Picton Property Income — Defensively positioned with embedded potential

Picton’s diversified portfolio of commercial property across the UK is actively managed for total returns but with a strong income focus. Through its occupier-focused, opportunity-led approach, the company aims to be one of the consistently best-performing diversified UK REITs. A strong weighting to industrial and regional office assets, together more than 80% of the portfolio by value, and significant underweighting of retail and leisure assets (no shopping centre exposure) continues to support property returns relative to the market. With an ungeared property total return of 5.3% compared with the MSCI UK Quarterly Property Index return of -0.5% in the year to March 2020, Picton maintained its long-term track record of outperformance over one, three, five and 10 years to 31 March 2020. The COVID-19 pandemic punctuated a strong performance through much of FY20, creating highly uncertain economic and market conditions. Although a cyclical sector, income returns have historically been much more stable than capital values, delivering c 70% of long-term total returns. At the time of reporting FY20 results (23 June 2020) Picton had collected 82% of quarterly rents billed in March 2020, had agreed to defer 6% and had moved 2% to monthly payment. 1% of rent was the subject of rent free agreements accompanied by lease extensions and 9% remained outstanding. In common with industry trends we would expect a more challenging Q220 collection performance (for rents billed in June 2020), reflecting the greater impact of the lockdown. We estimate that cash cover of the reduced dividend (an annualised 2.5p per share) requires 85% of start-year rents to be collected leaving scope for quarterly DPS to be lifted later in the year if collections improve as the lockdown eases and if the company makes progress with capturing the significant reversionary potential embedded in the portfolio. Meanwhile, a strong balance sheet with low levels of gearing is a defence against near-term uncertainties and provides scope for opportunistic acquisitions when the outlook become clearer. Before reviewing the FY20 results we first provide an update on the impacts of COVID-19, Picton’s preparedness and the near-term outlook for income and dividends.

Portfolio diversification provides a mitigation to risk in uncertain times such as these. Picton’s portfolio consists of 47 assets across the main industrial, office and retail and leisure sectors, generating income from around 350 occupiers across a wide range of businesses. The top 10 occupiers account for just 27% of total contracted income and the largest tenant for less than 5%.

At c £665m the overall portfolio reduced during FY20, including two property disposals (no acquisitions) at an average 15% premium to the c £30m aggregate March 2019 book value. Disposals also affected rent roll, which at £36.2m was reflected in an end-FY20 net initial yield of 4.9%. At 89% occupancy is below the trend of recent years (c 95%) and reflects a material amount of refurbishment activity, much of which is now complete or close to completion.

Although diversified, the portfolio’s active sector and regional positioning underline the company’s unconstrained approach to asset selection. This flexibility allows Picton to adjust the portfolio towards the sectors that are expected to offer the best returns while maintaining the balance to avoid the volatility that can from time to time arise in more focused, specialist portfolios. Compared with the MSCI Quarterly Property Index, the portfolio has around double the weighting to the industrial sector (with a high South-East share positive for performance) and around half the weighting in retail/leisure sectors (no exposure to shopping centres). Office exposure is tilted towards the regions and broader London market rather than central London. During FY20 the like-for-like property revaluation movement was 1.4%, comprising a 6% gain in industrial, a 3% gain in offices and a 12% decline in retail and leisure. This compares with a 4.8% decline for the MSCI UK Quarterly Property Index.

The end-FY20 estimated market rental value (ERV) at full occupancy was £45.2m compared with the annualised passing rent of £36.2m. Closing this gap, particularly in respect of refurbishment projects (74% of all vacant space) has the potential to significantly support income and capital values through these more challenging times. That would remain the case even if void space were to be let below current ERV. Five key properties alone represent 65% of the vacant ERV or more than £3m of annual rent.

Picton is working closely with its occupiers to optimise rent collection and provide support where this is appropriate to assist them through the current uncertainties, while minimising the impact on the company’s cash flows and capital values. Exhibit 1 summarises the March quarterly rent collection status at 23 June 2020. Unsurprisingly the retail and leisure sector was the weakest area both for collections and outstanding rents where no agreement on contractually due unpaid rent had been reached.

Picton is yet to update on the June collections but we expect the collection rate to be weaker than for March; the lockdown was in place for longer and the suspension until the end of September of the right of landlords to serve notice to quit weakened the incentive for tenants to pay rent even when they are able to do so.

We expect the easing of the lockdown to lead to a gradual improvement in quarterly collection rates. Rents that have been deferred by agreement are expected to be collected in instalments (we estimate starting in H221 and mostly completed by end-FY22). Over the same period, the position with respect to tenants with outstanding rents, for which no deferral agreement has yet been reached, should also become clearer. In some cases, particularly in the challenged retail and leisure sector, it may be necessary to agree lower rents although we would expect Picton to seek improvements to other lease terms, including extensions or the removal of break options, to mitigate the valuation impact.

During the quarter ending 31 March 2020 (Q420) the pandemic was largely responsible for valuation write-downs of 2.9% in retail and leisure, 0.3% in industrial and 0.2% in office.

MSCI UK Property Index monthly return data show that across the UK commercial property sector as a whole, positive total returns were recorded until March 2020, with a positive performance from the industrial and office sectors offsetting weakness in retail and leisure, which continues to undergo structural change due to evolving shopping habits, resulting in excess supply and falling rents. From March through May, due to the pandemic and lockdown, all main sectors experienced weakening capital values and negative total returns, while the weakness of retail and leisure accelerated; there is a broad consensus this will continue. Data for June from CBRE suggests that industrial and office values may be in the process of stabilising (-0.1% and -0.2% respectively) while the decline in retail values continued (-1.4%).

The industrial sector should continue to find support from a general tightness of supply relative to demand and has continued to see rental growth through May. Office rental value growth was broadly stable through May but capital values weakened and there is much debate as to whether the pandemic and remote working will have a negative long-term impact on the demand for office space. Home working has probably received an enduring boost but the case for full-time office working is less clear. When in the office, it is likely each worker will require an increased amount of space. Well-appointed offices, with good transport links, good IT infrastructure and environmental credentials are likely to retain a premium.

The investment market saw reduced volumes, especially after March 2020 when transactions effectively dried up, causing the Royal Institute of Chartered Surveyors to introduce a material uncertainty clause in respect of external valuations across most sub-sectors. The clause was not intended to signify that valuations were unreliable but rather that there was limited transactional evidence against which they could be benchmarked. As investment volumes begin to increase once again, the material uncertainty clause has been lifted from an increasing number of subsectors, including most recently industrial and logistics properties.

Using the proceeds of disposals, Picton had repaid all drawings under its flexible revolving credit facilities (RCF) by end-FY20. The remaining drawn debt of £167.5m comprised the two long-term (first maturity 2027) fixed-rate loan notes with Aviva and Canada Life. In June 2020, a new £50m RCF replaced the existing facilities, extending duration and reducing cost. For now, it too remains undrawn. If the RCF is fully utilised, the combined debt maturity would be 8.3 years and the weighted average interest rate would reduce from 4.2% to 3.7% pa. Allowing for £23.6m of end-FY20 cash the LTV was 21.7%.

The borrowing covenants provide a good level of headroom and Picton estimates that, on average, rental income or asset values would need to fall by more than 40% for there to be any impact. In any case it is in constant dialogue with its lenders, who remain fully supportive of the company. With none of the RCF drawn, Picton has access to £50.0m of undrawn borrowing facilities in addition to the positive cash balance.

Most current capital projects were suspended or slowed during the lockdown. At end-FY20 there were outstanding contracts for the refurbishment of 11 properties with an aggregate commitment of c £4.5m. The most significant of these is the Stanford Building in Covent Garden where the refurbishment is nearing completion (ERV £1.6m).

FY20 showed a solid financial performance with positive property and accounting returns and a further strengthening in the balance sheet. COVID-19 had a limited impact in the year but resulted in a prudential c £0.5m non-cash provision against March quarter rent collections and a negative impact on year-end valuations and NAV. Excluding the rent provision, the FY20 EPRA earnings were in line with our expectations and so too diluted EPRA NAV where we had anticipated some year-end weakness in valuations. On a like-for-like basis, rental income increased 1.2%, driven by rent reviews, lease renewals, re-gears and new lettings ahead of ERV. ERV also increased by 1.3% like for like.

During the year, disposals and the refurbishment programme acted as a drag on net rental income and EPRA earnings, although this was partly offset by lower interest expense (less debt at a lower average cost following the FY19 refinancing). Underlying administrative costs were well contained (and non-recurring REIT conversion costs dropped away).

Aggregate quarterly dividends paid during the year of 3.5p were 1.05x covered by EPRA EPS of 3.7p. The Q420 DPS paid in May 2020 was reduced to 0.625p (an annualised 2.5p) to reflect the impact of COVID-19 on near-term rent collections and maintain financial flexibility.

The increase in net assets to £509.3m from £499.4m at end-FY19 included £7m in new equity, invested back into the portfolio via refurbishment projects. Capex spending, primarily on refurbishment, was £9.0m, with little or no benefit to valuation in the period. However, we would anticipate a positive impact as all projects complete and are let. The like-for-like property revaluation movement was 1.4%. EPRA NAV per share was flat at 93p and including dividend paid in the year the EPRA NAV total return was 4.4%.

Total debt reduced by 14% to £167.5m and the net loan to value ratio fell below 22%.

In April 2020, Picton’s board decided to reduce the level of quarterly dividends until the longer-term impact of the pandemic on cash rental income can be better assessed and market conditions become clearer. We believe the 30% reduction allows for the likelihood that Q221 rent collections (June 2020 collections) will be below the level reported in Q121 (March 2020 collections) followed by a recovery in collection rates as the lockdown eases. We estimate that 85% cash collection during the year of the annualised rent roll in place at the beginning of FY21 is sufficient to fully cover annualised DPS of 2.5p with cash earnings. This does not include rents where a payment plan has been agreed but collection carries over into FY22.

There are a number of factors likely to impact the full-year level of cash rents and the potential for a recovery in the quarterly level of DPS, as well as the likely divergence between cash-collected rents and the level of IFRS rental income (including much of any deferred rents during the year) in the income statement. These include:

We have not made a specific forecast at this stage but believe the reduced DPS level has been set prudently with upside potential from an improving collection environment and capturing of some of the reversionary potential in the portfolio. Including all of the variables above, if the total cash rent collected in FY21 were equal to 90% of the start year annualised rent roll then dividend-paying capacity increases to 2.82p and at 95% it is 3.15p. Continuing collection of FY21 rent deferrals through FY22 would indicate a further improvement in cash flow in FY22, all other things being equal.

For the current year, the IFRS rental income reported in the income statement is likely to exceed the level of cash rents collected, as much of the rent deferred will still be recorded as income. For now, we expect the company to base dividend decisions on the cash figure. In FY22 it may be the case that cash rents exceed IFRS rental income as deferrals fall away and collection of FY21 rent continues.

If accounting income exceeds cash rental income in the current year and dividends are based on the latter, the retained earnings should support NAV.

We have similarly not made an estimate of capital value movements but note that based on the end-FY20 balance sheet to close the current P/NAV discount, allowing for the impact of gearing, would require a decline in portfolio value of slightly more than 20%.

Each 1% increase/decrease in the value of the end-FY20 portfolio value increases/reduces EPRA NAV by 1.2p.

We would expect a positive impact on property valuations from any progress with letting refurbished space, offset by some general downward pressure on market-wide property valuations, although less so in the industrial and office sectors, as well as from weaker rent collection.

In the five-year period ending 31 March 2020 (end-FY20) Picton generated a cumulative NAV total return (change in NAV plus dividends paid) of 60.2% (without assuming reinvestment of dividends) or a compound annual average return of 9.9%. Dividends are an important source of the return (just over 40%) but so too is reinvestment in the portfolio to improve assets and enhance longer-term total return.

At the currently reduced annualised rate of quarterly dividends of 2.5p, the prospective yield is c 3.7% and the P/NAV ratio is 0.73x. This compares with an average of 0.97x over the past five years.

In Exhibit 11 we show a summary performance and valuation comparison of Picton and what we consider to be its closest diversified income-oriented peers. Picton shares have declined over 12 months but by less than the peer average. However, the peer group performance is below that of the broad UK property sector where some of the long-income focused specialist REITs and industrial-focused REITs have been outperformers. In terms of valuation we show the trailing yield based on aggregate declared DPS over the past 12 months as well as the forward-looking yield based on the most recently declared DPS annualised. Neither is entirely satisfactory as the sector remains in a state of flux, with some companies having indicated a reduced DPS pay-out for the time being and some postponing DPS payments altogether until later in the year. It will take some time before the full-year prospective DPS outlook becomes clearer and a true comparison can be made. We believe the outperformance of Picton shares versus the peer group and its slightly higher P/NAV reflects the company’s strong track record of property level performance, the future income and valuation growth potential embedded in its portfolio, and its strong balance sheet with relatively modest gearing.