Regional REIT — Fully covered high-yielding dividend

In this note we review the recently released FY20 results, portfolio performance and outlook. We also discuss the rationale of RGL’s strategic focus as a pure play regional office REIT, providing a clear investment proposition for investors and reflected in the company’s positioning as ‘Regional REIT, the regional office specialist’.

RGL’s strategy of targeting a large number of occupiers operating across a range of industries, in growth regions outside the M25 delivered a resilient performance in FY20. Consistently strong rent collection throughout the year, recently up to 98.2% adjusted for monthly rents and agreed collection plans, underpinned uninterrupted quarterly dividends, fully covered by EPRA earnings, albeit at a reduced level. EPRA earnings of £27.9m (10% lower than FY19) and EPRA EPS of 6.5p were in line with our expectations. EPRA NTA per share of 98.6p (down 12% on FY19) were below our last published forecasts, as we indicated they would be after publication of the portfolio valuation in late February.

Key features of the FY20 financial performance include:

In its outlook statement, RGL stated that while it recognises continuing economic and market uncertainties resulting from COVID-19 and Brexit, it is confident of maintaining high rent collections this year and of accelerating the momentum of asset management initiatives. The asset manager remains convinced that high-quality, regional offices with affordable rents will continue to see demand for occupiers and that, given the tightness of supply, this is a positive indicator for rent growth.

Rent collection performance was consistently strong in 2020. RGL expects this to continue and to even improve as companies return to the office in FY21. At 12 March 2021, 98.2% of FY20 rents had been collected, adjusting for monthly (0.5%) and agreed collection plans (1.6%).

This marked a further improvement on the 97.8% reported on the same basis at 19 February 2021, which was only slightly behind the 98.6% collected in the equivalent period of 2019. RGL says it remains in supportive and ongoing discussions with occupiers about the remainder of the outstanding rent and expects to collect the vast majority in due course. On an annual basis, around 99.7% of rents are typically collected under normal conditions.

RGL’s continuing strong collection performance reflects several factors, including:

In this section we briefly review the portfolio at 31 December 2020 (end-FY20) and developments during the year, before examining the strategic decision to move the portfolio towards regional offices, differentiating RGL as a pure play in the sector and capitalising on the strengths and expertise of the asset management platform.

The portfolio was externally valued at end-FY20 at £732.4m. With the £53.4m (before costs) proceeds from disposals during the year substantially recycled into £42.4m (before costs) of acquisitions, the £55.5m (7%) decline in the portfolio value predominantly reflects the £54.8m reduction in fair value during the year after capital expenditure of £8.8m that is yet to be fully captured in valuation. Disposals crystalised a £1.1m loss on book value. The portfolio valuation was 7.2% lower on a like-for-like basis, although mirroring the market trend the second-half decline of 2.9% showed an improvement on the first of the year (a decline of 4.3%).

The disposals in FY20 were made at a blended average net initial yield of 5.1% (5.6% excluding vacant properties) with income more than replaced by the acquisitions, reflecting a blended net initial yield of 9.8%. The end-FY20 valuation reflects a net initial yield of 6.9% and with an estimated rental value (ERV) at full occupancy of £76.6m, the reversionary yield was 9.4%.

Gross contracted rent roll was little changed at £64.2m, with a weighted average unexpired lease term (WAULT) of 5.1 years or 3.2 years allowing for tenant lease break options (WAULT to first break). EPRA occupancy remained stable at 89.4%.

Across the market the COVID-19 pandemic reduced new letting activity; however, RGL remained active, renewing leases and agreeing new ones at or above ERV, in many cases achieving a strong uplift to previous rents. A total of 53 new lettings were completed, covering 177.9k sq ft (c 2.5% of the total portfolio space), adding c £2.0m pa to gross rental income when fully occupied. Retention of existing tenants was also strong and may have been boosted by the pandemic as tenants deferred long-term decisions about location and requirements and because of practical difficulties with moving. Of the leases that came up for renewal in 2020, 74.4% (by value) were retained, up from 65.9% in 2019, and the range of 67–70% that has been the norm since IPO. Encouragingly, where leases were renewed it was typically on normal (three- to five-year terms) rather than shorter-term extensions. In the current year, leases accounting for 14.2% (£8.9m) of gross contracted income will mature, or 25.8% (£16.2m) of gross contracted income including lease breaks. This includes a significant lease with Barclays (annual rent of c £1.4m), which expires in November, where the intention to aggregate a number of locations within a new purpose built site was made known some years ago. A dilapidations settlement has already been agreed. As lockdown measures ease, we expect a pick-up in leasing activity and RGL reported an up-tick in enquiries as the easing of the lockdown approaches. The £12.4m gap between contracted rental income and ERV represents a substantial asset management opportunity within the existing portfolio, primarily accounted for by void space and refurbishment projects (with an ERV of £3.7m). By sector, the reversionary potential sits primarily within office assets.

RGL’s consistent strategy since IPO has been to spread income risk across a large number of occupiers, operating across a range of industries, while targeting growth regions outside the M25 motorway. Its portfolio is highly diversified across more than 150 properties let to almost 900 tenants, that can fairly be said to reflect the broad spread of the UK economy. The largest tenant at end-FY20 represented 3.5% of gross rent roll and the top 15 tenants represented just 26.9%. RGL closely monitors the industry exposure of its tenants (and prospective tenants when assessing acquisitions) not just at the broad sector level but using detailed analysis based on Standard Industrial Classification (SIC) codes. It estimates that 52% of occupiers (by income) are classified as government-designated providers of essential services, continuing to operate during the lockdown.

In line with the strategy expressed at IPO there has also been a geographical repositioning of the portfolio towards more prosperous regions such as the south east (25.2% of the portfolio at end-FY20 compared with 12.7% at IPO) and away from Scotland (roughly halved to 17.3% since IPO).

In terms of sector exposure, the portfolio has already shifted significantly towards the office sector (83.5% by value at end-FY20) and the strategic decision to make this the focus of investment going forward (discussed below) should be seen in this context. Non-core retail and other assets within the portfolio at IPO have been steadily reduced and the shift from industrial to office assets began in 2018 when half the industrial portfolio was sold at a significant premium to book value.

Key to RGL’s high income returns and dividend paying capacity is the relatively high yield on its office assets (net initial yield of 6.8% at end-FY20 with a reversionary yield of 9.6%). The asset manager emphasises that rather than being an indication of low asset quality it reflects its strategy to target the provision of high-quality regional offices, fit for national, multinational, and regional and companies of all sizes, in a cost-effective manner. The November investor day webcast provides numerous examples from across the portfolio.

Because the portfolio assets are not typically prime/grade A they are often referred to as ‘secondary’. RGL challenges the usefulness of this phraseology, believing that it overlooks the high quality of most of the assets; built to a high specification, with raised access floors, air conditioned and refurbished to a high standard within the past 10 years. The asset manager believes these could be reasonably and better described as ‘grade A- or B’. For those assets it considers A-, achieved rents are 40–50% lower than for similar quality prime/grade A, although are likely to be in more peripheral locations or well-located business parks. For those assets considered grade B, the gap to prime/grade A assets is 50–70% while remaining very suitable and functional for most occupiers.

Nearly all of the assets in RGL’s office portfolio are low rise and c 62% are located in business parks, with an additional c 6% on edge of towns. RGL has only one high rise office (Arena Point in Leeds) which is contracted for sale. Low rise offices that are less reliant of lift facilities and assets with good parking facilities, enabling staff to drive comfortably to work and avoid public transport, may well benefit in a post COVID-19 environment.

Following a strategic review in November 2020, the board decided to continue the portfolio shift towards the office sector in the main regional centres of the UK, outside the M25 motorway. For the foreseeable future this will be the focus of investment with capital recycled out of the remaining investments in the industrial and other sectors.

The board shares with the asset and investment managers a positive outlook for the regional office sector, believing that high quality assets with affordable rents will continue to see demand from occupiers, combining with limited supply to generate rental growth. The strategic shift will enable the company to capitalise on the asset manager’s strong expertise and operational platform and will provide a clear investment proposition to investors. RGL says that there is a large number of interested parties in the sale of the residual industrial portfolio and we anticipate this is likely to occur during the current year (although this is not reflected in our forecasts). RGL is keen to take full advantage of a strong pipeline of investment opportunities and what it believes to be a mispricing in quality regional offices, brought into sharper contrast by the recent strong investor enthusiasm for industrial sector assets. In this environment it is hopeful of realising a premium over valuation on the sale of the industrial assets. Much smaller in value, the non-core retail and other assets sold as opportunities arise.

RGL set out in great detail the positive reasons for its confidence in the regional office sector and why it believes ‘the death of the office’ scenario in a post-COVID-19 world is misplaced. It presented additional details on the defensive characteristics of its current office portfolio in a capital markets presentation in November 2020. The slides and a webcast of the presentation are available on the company website.

Due to the supply overhang from the last great property cycle, which peaked in 2012 (later than economic activity due to development activity in progress), regional office rents have been slow to pick up. The relatively high yield on RGL’s office assets reflects low rents (an average £13.26 per sq ft for the office assets at end-FY20) and low capital values (an average c £130 per sq ft). RGL estimates an average new build cost (excluding land costs) of c £200 per sq ft, which continues to inhibit most new development, unlike previous cycles. Available market supply has reduced in recent years (in part through re-purposing towards residential, student and hotel accommodation); and although total office supply increased for the first time in a decade in 2020, availability, total supply and vacancy are all still below the 10-year average. With structural demand factors such as office migration from (more expensive) London to the regions and the political goal of rebalancing economic activity from south to north likely to remain, possibly reinforced by a shift to ‘localism’ (smaller, regional offices located in towns and cities outside the capital), beyond the immediate challenge of the pandemic the asset manager sees a strong opportunity for continued rental growth.

The counter argument to this positive outlook is primarily that the pandemic may lead to a permanent shift towards home working and that, combined with pressures on employment, this will reduce demand for office space in both the short and longer term. Although the ongoing restrictions have made the pace of return to offices uncertain and in most cases, business are still formulating their strategic responses, RGL’s analysis leads it to conclude that the ‘death of the office’ has been vastly overstated. Core to this conclusion is the broad role the office plays in company culture and productivity, being a place for both concentrated work and collaboration, connection, innovation, and social interaction. While each business will be different and it seems likely that working from home will increase for a great many businesses, it is unlikely to be a choice of either/or and more likely a hybrid model. It remains far from clear that this will translate into a reduced requirement for workspace, especially good quality space with affordable rents. RGL analysis indicates that occupational costs represent perhaps 10% or less of the cost base of a typical business; and for those business that do decide to focus on cost savings, RGL expects prime market assets to suffer most, as was the case following the 2008 global financial crisis. Hybrid models whereby employees spend perhaps three days per week in the office and two days at home may struggle to reduce space requirements once catering for peak use. Hot desking is typically unpopular with staff, who value their own space, a place to store belongings, the certainty of being in proximity to close colleagues, and the ability to work in teams. Social distancing at work and other behavioural changes may also reverse the long-term trend towards increased ‘office density’ – a smaller amount of workspace per worker – and a relatively small decrease in density has the potential to significantly impact the requirement for floor space. US-based data show a 65% reduction in floor space per employee since 1990 and are indicative of the trend in the UK. There was already some evidence of a limited move to lower-density working pre COVID-19 with the additional provision of different areas and services in offices and this may well increase as a result of the pandemic, increasing the demand for space.

The consensus of market observers appears to be that the industrial sector will continue to lead UK commercial property sector returns in the coming two years despite strong outperformance over the past two years. In this context RGL’s decision to sell its industrial assets and focus on the regional office sector is going against the consensus, although that is less clear-cut than it appears and RGL’s stance is in any case backed by a deep knowledge and experience of the sector.

In Exhibit 7 we show the most recent consensus of independent forecasts compiled by the Investment Property Forum. For 2021, the consensus is for All-UK office values to drop by 3.1%, limiting the sector total return to 1.1% (income and capital change combined), in contrast to the industrial sector where the consensus is for 4.3% capital growth to lift total return to 8.7%. All-UK office market rental values are forecast to decline by 2.4% with industrial rental values continuing to increase. The gap between the office and industrial sector across all measures is forecast to narrow in 2022 and be substantially closed by 2023.

The average consensus includes a range of differing views and even if it paints an accurate picture of the market as a whole this will not reflect any particular portfolio of differing assets in competing locations. The average consensus for income returns from office and industrial assets is broadly the same across all periods and so the difference in average forecast total returns is due to changes in capital values, always difficult to predict. To a large extent, investor enthusiasm for industrial assets has been focused on distribution and warehouse properties, benefitting from the accelerated challenge to the retail sector from the growth of online buying during the pandemic. RGL’s asset manager sees increasing indications of indiscriminate buying in the industrial sector and wants to take advantage of current market liquidity. In contrast, as shown above, RGL already has a portfolio of good quality regional office assets that generate income returns above the All-UK consensus forecast, despite affordable rents, and recent acquisitions have been achieved at net initial yields of c 10%, in part reflecting lesser competition currently for those office assets that are available.

We have slightly increased our FY21 recurring income and DPS forecast (EPRA NTA is slightly lower, reflecting the FY20 outcome) and have introduced forecasts for FY22. Although we would expect RGL to make progress with exiting industrial and other assets this year, recycling the proceeds into regional offices, we have not explicitly forecast this. Given prevailing market conditions we believe that a disposal of the industrial assets at a premium to book value may be possible with a positive yield pick-up as the proceeds are recycled.

Our rental income forecasts are based on our expectation for a relatively flat annualised gross contracted rental income (£63.8m at end-FY21 compared with £64.2m at end-FY20, rising to £64.5m at end-FY22) as RGL works hard to retain maturing income and re-let vacated space in what is likely to be a still-muted market. Underlying the gross contracted rental income forecast is an unchanged ERV with EPRA occupancy broadly at a similar level in FY21 (90%) and increasing slightly in FY22 (91%). We expect lower administration costs, including lower asset and investment management fees (due to a lower average NAV) and a falling away of bad debt charges. We expect net finance expense to benefit from continued low borrowing costs on an unchanged level of debt.

We have assumed no movement (realised or unrealised) in investment property values which we believe is a reasonable assumption given our ERV and occupancy assumptions and the potential to realise gains on the industrial portfolio sale, notwithstanding the consensus view that office valuations will fall moderately in 2021 before increasing slightly in 2022. We estimate that a 1% increase/decrease in the FY21e value of investment properties increases/decreases EPRA NTA by c 1.7%.

RGL has a broad spread of secured and unsecured borrowing with no maturity until August 2024. Drawn debt increased to £366.2m during FY20 (FY19: £344.0m) with the proceeds used to increase the level of liquidity, maintained at above-normal levels through the year as a precaution against market uncertainties. Adjusted for the cash balance of £67.4m, end-FY20 net debt of £298.8m was below the end-FY19 level (£306.8m). Despite this, the net loan to value ratio (LTV) was slightly higher at 40.8% (end-FY19: 38.9%) due to the reduction in property values, but still tracking the c 40% medium-term target.

Since end-FY20, Royal Bank of Scotland has agreed to extend the £55.0m facility for one year from June 2024 to June 2025, extending the weighted average debt duration to 6.5 years (from 6.4 years at 31 December) with no impact on the end-FY20 weighted average cost of debt of 3.3% (which was reduced from 3.5% at end-FY19). All of the debt is fixed or hedged.

The debt facilities include a £50m unsecured retail eligible bond and RGL says that the secured bank facilities provide substantial headroom against covenants. Group interest cover in FY20 was 3.4x (or 3.0x including debt cost amortisation).

RGL aims to provide an attractive total return to shareholders, targeting a total return of more than 10% pa, with a strong focus on income supported by the potential for additional capital growth. Up to end-H119 the cumulative accounting total return (the change in EPRA NAV per share plus dividends paid out) was 40.8% or a compound average annual return of 9.8%, very close to the target. Dividend payments are a major component of returns and have accounted for 65% of the total return over this period. Given our cautious assumptions for capital returns over the next couple of years, outlined above, our forecasts imply a total accounting return over the FY21–22 period of c 7%, effectively all generated by dividend payments. Although lower than historical returns, and below the 10% target, we think this represents an attractive return in the context of generally low interest rates. 10-year gilt has recently increased noticeably from the low point of last year (c 0.1%) but remains comfortably below 1%. We would also view RGL’s target return as a medium-term target, which will be difficult to achieve in all market conditions given the historical volatility of commercial property capital values.

In Exhibit 11 we show a comparison with a narrow group of peers that are similarly focused on regional commercial property. RGL’s high dividend yield continues to be at the very top end of both this narrow peer group and the broad UK property sector, particularly in respect of covered dividends. The company’s strong focus on income returns meant that it continued to make quarterly dividend payments through 2020, in contrast to several of its peers that temporarily suspended payments, in some cases where these had been declared, during the early, uncertain months of the pandemic.

To ease comparison, the data shown in Exhibit 11 is based on 12-month trailing DPS declared and last published NAV. RGL’s c 8% yield is almost double the peer group average, yet its P/NAV is broadly in line with the average and over the past three and 12 months its share price performance is below the peer group average. Given the continuing prospects for fully-covered, high dividend distributions (we forecast increasing) this seems somewhat perplexing. Picking up on earlier sections of this report we believe that investors may be focusing on:

RGL is a UK-based REIT that aims to provide an attractive total return to shareholders, targeting a medium-term total return of at least 10% pa, with a strong focus on income supported by the potential for additional capital growth. The company’s investment portfolio is comprised wholly of UK commercial property assets, predominantly office assets located in the regional centres of the UK outside of the M25 motorway. As noted above, it is the company’s intention to focus solely on investment in the regional office sector for the foreseeable future and it plans to divest of its remaining industrial and other assets, recycling the proceeds into offices.

Since listing on the Main Market of the London Stock Exchange (LSE) in November 2015, RGL has almost doubled the portfolio in size through an opportunistic acquisitive growth strategy, seeking to generate operational and financial economies through increased scale and further diversifying the portfolio to mitigate cyclical and tenant-specific risks to income. A key element of the investment strategy is to acquire under-managed properties where there are opportunities to create additional value through lease renewals and rent increases; minimising voids through effective marketing of vacant space; enhancing the tenant mix and covenant strength; and through refurbishment, extension, or change of use. When properties have met their return objectives they are assessed for sale (or to hold if their income and capital growth outlook looks strong), allowing the recycling of resources into new value-creating opportunities.

Ahead of its listing, RGL was 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 Management (Toscafund) is the investment manager, responsible for management functions of the company.

LSPIM is a privately owned co-investing asset management and property development business, based in Glasgow with offices in Leeds, Manchester and London. The senior management team has day-to-day involvement in the management of RGL assets and is highly experienced with a proven track record of adding value to property portfolios across cycles, through intensive property management, focusing on income generation. With a team of more than 60 individuals it is responsible for the property management of the RGL portfolio, including identifying and evaluating investment opportunities, the collection of rent, leasing and asset management, subject to the overall control and supervision of the board. In our view, this fully integrated asset management platform has made an important contribution to RGL’s strong rent collection during the pandemic.

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. An additional incentive is provided to the managers by way of a performance fee, set at 15% of total EPRA NAV per share return (EPRA NAV growth plus dividends declared) above an 8% hurdle, subject to a high-water mark. The performance fee is calculated annually and the intention is that one-third be paid in cash and two-thirds in shares (where new shares may be issued at above NAV). Performance fees were last accrued/paid during FY18; market conditions since have particularly pressured capital returns. With the current high-water mark at 115.5p we do not anticipate performance fees being generated in the near term.

Regional REIT has a six-member board of non-executive directors, including Kevin McGrath (chairman), a chartered surveyor with more than 30 years’ experience in the property sector and property asset management; William Eason, with extensive investment management and board experience; 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 on corporate finance and senior finance roles; 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 at the back of this report.

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 is exposed to similar but lesser 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: