Palace Capital — Earnings deferred to unlock potential

There have been several significant developments since the interim results, most notably including non-core disposals and accretive reinvestment, leasing events and progress with the Hudson Quarter development in York. We review these in brief below and discuss our forecast revisions in the financial section that follows.

The £18.2m disposal of 50 of non-core residential assets acquired as part of the October 2017 Warren portfolio that was agreed in November 2018 has now fully completed and since year-end two additional properties have been sold for £0.8m. Including sales earlier in FY19, 55 of the 65 residential properties acquired have now been sold, with just 10 remaining, of which the company has previously indicated an interest in retaining two. Proceeds of more than £20m have been generated by the disposals at a blended average 98% of book value. The gross rental yield on the residential assets was less than 4%, and disposal frees capital for recycling into the commercial portfolio where yields are significantly higher (H119 net initial yield of 5.7%).

In December 2018 Palace acquired the freehold of the recently refurbished One Derby Square in Liverpool for £13.98m (before costs), reflecting a 6.75% net initial yield. The property was 96% let at acquisition to a range of tenants including Prêt a Manger, Tesco, Medicash, Reed Specialist Recruitment and Brook Street. The acquisition is in line with PCA’s strategy to focus on city centre locations in university towns and regional cities with a positive supply-demand position and the company sees a significant further opportunity for active management to capture reversionary potential and enhance the future capital value.

At the Hudson Quarter development in York, demolition has been completed, a £35m construction contract has been signed, and the contractor is on site. As an indication of the profile of the development and the sensitivity of the site, within the city walls and just a minute’s walk from the York railway station, the Archbishop of York recently officiated at the commencement of building works. The scheme, which comprises three residential buildings and an office building, will provide 127 flats, 5,000 sq ft of retail/restaurant space, 34,500 sq ft of offices, and car parking. Construction is expected to take around two years. Marketing of the scheme will be formally launched on 20 June 2019, when the first batch of apartments will be offered for sale. York was recently voted by The Sunday Times as the best place in the UK to live (2018), and the company reports strong early interest. Palace also expects Hudson Quarter to indirectly benefit from a complementary proposed development, in which Palace has no financial interest or ownership, at York railway station, known as York Central. Outline planning consent was granted in March 2019 for 2,500 homes and 932,00 sq ft of offices. In February 2019, a £26.5m loan facility was signed with Barclays Bank to part-finance the development, alongside existing cash resources. The terms have not been disclosed but management describes the facility as being “on very competitive terms”.

Palace also reports a strong pipeline of development opportunities, within the existing portfolio, in core city centre locations. In High Street, Weybridge, Surrey, the company has secured a resolution to grant planning consent for the development of three retail units and 28 apartments, subject to a Section 106 agreement, and hopes to be able to secure formal planning approval later this year.

During FY19, 37 leases and rent reviews were completed at an average of 14% ahead of estimated rental value (ERV), or an uplift of £0.8m on the previous passing rent of £3.4m.

Since the year end, a lease surrender has been agreed with the tenant of Priory House in Birmingham, which is expected to complete on 31 May 2019, under which the company will receive a significant cash sum upfront in respect of the remaining lease term, which runs to December 2027. Palace acquired the leasehold to the property in October 2013 as part of the Sequel portfolio acquisition from Quintain. The tenant vacated the building in 2012 but has continued to pay the £322k annual rent. Under the surrender agreement, Palace will receive £2.85m, effectively all the rent due until the lease expiry, allowing it to move forward with a business plan for the property, and boosting its cash resources. All options to maximise the value of the asset, £2.2m as at 30 September 2018, are currently being assessed, including a potential refurbishment or development in conjunction with the freeholder, or alternatively a sale of Palace’s freehold interest.

Palace is not a REIT and operates a total return model, carefully targeting properties at attractive prices that provide an opportunity for active asset management strategies, including refurbishment and development, to unlock potential and grow sustainable cash returns. This means that unlike most REITs it is not always focused on maximising near-term portfolio income. By operating this total return strategy, Palace has built a strong track record of value creation over several years, primarily driven by corporate acquisitions that additionally benefit from lower stamp duty and provide the potential to benefit from acquired tax losses and capital allowances. NAV total return in the five years from September 2013 (H114) to end-H119 is 126.1% or a compound 17.7% pa. We have begun the analysis at H114 because this corresponds to the acquisition of the Sequel portfolio, Palace’s first transformational acquisition. The negative total return in FY18 resulted from the share issuance to fund the RT Warren portfolio and captures none of the future asset management-driven value creation that management hopes to achieve from this, its largest portfolio acquisition to date.

For FY19, management indicates that having taken a strategic decision to hold back on near-term letting of some vacant space in order to enhance medium-term returns through refurbishment and development, adjusted earnings for the year that ended 31 March 2019 (FY19) will be slightly below expectations. However, it expects to be able to enhance total returns over time while improving the overall quality of the portfolio. Given this expectation, and backed by a solid cash position, the board has reaffirmed its commitment to maintaining the current level of dividend payments despite the near-term dip in income, although our forecasts suggest that the dividend may not be fully covered by adjusted earnings, on a recurring basis, until completion of the Hudson Quarter development, expected in early calendar 2021/late FY21.

Refurbishment development activity, and the potential for value creation, is a core element of the Palace strategy, but can be difficult to forecast with accuracy, both in terms of timing and impact. This is particularly the case in respect of a significant development project such as Hudson Quarter (see below) but is also true for smaller projects. The nearer-term income effects of the letting deferral and lease surrender are easier to model and have a noticeable impact on our forecasts, both positive and negative (Exhibit 2), but we would not consider this to provide an accurate reflection of potential value creation over time.

Palace has indicated that end-FY19 gross passing rent, excluding the non-core residential assets held for sale and now mostly disposed of, was £17.7m. After the deduction of non-recoverable direct property costs of £1.9m the net effective rent was £15.8m, c £0.5m lower than we had assumed. This is the main driver of our FY19 forecast revision.

The additional one-off £2.85m of lease surrender income lifts our FY20 forecast, although this is partly offset by the lower starting base of net contracted income, and our no longer assuming any acquisitions in FY20. We had previously assumed a notional c £5.2m acquisition, adding just over £400k in annual gross income, but we now anticipate that given more uncertain market conditions Palace will be even more selective and perhaps more inclined to focus on its internal asset management opportunities.

FY21 sees no benefit from the lease surrender income and carries the full impact of the forgone recurring rental income.

More specifically, our revised forecasts include the following key assumptions:

The Hudson Quarter development has the potential to add materially to our forecast NAV and adjusted earnings when complete. Our expectations can be found in detail in our update note in December and the only change that we have made to these is to slightly reduce the capital development loan interest, having previously assumed a larger facility to fully fund the construction. Palace is yet to provide any firm guidance on the financial impact of the Hudson Quarter development but our assumptions are based on discussion with management and industry observations We forecast the full development cost to be c £54m, including the £16.8m site value at 30 September 2018, construction costs of £35m in line with the construction contract, and capitalised development loan costs. The impact on NAV will reflect the development gain on completion or the gross development value of the completed assets compared with the £54m development cost. Construction cost risk should be minimised under the construction contract such that the main uncertainty is market conditions at or nearer to the point of completion/sale. As we have commented on elsewhere, market fundamentals for York are currently positive. We show a range of potential outcomes in Exhibit 3, and note that a 20% development profit margin, the level that we think would be a target for management, would lift our forecast FY21 EPRA NAV by 5% or 20p.

Our expectation is that Palace will sell the residential assets and retain the office development to provide recurring rental income, which our analysis suggest could be c £1.0m pa. The potential impact on FY21e NAV, adjusted earnings and LTV, assuming a 20% development profit margin, is summarised in Exhibit 4. In addition to lifting forecast EPRA NAV by 5%, this scenario would reduce LTV by more than 11 percentage points to less than 30% and enhance adjusted earnings per share by 19% to 18.6p.

Clearly, there are risks attached to our analysis and to development activity in general. We have been explicit about the assumptions that we have made, but the actual outcome could differ materially from what we have assumed, especially at planned completion in 2021, when market conditions may have shifted. Development activity runs risks of cost overrun or delay and the development activity is being undertaken on a ‘speculative’ basis. However, we expect PCA to target pre-sales of residential space and pre-letting of commercial space well ahead of completion.

Palace’s strong track record of total returns is shown in Exhibit 1 above. The shares are trading at a c 30% discount to EPRA NAV and provide an almost 7% dividend yield, albeit less than fully covered on a recurring basis during the forecast period to end-FY21, excluding the lease surrender payment in the current year. Exhibit 5 compares the valuation and share price performance of Palace with a peer group of UK commercial real estate investment companies with a strong regional focus. Many of these are REITs and correspondingly give more focus to recurring income returns compared with Palace’s total return strategy. Due to the continuing search for sustainable income, and perhaps due to concerns about the maturity of the economic and commercial property cycle, those companies with an income focus have seen stronger share price performance. As a result, Palace is now trading at a considerable P/NAV discount to the peer group and a yield premium.

Given the strong track record of total return generation and the potential to drive further returns from the existing portfolio, the Palace valuation continues to appear undemanding. As more detail about the potential returns from the Hudson Quarter and the company’s other asset management plains aimed at capturing the significant reversionary potential in the portfolio emerge this may serve as a catalyst for a re-rating of the shares.