Regional REIT — Continuing to deliver income-led returns

With the easing of pandemic restrictions, nearly all tenants (c 99%) have returned to occupation in some form, be it full time or hybrid, while the 14 that have not indicate an intention to shortly do so, and rent collection is now effectively back to normal. Rents due to 30 June 2022 have been 98.7%1 collected, compared with 96.4% in the equivalent period of 2021. Currently, more than 85% of rental income is collected within 30 days of the due date.

H122 occupational demand was strong, with 47 new lettings completed, totalling c 146k sq ft, which when fully occupied will provide an additional gross rental income of c £2.6m pa. Further lettings during Q322 have increased the year-to-date total to 62 lettings with an annualised rental value of c £3.3m, almost 90% of the full-year 2019 total, immediately prior to the pandemic.

The investment market has continued to provide opportunities to accretively recycle capital out of non-core assets and properties where asset management plans have been completed, into higher-yielding, higher-quality assets, adding further diversification of the occupier base. Assets amounting to £78.9m (after costs) were acquired at a blended net initial yield of 8.4% and £71.4m (after costs) of assets sold at a blended yield of 5.5%. The 290-basis point spread between purchases and sales locked in a c £1.9m annualised uplift in gross rental income. Three additional properties with completed business plans have been sold since H122 for an aggregate £7.2m, in line with the 30 June 2022 valuation.

EPRA occupancy increased to 83.8% (end-FY21: 81.8%), including a benefit from the new lettings and from transaction activity (with acquisitions at a higher level of EPRA occupancy than the disposals). On a like-for-like basis the end-FY22 EPRA occupancy rate was 82.1% compared with 86.3% at end-H121, with two properties in particular accounting for c 60% of the decline due to the timing of lease expiry and refurbishment.

The gross rent roll ended the period at £72.1m, a similar level to end-FY21, reflecting a net positive £1.9m impact from acquisitions and disposals as well as new lettings and lease renewals, offset by the impact of lease maturities and terminations. RGL entered FY22 with c £14m (11.5%) of income ‘at risk’ from lease maturities and break options over the following 12 months. During H122, 72.1% of expiries/breaks (by unit) were retained, an increase from 69.6% in FY21.

At end-H122 the portfolio was valued at £918.2m (end-FY21: £906.1m and end-H121: £729.1m). H122 growth included like-for-like revaluation gains of 1.0% and the net initial yield of 5.7% was unchanged on end-FY21. By value, the share of office properties had increased to 92.0%,2 or 91.6% by gross rental income. The portfolio remained strongly diversified by the number of properties (159), property units (1,517) and occupiers (1,086 occupiers) as well as by geography.

Within its overall ESG framework, RGL is targeting an EPC rating3 of B or better for all properties by 2030 and made good progress in H122. Capex during the period of £3.1m and quality-enhancing transaction activity supported an increase in the proportion of such properties to 13.2% from 9.9% at end-FY21 (EPC A–C 48.0% vs 43.6% at end-FY21). The company expects that most of the further investment required to meet its EPC targets will form part of the existing rolling programme of capital expenditure and H122 investment was consistent with the c £44m allowed for in the external property valuation (and RGL’s internal estimate of c £40m). It is likely that some of this investment will be undertaken by tenants that are also seeking to enhance their environmental performance and we anticipate further disposals of properties and capital recycling.

More generally across the regional office market, RGL observes an improvement in occupier demand from the pandemic trough. The return to the office is underway but that applies more clearly to tenants rather than employees. Many companies are still in a process of trialling new ways of office working, commonly a hybrid model whereby employees spend perhaps three days per week (typically Tuesday, Wednesday and Thursday) in the office and two days at home. RGL does not expect hybrid working to materially reduce space requirements as it must cater for peak usage. It also notes a growing preference amongst employers to have more staff on site for an increasing amount of time, recognising the collaborative and creative benefits of office working. However, the company continues to believe it will take until the end of 2023 for this balance to be resolved across the market and for market uncertainties regarding the future use of the office, and the demand for office space, to be resolved.

Given its views on future office usage, RGL remains positive about the structural occupational supply-demand balance for secondary regional offices, the market segment in which it invests. It notes that going into the pandemic, supply was tight and although rents had begun to increase, they remained at a relatively low level. Coming out of the pandemic, many occupiers have retained their office space and occupancy remains relatively high. RGL expects that in time, where there is additional demand by occupiers to switch location, upscale or improve the quality of their accommodation to retain or recruit staff, it is likely to meet tight supply, with positive indications for rental growth.

RGL is cognisant of the challenge to this scenario from the generally anticipated economic downturn, but notes that negative impacts would be widely spread across the commercial property market, including some sectors where valuations have recently increased noticeably more strongly than has been the case for offices.

A key element of RGL’s strategy since it listed in November 2015 has been to build a diversified portfolio that spreads income risk across a wide range of occupiers operating across a broad spread of industries.

A more immediate challenge to the commercial property sector is the sharp increase in borrowing costs, for which RGL is well placed with all agreed and drawn debt fixed or hedged (with swaps or caps), with a maximum cost of 3.5% for a duration of five years. The earliest maturity is not until August 2024 (the retail eligible bonds).

The weighted average cost of debt increased a little in H122, to 3.5% from 3.3% at end-FY21, as interest rates increased and the interest rate caps were reached, but has now reached its limit.

The net loan to value ratio (LTV) was 43.2%4 at end-H122, slightly up on end-FY21 (42.4%), mostly reflecting net capital investment in the period, but RGL continues to target a reduction towards its c 40% medium-term target. There is a good level of headroom against borrowing covenants that require LTVs at the loan facility level of no more than c 60%. Group level interest cover was 3.0x at 30 June 2022.

RGL came to market in November 2015 targeting a higher yield portfolio that would provide progressive, regular dividends with the potential for capital growth. Active asset management and capital recycling are key elements in sustaining asset yields. RGL’s dividend yield has been consistently one of the highest in the sector and quarterly dividends were maintained during the pandemic, albeit at a reduced level.

The accounting total return5 has been positive in each year since listing, other than in FY20 due to the pandemic. The total return up to end-H122 amounts to 44.4% or an average annual return of 5.7%. Reflecting RGL’s strong income focus, its returns have all been generated by dividends paid with a good level of consistency, as shown in Exhibit 2.

Despite the operational progress described above, EPRA earnings growth was held back by the increase in non-recoverable property costs, primarily reflecting the impact of increased energy costs relating to vacant space but also ‘shared’ space (such as reception areas or lifts) within properties that are unallocated to tenants. EPRA EPS of 2.9p was below DPS declared of 3.3p, but dividends would otherwise have been covered. RGL is confident of a stronger earnings performance in H222, reflecting normal income seasonality and a lesser impact from energy cost inflation, in part due to government energy cost support. The company remains committed to its full-year DPS target of 6.6p.

In particular we note:

Management is confident that H222 earnings will exceed the H122 level, reflecting the usual seasonality in the business, which includes the tendency for non-rental income (such as surrender premiums and dilapidation payments) to be bunched towards year-end. In our revised estimates, higher rental and other income (primarily other income) offset the impact of higher non-recoverable property costs, and with higher interest costs (as the rate caps are reached) EPRA earnings reduce c 2–4% in FY22 and FY23. We have reduced our forecast for the rate of FY23 dividend growth, but cover is effectively maintained throughout the forecast period.

Our key forecasting assumptions include:

With EPRA earnings distributed in full and acquisitions and disposals matched by value, our forecast LTV increases slightly (to 43.7%) by end-FY23, rather than declining in line with RGL’s target. Our LTV forecast may similarly be conservative should valuations increase or if RGL is able to further recycle capital from lower-yielding to higher-yielding assets, allowing a net divestment with no impact on portfolio income, and a reduction in net debt. Without assuming management action, we estimate that the impact of an additional 25bp yield widening on our forecast property valuation would be to increase FY22 LTV to 44.4% and FY23 LTV to 44.7%, with a positive impact (lower LTV) should property yields tighten.

Based on our FY22 DPS forecast of 6.6p, RGL provides a highly attractive 10.6% dividend yield, one of the highest in the sector, if not the highest.

In Exhibit 5 we show a comparison with a selected group of peers comprising mid-market diversified property investors and focused office sector investors, many of which are significantly larger than RGL with primarily central London exposure. To ease comparison, the data are based on 12-month trailing DPS declared and last published EPTA NTA/NAV. On this trailing basis (and we forecast on a prospective basis), RGL’s dividend yield continues to be at the very top end of both this selected peer group and the broad UK property sector (we estimate c 5.3% on an unweighted trailing average basis). This is only partly reflected in a narrower discount to NAV.

RGL’s significantly higher yield versus the peer average is despite it paying covered dividends. This is not explained by P/NAV multiples as RGL’s trailing yield on NAV is also the highest among the peer group. The market appears to be pricing in dividend unsustainability and, effectively, a material dividend reduction, based a decline in income (as borrowing costs are fixed). Notwithstanding economic uncertainty and likely recession, the impact of which would affect the market more broadly, this appears significantly at odds with RGL’s expectations for the regional office market and for its portfolio, as discussed above.