Regional REIT — Covered dividend with a 12% yield

The FY22 results were in line with our expectations and the changes to our forecasts are modest. In this note we focus on the success of RGL’s income-driven strategy and the issues that we believe are holding back valuation. These include continuing uncertainty about the future of the office (RGL provides positive data points), relatively high gearing (although fixed-cost borrowings are well inside covenants) and energy efficiency capex requirements (which RGL expects to fall within existing capex programmes and which are reflected in the current portfolio valuation).

We review FY22 financial performance in detail below. In challenging conditions, leasing progress stood out. FY22 new lettings of £5.9m compared with £2.5m in the prior year and £3.8m in FY19, pre-pandemic. Combined with a good level of retentions at lease maturity (c 70%) and accretive asset recycling, rent roll was broadly maintained (£71.8m vs £72.1m at end FY21) and remains well below the estimated market rental value of £92.0m, indicating material income upside potential, primarily from leasing vacant space. Accretive portfolio transactions will add c £1.6m to rent roll as incentives run off, comprising £74.7m (before costs) at an average net initial yield of 8.4% and £84.1m (after costs) of disposals at a blended 4.9% (6.3% excluding vacant properties). The c 12% growth in net rental income primarily reflected a full contribution from prior acquisitions, partly offset by upward pressure on property costs. EPRA earnings also increased by 12% and, allowing for a higher average share count, EPRA EPS was flat at 6.6p. The 12.1% like-for-like decline in property values compared favourably with a 17% decline in regional offices (outside central London) indicated by MSCI data and benefited from the leasing progress.

Since listing in 2015, RGL has consistently pursued an income-focused strategy and maximising dividends. Dividend return (as a percentage of NAV) has averaged 5.9% and has been fully covered by EPRA earnings over the period to end FY22 (the dips in FY18 and FY19 were primarily driven by cash drag from equity raising). Supporting dividends, RGL’s rent collection performance through the pandemic was outstanding (99% in FY20, 98% in FY21 and 99% thus for FY22, with the remaining rent expected to be collected in due course). We believe rent collection performance significantly reflects RGL’s strong, regional asset management platform, maintaining close relationships with tenants. Capital return has been volatile but overall has generated a negative return, predominantly during and since the pandemic, averaging 4.2% pa. The impacts of the pandemic on RGL’s ability to increase occupancy and on office sector valuations have been key factors. We discuss this below.

Combining income with capital, NAV total return has been 3.1% pa since listing. Although below the target of at least 10% pa set at listing in November 2015, based on the share price, total shareholder return was 1.4% over the same period compared to the leading UK Total Return Index, which has generated a negative return of 16.9% over the same period.

Across the UK commercial sector, income returns have historically shown much less volatility than capital returns and this has been true for RGL. External valuation consultants primarily estimate fair values based on comparable recent market transactions on an arm's length basis. At times of uncertainty, the expectations of sellers and buyers may diverge noticeably, reflected in a dearth of transactions and a relative lack of market pricing evidence. The final quarter of 2022 was such a time, although transactions volumes have begun to pick up so far in 2023. Property income may thus be seen as a better guide to long-term value, while permanent capital vehicles such as RGL are at an advantage to open-ended funds that must additionally manage fund outflows and inflows.

FY22 earnings and dividends were in line with our forecasts and NAV was slightly above. We discuss this in more detail below. Although the company has signalled its intentions to continue its progressive dividend policy, for FY23 we forecast an unchanged DPS of 6.6p (previously 6.7p), fully covered by EPRA earnings, with growth in these resuming in FY24 (6.7p). All debt is fixed or hedged at a cost of 3.5%, removing interest rate uncertainty in respect of FY23, although the £50m 5.5% retail eligible bond will require refinancing at maturity in August 2024 (see below). Investment and asset management fees account for c 50% of administrative expenses and are directly linked to NAV, while a further c 25% are linked to the level of gross property income. The key forecasting uncertainty, including the ability to pay covered dividends, is net rental income, which we expect to be flat in FY23 and slightly higher in FY24. A high level of diversification by geography, tenant and industry exposures1 mitigates macroeconomic risks but a continuation of strong leasing progress will to a significant extent rely on structural developments in the office sector (see below).

UK REITs are required to distribute at least 90% of property income in dividends and, while RGL has the flexibility to lower its pay-out ratio, its policy is to maximise dividends. We see any risk to dividend sustainability being primarily the level of EPRA earnings (taking this as a proxy for ‘property income’2). We would also note the need to fund, through existing cash and debt resources.

RGL’s rolling capital expenditure programme is c £10m pa. With EPRA earnings fully distributed, if the portfolio enhancement that capital expenditure targets is not recognised in external property valuations, its impact will be to increase gearing (end-FY22 LTV of 49.5%) and reduce capital flexibility.

The only year-on-year decline in EPRA earnings that the company has reported since listing was in 2020 (-9%) as a result of the pandemic. A 10% decline compared with our FY23 forecast would still support a fully covered DPS of more than 5.9p, which would reflect a yield of almost 12%.

Despite delivering on its high-income strategy, the share price has been weak, even in the context of a REIT sector negatively affected by rising interest rates. To an extent, this is likely to reflect some disappointment with RGL’s capital returns (the company came to market with a target return of at least 10%), but nonetheless RGL trades with one of the highest if not the highest fully covered dividend yield in the sector, both in absolute and relative terms.

In Exhibit 6 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.

In the following sections we address what we think are the key concerns that are currently weighing on RGL’s valuation, namely:

Post-pandemic, opinions remain polarised about the future role of the office in working life, with the risk of economic downturn adding to near-term uncertainty. Throughout this period, RGL’s asset manager has consistently expressed the view that employees will not return to the office in numbers before the end of 2023/early 2024, providing occupiers with the visibility to plan for the future. It seems already clear that different employers will take different approaches, with some form of hybrid working being most common, but RGL expects that most will end up with the majority of employees being in the office for most of the time. At the same time, it expects the trend, evident before the pandemic, towards a more attractive working environment, including more space per employee to continue and provide an offset to other structural or cyclical headwinds. In its November 2022 study, RGL identified that 99% of its office tenants had returned to occupation in some form. It has already observed increasing numbers of employees returning (‘physical occupation’) across all regions and plans to release data shortly.

Meanwhile, office supply remains reasonably tight, with secondary space reducing, often for repurposing for residential, student accommodation or hotel use. While Grade A supply is increasing through targeted development, significantly pre-let, RGL’s leasing performance shows robust demand for the middle ground of good-quality accommodation.

End-FY22 borrowings of £441m were all fixed or hedged at an average cost of 3.5% with an average duration of 4.5 years. RGL has subsequently repaid c £7m of the Scottish Widows & Aviva facility. After adjustment for end-FY22 cash of £50m, UK total return Index the net loan to value ratio (LTV) was 49.5%, increased from 42.4% at end FY21 by the decline in portfolio value. RGL’s LTV is relatively high compared with peers,3 which benefits overall portfolio income but creates additional volatility to NAV, both positively and negatively (as in FY22). The secured debt facilities (£391m) are all well within LTV covenants of 60% and it would require a more than 15% decline in portfolio value for these to be tested. Meanwhile, the high portfolio yield, protected by significant diversification, generates a strong level of interest cover (c 3.4x at end-FY22).

The first debt maturity, in August 2024, is the company’s £50m unsecured Retail Eligible Bond with a fixed coupon of 4.5%. RGL’s preference is to refinance this, at maturity or earlier, with a similar unsecured bond, maintaining financial flexibility. The cost will have increased but the impact on earnings should be relatively muted. A doubling of the current cost (to 9%) would negatively affect EPRA earnings by c £2.3m but RGL hopes to achieve a much lower rate than this. The existing bond, which trades on the London Stock Exchange ORB platform. The mid-price at 14 April 2023 was a little over 94% of par, reflecting a yield to maturity of c 9%. However, market consensus indicates that by the time it reaches maturity, interest rates will have peaked and begun to fall.

RGL undertakes a rolling programme of capital expenditure aimed at enhancing and maintaining the attractiveness and income-generating capacity of its properties. This has become even more important post-pandemic as more occupiers seek to attract their workforce back to the office into properties that will assist them in meeting their own carbon emission targets. In addition to investments undertaken by tenants, RGL invested £10m in FY22 or 1.1% of the opening portfolio value, in line with the past five-year average.

As part of the government’s drive towards net carbon zero by 2050, minimum energy efficiency standards required, with some exceptions, all rented commercial property to have an Energy Performance Certificate (EPC) rating of E or above by March this year. The expectation is that the minim rating will increase to C by 1 April 2027, and to B by April 2030.

RGL says it is on track to achieve a minimum B rating by 2030 and made significant progress towards this goal in FY22.

Progress is being made through a combination of investment, within its rolling capex programme, and portfolio repositioning/capital recycling. The external valuation reflected in the balance sheet already allows (is reduced by) an assumed c £60m of capex and RGL does not expect the investment required to achieve EPC compliance to fall outside of this. RGL has already identified, and has been disposing of, properties that cannot be enhanced on an economic basis and the low average capital value of its office portfolio (£126 per sq ft) increases their attraction for alternative use. By way of example, during H121 RGL disposed of the 19-storey Arena Point office tower in Leeds, with vacant possession, to a purchaser intending to demolish it to make way for student accommodation. The sale price was £10.7m or c £140 per sq ft, 16% above the previous valuation. Arena Point was part of a larger site which included a two-storey casino and pub, known as the Podium Buildings. Acquired as part of a portfolio purchase, the potential for the site to be repositioned for alternative use was recognised. Podium was sold to Unite Students for development as large-scale student accommodation. The sales of Podium and Arena Point together secured profits of £9.3m, representing a geared internal rate of return of 24.6%.

As shown in Exhibit 3 above, the FY22 results were in line with our expectations, reflecting a robust income performance but with NAV negatively affected by market-wide property yield widening.

The key points from the results were: