Custodian REIT — Good momentum through Q123

In addition to recent financial performance, this report covers CREI’s long-term performance and strategy. The strength of the FY22 result may be seen as exceptional, benefiting as it did from a bounce-back in property valuations as pandemic restrictions were progressively eased. However, recurring earnings and dividends also showed good growth, with rent collection back to pre-pandemic levels. A strong performance continued through Q123. Despite growing headwinds from rising inflation, only partly explained by the war in Ukraine, CREI remains positive about the strength of the regional occupier market and its ability to grow income further. It recognises the risk of property valuations being negatively affected on a broad scale by weakening volumes and sentiment in the investment market, thus far restricted to a minority of sub-sectors such as ‘big-box’ logistics. However, given the company’s focus on income driven returns, any falls in the valuation of those assets that CREI targets for acquisition would support reinvestment at higher yields, supporting earnings and enhancing dividend capacity.

The underpinning for CREI’s optimism is covered throughout this report, but in summary includes:

CREI will hold its annual general meeting (AGM) on 31 August 2022. Within the ‘ordinary’ business of the AGM we think it worth highlighting three proposals:

Although UK commercial property market returns have historically shown significant cyclicality, the income component has been much less volatile than capital values. CREI’s income-focused strategy has consistently generated positive annual total returns. From listing in March 2014 to June 2022 (Q123), it generated an EPRA NAV total return (without assuming reinvestment of dividends paid) of 73.3%, or a compound annual average return of 6.9% pa. Income return has represented the majority of the total return and has been relatively consistent. In the period from IPO to end-FY21, income contributed 100% of total returns, but the strong growth in property values and NAV in FY22 and Q123 has reduced the contribution to c 70%.

The relative consistency of income returns can be seen in the following chart and as interest rates rise, with negative implications for property valuations, we expect this trend to continue.

Reflecting CREI’s focus on higher-yielding, smaller-lot-size properties, the end-Q123 portfolio value of £699.8m reflected an average value per property of c £4.3m. Excluding the DRUM REIT acquisition, during FY22, CREI acquired six assets with an average lot size of £3.6m. The 10 DRUM REIT assets were acquired with an aggregate value of £49m.In FY23 year-to-date CREI has acquired seven assets with an average lot size of £5.9m.

Exhibit 3 compares the transaction net initial yields for properties below £10m versus those above, on a two-year rolling average basis, up to the end of 2021, the most recent available data. On this basis, over a c 20-year period the yield spread of sub-£10m transactions over those of more than £10m has averaged c 1.1%. At end FY21 the spread had widened to c 1.9% compared with c 1.4% immediately before the pandemic. In part, this widening may have reflected investor perceptions of relative risk to the extent that smaller properties may be disproportionately let to smaller tenants, perhaps more exposed to the impacts of the pandemic. Independent data provided to CREI indicate that the spread narrowed a little during Q122. It also indicates that the spread based on lot sizes of less than £15m is a little narrower than for lot sizes of less than £10m but is still clearly positive. As the recent acquisition data show, this does not mean that the intended change to investment policy necessarily indicates a new focus on larger, lower-yielding assets. Rather, the company will have increased flexibility to selectively invest in a wider range of opportunities.

The higher yield on smaller properties is often considered to reflect higher risk and typically a higher cost of management relative to income. However, smaller size does not in itself determine the quality of the property, its appeal to tenants, or the quality of tenant. While there may be less competition for assets from investors, there is an active owner-occupier market which supports vacant possession values and mitigates valuation risk. Asset selection and a long-term approach to investment are key to managing risk and of CREI’s strategy for producing an attractive risk-adjusted income return, more than sufficient to offset the additional administrative complexity. Other key elements of CREI’s investment strategy for achieving above-average risk-adjusted returns include:

Portfolio diversification provides a mitigation to risk in uncertain times such as these and CREI’s portfolio is well spread across the main commercial property sectors and by location, tenant and lease term.

At 30 June 2022 (end-Q123) the externally appraised portfolio value of £699.8m reflected a net initial yield of 5.5%, with a rent roll of £41.1m pa. Net transaction activity since has increased the rent roll to £42.4m and the number of properties to 164 from 161. The weighted average unexpired lease term to first break at end-Q123 was 4.7 years.

Of the 347 individual tenancies at end-Q123, the top 10 tenants represented a little more than 20% of overall rent roll, with rents from the largest tenant, Menzies Distribution, spread over eight individual assets. Menzies is one of the UK's leading urban logistics businesses.

Exhibits 6 and 7 show the sector and geographic spread of the portfolio. Geographically, it has minimal exposure to London, but exposure to every other region. It is split between the main property sectors, in line with the company’s objective of maintaining a suitably balanced portfolio, with relatively high exposures to the industrial, retail warehouse and alternative sectors (‘other’, including drive-through restaurants, car showrooms, trade counters, gymnasiums, restaurants, and leisure units), with relatively low exposure to offices and high street retail. Reflecting yield differences, by value, the industrial weighting is higher (48%) than the income weighting shown in Exhibit 6 and the weightings to offices (12%) and high street retail (8%) are lower. For retail warehouse and ‘other’, the differences are small.

Although the portfolio is diversified to manage risk, the investment strategy provides flexibility to adapt to changing market conditions. CREI seeks to position the portfolio to attract the best of occupational market demand through careful stock selection and asset management. This is reflected in active sector positioning and the high weighting currently to industrial and retail warehouse assets, together 69% of the portfolio by value (59% by income).

Asset management has been a key driver of both income and capital growth. This includes lease renewals and re-gears, rent reviews, new lettings, acquisitions and disposals, and investment in asset enhancement, including environmental improvement.

As a long-term investor, changes to the overall portfolio positioning have been evolutionary rather than revolutionary, but we highlight the following:

CREI’s investment manager expects medium-term rental growth across the market to broadly match inflation, although over shorter periods this relationship is influenced by the incidence of rent reviews (typically on a five-year basis) and the timing of lease maturities. At the end of FY22, 81% of CREI’s income was on an open market review basis3 and the weighted average unexpired lease term to first break across the portfolio was 4.7 years at end of Q123. While recognising the shorter-term visibility of index-linked reviews, the investment manager is cautious of the ‘bond-like’ characteristics this may create, and the potential for greater emphasis to be placed on the tenant covenant over property fundamentals. It notes that ‘at some point in a property’s lifecycle, rents will always be re-based to open market values. An over-reliance on index linked rent reviews can lead to disparity between investment values and underlying property values’. For this reason, CREI will continue to target good real estate where open market rent reviews have the capacity to deliver rental growth, aiming to ‘provide inflation protection from the bricks and mortar, not the lease contracts’. Although ‘under-renting’ across the CREI portfolio is relatively modest (c £0.4m), like-for-like ERV continued to grow through Q123.

While lease maturities reflect an element of income risk, they also provide an opportunity to reset rents towards or ahead of ERV. As at end-FY22, c 38% of portfolio rental income was due to mature over the following three years (Exhibit 11), representing a reasonable balance of risk and opportunity in our view.

CREI operates with moderate gearing and for most of its debt the interest rates are fixed. The end-Q123 net loan to value (LTV) ratio of 21.5% (21.7% including post-Q123 investment activity) remained below the medium-term target of 25%. A Q123 refinancing increased the proportion of agreed debt facilities that are fixed rate to 74% from 61%, providing significant protection against rising interest rates.

In June 2022 CREI arranged a £25m tranche of term debt with existing lender Aviva Real Estate Investors at a fixed 4.10%, using the proceeds to refinance a £25m variable rate revolving credit facility (RCF) with RBS. The RBS facility was acquired with DRUM REIT and was due to expire in September 2022.

Total agreed debt facilities now amount to £190m, of which £140m is fixed-rate debt with a blended cost of c 3.6% and average term to maturity of just under eight years. Including the shorter-term, flexible, floating rate RCF with Lloyds Bank, the total average cost of debt at end-Q123 was 3.2% with an average term to maturity of just over six years. Reflecting the impact of interest rate movements on CREI’s floating rate debt, we anticipate an increase to c 3.4% in the average cost of borrowing by end-FY23.

CREI has grown strongly since IPO, increasing an initial seed portfolio of c £95m to an end-Q123 portfolio valuation of c £700m, and it targets further accretive growth. For shareholders, the benefits of growth are for CREI to become a larger, more liquid and further diversified vehicle, appealing to a broad range of investors, that can benefit from scale efficiencies, spreading fixed costs over a wider income-producing asset base and ultimately reducing the marginal rate of asset management charges. With net assets now above £500m, the marginal asset management charge has reduced to 0.65% of average net assets (and the administration fee to 0.05%), and at net assets of more than £750m would fall to 0.55%/0.03%. Initial portfolio growth in the three years to end-FY19 was funded by significant equity raises. Net acquisition activity slowed noticeably in FY20, as attractive opportunities that met CREI’s investment criteria were more difficult to identify. Due to high demand for the shares, maintaining a consistent premium to NAV, net acquisitions were funded by share issuance under the company’s tap issue facility in addition to capital recycling. During the pandemic, activity slowed further but picked up in FY22, and to a lesser extent net investment, continuing into 2023.

FY22 was dominated by two main transactions. DRUM REIT was acquired for £43.5m, adding a portfolio of 10 assets with a valuation of £49m. The consideration was settled by the issue of new CREI shares. Also in FY22, a portfolio of nine industrial assets, non-core to CREI over the medium term, was sold for £32.6m, 19% above the start-year valuation.

Including DRUM REIT, during FY22 CREI acquired assets with an aggregate value of £63.5m (before costs) at a blended net initial yield of 6.6%. Properties with an aggregate consideration of £54.5m were sold, £9.6m ahead of the pre-sale valuation, at a blended 6.0% yield for those occupied.

So far in FY23, CREI has acquired properties for an aggregate £41.6m (before costs) at a blended net initial yield of 6.6% and disposed of properties for an aggregate £14.8m, £4.8m ahead of the end-FY22 valuation, at a blended 6.0% yield for those occupied.

While CREI’s preference is for selective individual property acquisitions, we expect it will also consider further strategic portfolio acquisitions and corporate acquisitions, seeking to benefit from sector consolidation. The company also sees the potential to take market share from struggling open-ended funds. Strategic disposals, particularly of mature assets, may provide capital recycling opportunities, but to significantly grow scale will require additional capital. Maintaining a moderate level of gearing, larger acquisitions will require additional equity and debt capital. Equity issuance for cash, including under the tap issuance facility, is unlikely while the shares trade at a discount to NAV, but given the above-average price to net asset value at which CREI shares trade, vendor placings and equity swaps are possibilities. This was the case with DRUM REIT, which had the added advantage of broadening CREI’s shareholder base.

Within its broader ESG strategy, CREI has seen a continuing improvement in the environmental performance of its portfolio. During FY22, the percentage of properties with an EPC rating of C or better increased to 73% from 59% in FY21 and the weighted average EPC score of the portfolio at end-Q123 was C (60) compared with C (61) at end FY22 and C (63) at end-FY21.

The company plans no EPC E-rated properties by 2025 and no D-rated properties by 2027 in line with MEES regulations.4 Most of the investment required to meet its these targets will form part of the existing rolling programme of asset enhancement and CREI will work with occupiers that share similar environmental performance goals. The company sees such improvements as an opportunity to benefit from improved asset quality, attractive to tenants, with enhanced rents and valuation, generating a positive return on investment. CREI’s ESG committee report in the FY22 annual report details its other targets and progress towards achieving these, and a next stage is to publish its net zero carbon pathway.

FY22 results were published in June 2022, reflecting CREI’s strongest ever year of total returns. On an IFRS basis, earnings increased to £122.3m from £3.7m in FY21, driven by a £117.0m swing in realised and unrealised property gains after acquisition costs (to £97.1m from a loss of £19.9m). Excluding capital gains, EPRA earnings also showed a good level of growth, increasing 6.7% to £25.3m or 5.9p per share (FY21: 5.6p). DPS declared for the year showed a continuing recovery, up 5% to 5.25p and was 110.3% covered by EPRA earnings, while rent collection returned to pre-pandemic levels. Custodian has subsequently published its quarterly update for the three months that ended 30 June 2022 (Q123), which shows further progress with a three-month total return of 3.2%.

Exhibit 15 shows a summary of the FY22 results. We highlight the following:

Further progress in Q123 included NAV growth of 2.1% to 122.2p, driven by a 1.7% like-for-like increase in portfolio valuations. ERV increased by 1.4% like-for-like and net capital deployment added 1.5% to annualised rent roll of £41.1m (end-FY22: £40.5m). Strong leasing activity saw 13 new leases secured, adding £1.8m of annualised rental income for an average 6.8 years. The positive impact of letting four vacant units was offset by vacancy at two industrial properties earmarked for refurbishment and another that has since been profitably divested, with EPRA occupancy reducing to 88.7% (end-FY22: 89.9%). A Q123 DPS of 1.375p, in line with Q422, is consistent with the FY23 target of at least 5.5p and was covered by EPRA earnings. Quarterly EPRA EPS of 1.4p (Q422: 1.6p) was affected by the timing of capital deployment and the change in occupancy.

The changes in our EPRA earnings forecasts are driven by higher administrative costs and net interest expenses.

The increase in administrative costs is substantially related to higher management fees, reflecting the strong growth in NAV and despite the lower marginal fee reducing with growth. We also expect other administrative costs to be higher than previously, in line with FY22. The increase in our forecast interest charge reflects borrowing costs rather than the level of borrowing.

Our gross rental income forecasts are little changed and reflect like-for-like ERV growth of c 2.8% in FY23 (Q123 c 1.4%). This may prove to be conservative given the growth currently being experienced. Similarly, our forecasts imply only a modest increase in occupancy from 88.7% at end-Q123 to c 89.0% at end-FY23 and 89.4% at end-FY24. We have assumed no acquisitions or disposals other than those already announced, although capital recycling is likely.

Following a 1.7%/£11.3m like-for-like valuation increase in Q123, we forecast c 2.6%/£18.7m for the year and flat in FY24. We estimate that a 0.5% increase in the valuation yield (Q123: 5.54%) would reduce NAV per share by c 14p.

CREI’s target DPS for FY23 of at least 5.5p represents a prospective yield of 5.2%. Based on our forecast DPS of 5.625p, the yield is slightly higher. Meanwhile, the shares trade at a c 13% discount to the Q123 NAV per share of 119.7p, below the average premium of c 3% since IPO.

In Exhibit 20, we show a summary performance and valuation comparison of CREI and what we consider to be its closest diversified income-oriented peers. CREI’s share price performance is above the peer group average over one and three years. For comparative purposes, the valuation data are shown on a trailing basis. CREI trades on a higher P/NAV than the average of the group, as it has done for most of the period since IPO, and its trailing yield is below average. Factors supporting CREI’s valuation include uninterrupted quarterly DPS during the pandemic (albeit at a reduced level), moderate gearing and a focus on smaller lot size properties with a yield premium that has historically supported risk-adjusted income returns.

Custodian REIT is an externally managed UK real estate investment trust (REIT), listed on the Main Market of the London Stock Exchange. Its portfolio of commercial property assets is managed with the objective of providing long-term, secure income with an attractive target dividend and long-term NAV growth. To this end, CREI looks to maintain a diverse tenant, region and sector mix with properties, outside of London, with high residual values and a lower risk of obsolescence. It is differentiated from most peers by investing in smaller lot-size assets of between £2m and £10m at the point of acquisition, where there is less price competition.

CREI’s board of directors typically comprises six members, all of whom are non-executive and responsible for the overall management of the company’s activities. The board is chaired by David Hunter, a professional strategic adviser focused principally on UK and international real estate, who sits on the boards of a number of listed and unlisted companies, as well as holding corporate advisory roles.

The independent non-executive directors are Hazel Adam, who joined the board in December 2019, bringing a range of experience including the buy-side and sell-side investment industry, strategies and markets; Elizabeth McMeikan, a former Tesco executive and experienced board member, appointed in March 2021; Chris Ireland, a former CEO of JLL UK and former chair of the Investment Property Forum, who also joined the board in March 2021; Malcolm Cooper, who has extensive board experience and a background in corporate finance, infrastructure and property, and who joined the board in June 2022, replacing Matthew Thorne, who will retire at the AGM in August 2022 after eight years’ service. Ian Mattioli, chief executive officer of Mattioli Woods and a board member of the investment manager, is also a non-executive board member but deemed not to be independent. Ed Moore, finance director of Custodian Capital, is company secretary to CREI. Full details of the board can be found at www.custodianreit.com/about-us-2/meet-the-directors/.

The company is externally managed by Custodian Capital (www.custodiancapital.com), a wholly owned subsidiary of Mattioli Woods (www.mattioliwoods.com). Custodian Capital was appointed investment manager at the IPO, an arrangement that is subject to regular board review. Richard Shepherd-Cross is the managing director of Custodian Capital and the fund manager of CREI. He is a former director of Jones Lang LaSalle in London, where he led the portfolio investment team before joining Mattioli Woods in 2009, with responsibility for its syndicated property initiative, the precursor to Custodian. In total, the Custodian Capital team that is dedicated to the management of CREI’s assets consists of 18 members, including six property professionals.

Management and administration fees are paid to the manager on a sliding scale that allows shareholders to benefit from growth in NAV. The fees on continued growth in NAV above £500m were reduced during the year.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. From a sector viewpoint, we also highlight 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. CREI’s development exposure is modest and limited to the improvement of existing properties. In this respect it may best be seen as an extension of its refurbishment activity, aimed at enhancing long-term income growth and returns. Forward funded development activity is likewise modest and, in our view, very low risk. More generally we note the sensitivity to: