield, with a strong management commitment to dividends and an alignment of interest between management and shareholders. Additionally, its regional focus (Leeds and Manchester), increasingly diversified portfolio, and significant development opportunities for further growth are all potential catalysts for a re-rating.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but fluctuating with tenant demand and rent terms. For TCS we would highlight the near-term cyclical risks attached to retail-focused property and 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. We consider the main sensitivities include: