Regional REIT — Dividend rebase pragmatic and sustainable

Having paid a quarterly DPS of 1.65p, the second quarter DPS was rebased to 1.2p, and the company expects to declare quarterly DPS at a similar rate for the balance of the year, making a total of 5.25p, fully covered by earnings. Assuming that quarterly DPS continues at this new level, as we do, FY24 aggregate DPS will be 4.8p, fully covered by our revised earnings forecasts. In this note we provide details of the interim results and explain why we forecast the re-based dividend level to be sustainable. By way of summary:

RGL came to market 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.

Exhibit 1 reflects the impact on NAV of dividends paid, typically in the quarter following the dividend being declared. Aggregate DPS paid in H123 of 3.30p includes the dividends declared in respect of Q422 and Q123, each 1.65p. Dividends declared in H123 were 2.85p, comprising the Q1 DPS of 1.65p and the Q223 DPS at the rebased level of 1.2p. RGL expects to declare two further quarterly dividends of 1.2p in respect of FY23, taking aggregate FY23 DPS declared to 5.25p compared with an ongoing annualised run rate of 4.8p.

RGL says that it has rebased dividends to a level that it expects to be sustainable and fully covered. Historically it has maximised distributions to shareholders by distributing EPRA earnings in full but by doing so it is required to fund capital expenditure with cash resources or additional debt. Given the company’s focus on LTV reduction, combined with continuing investment in the portfolio, we would interpret a sustainable level of dividends to be more than fully covered by EPRA earnings while adhering to real estate investment trust (REIT) requirements that at least 90% of income be distributed.

H123 DPS declared of 2.85p was only partially covered by EPRA EPS of 2.5p. RGL’s intention to distribute 5.25p per share in respect of FY23 implies an expectation that full year EPRA earnings will be at least 5.25p per share, or at least 2.75p in H223. We discuss our earnings forecasts below, but they are consistent with this, and we note that RGL’s earnings have been consistently higher in the second half of the year than in the first half. The second half is seasonally slightly longer (184 days versus 181 in the first) but more importantly there is a strong tendency for non-rental income, such as dilapidation receipts and lease surrender premiums, to be agreed towards year-end.

The immediate trigger for rebasing the dividend is weaker than expected leasing activity in H123 with a negative impact on gross income and, more importantly, lower occupancy increasing the share of property costs borne by the company. This has been exacerbated by upwards pressure on those costs from stubborn inflation.

Providing more perspective, ahead of the pandemic, FY19 dividend per share was 7.8p. Since then, the portfolio equivalent yield2 has increased (to 9.5% at end-H123 from 8.2% at end-FY18), while the EPRA cost ratio (before direct property expenses) is lower (17.3% in H123 versus 19.6% in FY19) and gearing is higher (c 52% versus c 40%). These are positive indicators for income potential. However, the net initial yield, which is based on currently contracted rents, less expected property costs, and adjusted for lease incentives, is lower as a result of lower occupancy and increased property costs, exacerbated by high inflation, and reflected in a lower ratio of net property income to gross.

RGL is focused strongly on increasing net income, primarily by letting space and selling costly void space, eliminating the property costs attached to these and providing an opportunity to reallocate the capital to reduced borrowings. RGL’s net LTV of 52.9% is relatively high compared with peers,3 and above the company’s 40% medium-term target and self-determined upper limit of 50%. Gearing is a benefit to overall portfolio income but creates additional volatility to NAV, both positively and, more recently, negatively. It is weakness in property values that has pushed up LTV while borrowing has actually slightly reduced.

Assuming no benefit from property values, reducing LTV to 40% through asset sales alone implies the sale of c £150m worth of properties, although we would expect sales to be spread over the next couple of years. We have assumed sales of £75m in aggregate through H223 and FY24 and, as with H123, we assume this will include a significant share of vacant properties. This mix was reflected in a 2.4% net initial yield on the H123 sales compared with 9.4% on the occupied properties alone.

UK commercial property market investment transactions remain subdued, but RGL says that there is an active market in smaller lot size assets (of £5m to £10m). Smaller lot sizes are typically substantially equity funded and less influenced by the cost and availability of debt. Low capital values (an average £14.6 per sqm for RGL’s office properties) support the change to a broad range of alternative uses, dependent on location among other factors, such as student accommodation, hotels, residential, nursing homes, nurseries and industrial. The average lot size of the RGL portfolio is £5.0m but, excluding the top 15 assets (valued at £232m or an average £15m), the remaining assets, valued at £520m, have an average lot size of £3.9m. This indicates a broad pool of assets from which disposals can be selected.

The total externally estimated market rental value, at full occupancy (ERV) reported by RGL at end-H123 was £88.9m, £19.0m or 27% above the contracted passing rent of £69.8m. Using the EPRA yield disclosure, the methodology of which excludes properties that are under refurbishment and development that are not immediately available to let, we show an approximate breakdown of this gap. At end-H123, on an EPRA basis, the annualised contracted cash rent to be paid was £61.7m pa. This excluded lease incentives in place of £6.0m. Lease incentives are included in the gross contracted rent published by RGL. As there will always be an element of lease incentives in place, the most immediate opportunities for increasing rental income are the reduction in voids (£14.7m) and using leasing events to capture the upside from current rents to market levels (£1.9m). The letting of refurbished space at completion also provides opportunities but given RGL’s rolling programme of capex there will always be properties that are not immediately available to let.

A level of new letting is always required to maintain a given level of occupancy as some level of tenant turnover is inevitable. RGL typically achieves a strong level of retention, at around 70% or above, and in H123 it was 76.3%.4

Following subdued leasing activity during the pandemic, new lettings in FY22 generated additional gross rents of £5.9m (FY21: £2.5m), well above pre-pandemic levels (FY19: £3.8m). The strength of letting activity continued throughout the year despite the volatility in the gilt market and political uncertainty that followed the government Autumn Statement.

However, despite the positive momentum going into the current year, with inflation and interest rates remaining stubbornly high, occupiers have adopted a cautious ‘wait and see’ approach as the impact of the sharp rise in interest rates remains uncertain. New lettings were just £1.2m (H122: £2.6m) although positively, these were at an average 13.5% above ERV. Despite the strong retention lease income expiring in the period, there was a net reduction in gross contracted rents of £1.4m, excluding the c £0.5m reduction attributable to asset sales.

The weighted average unexpired lease term was 4.8 years at end-H123, or 3.0 years to first break.5 Coming into FY23, leases representing c £10m of rental income were due to expire over the following year and c £20m over two years. The remaining income to expire during H223 is now c £7m. At a typical c 75% retention rate it requires c £1.75m of gross new letting in H223 to maintain the expiring income and a further c £2.5m in FY24. Additional new lettings are required to replace any exercise of lease break options or other terminations of tenancies. In this context, the asset manager expects an acceleration in leasing activity by the end of the year, as we discuss in the following section.

Regional office supply remains reasonably tight. Secondary space continues to reduce, mainly through repurposing, and while Grade A supply is increasing through targeted development, this is significantly pre-let. Meanwhile, occupier demand for space has remained robust, and the asset manager expects it to benefit from improved occupier visibility with regards to office use as well as improved confidence as the anticipated peak in interest rates is reached. RGL notes that although its H123 leasing performance was less than it had expected, its ability to secure rental uplifts on those leases that were concluded indicates good demand for the middle ground of good-quality accommodation.

Commercial property agent Avison Young estimates that H123 regional office take-up was less than 4% below the five-year average, with city centre space being the largest component despite its share of the total (less than 60%) continuing to trend down in favour of out-of-town locations.

The asset manager has consistently expressed the view that it will not be until the end of 2023/early 2024 that employers will have a clear view of the shape of post-pandemic office use, but meanwhile there is a drive by employers to get workers back to the office, seeking to support collaborative working practices and increase productivity. This is confirmed by RGL’s own market analysis. It had already identified by November 2022 that 99% of its office tenants were in some form of physical occupation, up from just 30% in March, as the pandemic was subsiding. It has since concluded a large and comprehensive study, covering more than 100 of its properties, accounting for more than 240k employees, with an 82% response rate. The survey highlighted that the employees who confirmed they are back in the office now attend for an average of 4.2 days per week and that actual occupation was 65% or 93% of the estimated pre-pandemic level of 70%. Actual occupancy refers to the proportion of leased space that is being used and not to portfolio occupancy. By way of example, if a company had leased space for 100 desks, then the study showed that an average 63 of these of these would be used during business hours, with the balance unoccupied due to absences due to holidays, illness or being out of the office on business.

RGL’s asset manager observes that while different employers will take different approaches, a picture is emerging that most will adopt some form of hybrid working. As such, it expects that most businesses will end up with the majority of employees being in the office for most of the time, whether that be three days a week or four. 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.

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 c £10m in FY22, or c 1.1% of the opening portfolio value, stepping up to c £7m in H123.

As part of the government’s drive towards net carbon zero by 2050, minimum energy efficiency standards require, with some exceptions, all newly rented commercial property to have an Energy Performance Certificate (EPC) rating of E or above by March this year. The expectation is that the minimum 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 further progress towards this goal in H123 through a combination of investment, within the rolling capex programme, and sales of lower rated assets that cannot be enhanced on an economic basis. This will continue, consistent with the targeted LTV reduction. At end-H123, the weighted average portfolio EPC rating was C (70), an improvement from C (73) at end-FY22. In combination, EPC B plus and exempt assets were 26.4%, up from 23.6%.

The external valuation reflected in the balance sheet already allows (is reduced by) c £40m, representing the expected costs to RGL of future capex requirements over several years. Energy efficiency improvements are embedded within this, and the figure does not include capex undertaken by the tenants themselves or capex that is recoverable from tenants through service charges.

The further rise in interest rates is currently having no impact on borrowing costs as all debt is fixed rate or hedged at a maximum average cost of 3.5%, with an average duration of 4.0 years.

The first debt maturity, in August 2024, is the company’s £50m unsecured Retail Eligible Bond with a fixed coupon of 4.5%, which is traded on the London Stock Exchange ORB platform. The mid-price at 26 September 2023 was a little over 94.75% of par, reflecting a yield to maturity of c 12%. RGL is considering various options including refinancing with similarly unsecured fixed rate debt, thereby maintaining financial flexibility, or repaying the borrowing from existing cash resources supplemented by sale proceeds, and it expects to update the market by year-end, well ahead of maturity. Despite volatility in debt markets and uncertainty in the commercial property sector, the unsecured debt market remains open, with a range of lenders, retail and institutional, seeking to lock in the higher yields that are currently available. While current yields would significantly increase the cost, the bond represents less than 15% of RGL’s borrowings and this would be manageable. To repay the bond entirely through asset sale proceeds would require c £100m of properties to be sold, allowing for those held as secured debt collateral, a faster rate of disposal than the company currently envisages. Reflecting current market expectations that UK interest rates will soon reach a peak and begin to decline over the next few months, as a working assumption, our forecasts include a refinancing rate of 10%, increasing financing costs by c £2.8m. Each 1% change in the refinancing rate is equivalent to c £0.5m.

The secured debt facilities were £376m drawn at H123, adjusted for the subsequent £5.5m repayment. Each facility has distinct covenants, which generally include historical interest cover, projected interest cover, LTV cover and debt service cover. RGL indicates that LTV covenants would be tested at around 60%. For the debt facility with the highest current LTV (the Royal Bank of Scotland, Bank of Scotland and Barclays facility), 52.7% at end-H123, it would require a c 11% average decline in the value of properties held as security. At the group level, interest cover (excluding non-cash debt amortisation of loan arrangement fees) remained strong at end-H123 (2.8%) albeit down from end-FY22 (3.4%).

The first secured bank loan maturity is in August 2026, by which time we expect RGL to have materially reduced LTV, providing increased flexibility and an enhanced negotiating position with respect to refinancing.

Our earnings forecasts for FY23 and FY24 are very substantially reduced although the change to NAV is relatively modest. FY23e EPRA earnings is reduced by c 24% and FY24e by almost 30%, a blend of operational performance with the impact of significant disposals and de-gearing. The FY23 changes are driven by lower gross rental income and higher property costs, only partially offset by lower financing costs. Disposals have a greater impact on FY24 but significantly lower the LTV. For both years we expect DPS to be fully covered, with the level of cover increasing in FY24.

The key forecasting variable for EPRA earnings is net rental income, and our assumptions include:

Other forecasting assumptions include:

RGL has consistently provided one of the highest dividend yields in the sector, reflecting its focus on income to drive returns. Over the past year, as interest rates have increased, dividend yields across the sector have substantially increased and that is true for RGL. However, at c 15% ahead of the interim results, the yield had moved beyond attractive to a point where it was already signalling a lack of investor confidence about dividend sustainability. Despite the dividend rebasing to a level that the company believes is sustainable in the context of asset sales and de-gearing, the yield remains unusually high. In part this reflects a lack of investor confidence in ‘the future of the office’ in a post-pandemic, artificial intelligence era, but if the regional office market develops as the company expects, and if the balance between earnings and de-gearing is successfully achieved, the FY24e dividend yield of 16% and c 50% discount to NAV will prove to be a highly attractive entry point.

In Exhibit 15 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. However, for RGL the dividend yield is based on the annualised rate of Q223 DPS (4.8p).

RGL’s share price has significantly trailed the peer group over the past year, with the decline accelerating since release of the interim results. Not only is the dividend yield back at an unusually high level, the dividend, which we expect to be fully covered by EPRA earnings, represents a more than 7% yield on the last reported NAV, more than double the peer group average. By both measures the market price implies that the rebased dividend continues to be well above a sustainable level. This is at odds with the company’s expectations and the office sector and supported by our analysis, offering the potential for a significant re-rating over coming months.

The interim results disappointed versus the company’s and market expectations, primarily in terms of the immediate impact of lower non-rental income and the more enduring effects of the slowdown in letting activity.

In particular, we highlight:

RGL is focused on offices in regional centres across the UK, outside the M25. Despite this sector focus, income risk is mitigated by broad diversification across c 150 properties, let to more than 1,000 tenants, operating across a wide range of business activities that can be fairly said to reflect the broad spread of the UK economy. The largest property represents 2.4% of rent roll and the largest 15 tenants 20.3%.

Within the office portfolio, the largest exposures is to business park locations (c two-thirds) and central business districts.

Exhibit 19 shows the top 15 properties in the portfolio.

The top 15 tenants include many high-quality, recognisable names, active in economically defensive areas.

RGL is a UK-based REIT, which aims to provide investors with consistently attractive income returns with the potential for additional capital growth. It listed on the Main Market of the London Stock Exchange in November 2015, having been formed by the combination of two UK commercial property investment funds previously created by the external asset and investment managers. London & Scottish Property Investment Management (LSPIM) is the asset manager, responsible for the day-to-day management of the asset and debt portfolios. Toscafund Asset Management (Toscafund) is the investment manager, responsible for the company’s management functions.

LSPIM is based in Glasgow, with regional offices in Leeds, Manchester and London, supporting its fully integrated asset management platform. The senior management team is highly experienced, with a proven track record of adding value to property portfolios across cycles. In April 2023, ARA Asset Management6 acquired a majority shareholding in the company from its founder and CEO, Stephen Inglis, who retains a significant minority interest. The management team remains unchanged but now benefits from the resources of a large global real estate platform.

Management fees are set at 1.1% of net assets up to £500m and 0.9% above £500m, split equally between LSPIM and Toscafund. In addition, a property management fee of 4% of annual gross rental income is payable to LSPIM.7

The non-executive board consists of five members, chaired by Kevin McGrath, a chartered surveyor with more than 30 years’ experience in the property sector and property asset management. Other members are Daniel Taylor, founder and CEO of Westchester Capital, an investment and advisory firm specialising in real estate; Frances Daley, a chartered accountant with considerable experience in corporate finance and senior finance roles; Massy Larizadeh, with over 30 years’ experience across the financial services and commercial real estate sectors; and, with a particular interest in environmental, social and governance issues, Stephen Inglis (representing LSPIM) and Tim Bee (representing Toscafund).

Detailed biographies of all board members can be found here and we provide biographies for key members of the leadership team on page 18 of this report.

The two largest shareholders are Majik Property Holdings (47.1m shares or 9.1%of the total)8 and OMP-SS5 (35.5m shares/6.9%).9 These both originate from RGL’s acquisition of a £236m regional office portfolio from Squarestone Growth in August 2021. The consideration was part settled by the issue of 84.2m new RGL shares at 98.6p per shares. Of the shares issued, 74.6m shares were subject to lock-up arrangements which have now expired.

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. RGL is not a developer but, on a significantly lesser scale, is exposed to similar uncertainties as it actively invests in improvements to existing assets with the aim of enhancing long-term income growth and returns. We consider the main sensitivities to include: