Picton Property Income — FY18 builds on successful track record

The year ended 31 March 2018 was a very successful one for Picton. At the portfolio level, it continued to outperform the MSCI IPD Quarterly Benchmark, with a total property return of 13.0% compared with 10.1% for the benchmark. With the benefit of gearing, NAV total return (dividends reinvested during the year) was 14.9%.

Management provided a positive outlook for the current year, despite the risks associated with current economic conditions and the Brexit transition. Occupational demand for industrial and office property, where the Picton portfolio remains overweighted, has remained robust, with supply tight in many areas. Portfolio occupancy is at a good level, and the company has a number of asset management plans aimed at enhancing the existing asset base and capturing the inherent reversionary potential to grow income and value further.

Picton Property Income is an income-focused, internally managed investment company, with an investment objective to provide shareholders with an attractive level of income, together with the potential for capital growth, by investing in the main UK commercial property sectors. As at 31 March 2018 the fair value of the investment portfolio was £670.7m, diversified across 51 assets, let to more than 360 occupiers. Although diversified, the portfolio is actively positioned compared with the MSCI IPD Quarterly Benchmark, with an overweighting in industrial and office properties and an underweight position in retail and leisure property, and in central London.

Picton was launched in October 2005 as the ING UK Real Estate Income Trust in an offshore structure, and listed on the London Stock Exchange. In 2011, the company name was changed to Picton Property Income and in January 2012 it internalised the investment management function of the company through a newly created, wholly owned subsidiary company, Picton Capital. Picton Capital was substantially created by former employees of the outgoing external manager, ING Real Estate Investment Management. The change in structure was aimed at giving the company greater flexibility to manage costs and benefit fully from the growth in assets and, as the UK economy and commercial property markets have recovered in recent years, Picton has grown assets, earnings and dividends while the ongoing charge ratio (recurring costs excluding property costs as a percentage of average net assets) has trended lower (Exhibits 3 and 4).

Management’s aim is for Picton to be one of the consistently best-performing, diversified, UK-focused property companies listed on the Main Market of the London Stock Exchange. In the five years to end-FY18, positive property returns have combined with effective use of debt and efficient operation to generate an EPRA NAV per share total return of 117%, or a compound annual return of 16.8% pa (see Exhibit 15).

Picton describes its strategy as occupier focused and opportunity led. Occupier focused refers to working closely with its own tenants, to understand their needs, enhance occupancy, improve retention and maximise income, but it also applies to the occupier market as a whole, helping to drive portfolio strategy and asset selection. The opportunity led part relates to being commercial when buying, managing and selling. During FY18, Picton acquired one office asset in Bristol city centre, with significant reversionary potential for £23.2m and sold three non-core assets for an aggregate £10.4m, 37% ahead of the start-of-year valuation. By year-end, occupancy at the acquired Bristol asset had increased from 65% to 91%, contributing to a 15% uplift in valuation in the four months since completion. To achieve this two-pronged strategy, it targets five strategic priorities:

The externally appraised value of the portfolio as at 31 March 2018 was £683.8m (FY17: £624.2m) with a balance sheet fair value, after lease and other adjustments, of £670.7m. The valuation reflects a net initial yield of 5.5% and a reversionary yield of 6.6%, and increased by 6.5% on a like-for-like basis. In addition, purchases less sales of properties added a net £12.8m and £3.6m were invested into refurbishment projects to enhance the portfolio.

The rent roll at year end was £41.4m and increased by 3.9% during the year on a like-for-like basis. The estimated rental value (ERV) of £47.9m, up by 2.4% during the year, indicates a significant opportunity to increase rental income from the existing portfolio, as discussed below. Occupancy improved form 94% to 96% with a weighted average unexpired lease term of 5.2 years.

Exhibits 6 and 7 show the sector and regional positioning of the portfolio. The bias towards industrial and office assets was very beneficial to performance during the year, and the low exposure to central London (reduced significantly in FY17) was also beneficial.

The 13.0% total property return generated by Picton during FY18 compares with a 10.1% return on the MSCI IPD Quarterly Benchmark over the same period, around half of which is attributable to income and the rest to capital growth. Picton is c 41% weighted to the industrial sector (MSCI IPD c 22%) and its industrial assets saw 12.6% like-for-like valuation growth. Like-for-like valuation growth in Picton’s office assets (c 36% weight versus MSCI IPD at c 27%) was 6.5%. Retail and leisure values declined by 2.3% despite a high level of occupancy (97%) being maintained.

Of the £6.5m pa gap between end-FY18 contracted rents and ERV, c £2m represents the upside potential from leasing vacant space, with the balance attributable to asset management opportunities. With occupancy at 96% already, active asset management is likely to be the key to unlocking income and value from the existing portfolio.

The weighted average unexpired lease length (to first break) was 5.2 years as at 31 March 2018, and the maturity profile is shown below in Exhibit 8.

Over one year, lease maturities to first break represent just under 14% of contracted rent, or c £5.7m. Exhibit 9 provides a summary of some of the key asset management opportunities for FY19 and the potential upside from reversion to ERV.

Despite some slowing of UK economic growth, continuing Brexit uncertainty and a significant retracement of the boost to export competiveness that resulted from post-EU referendum sterling weakness, with much regional variation, property markets have remained robust over recent months. Industrial occupier demand has been robust across the UK, driving rents higher, and this seems likely to continue with little sign of material new supply. Sentiment towards London offices has weakened somewhat, and the large financial services sector is viewed as being particularly vulnerable to Brexit uncertainty. Regional markets continue to benefit from structural factors such as business relocation away from London, office conversion to residential use and a relative lack of new development in the years following the financial crisis. The retail sector continues to struggle, negatively affected by consumer income pressure, internet competition and cost pressures including business rates. The impact on Picton is mitigated by its relatively low weighting, a good level of occupancy and a high yield on assets. Management sees opportunities to create value through active asset management.

The Investment Property Forum (IPF) UK Consensus Forecasts survey gathers independent forecasts for UK commercial property from 26 leading consultants and fund/investment managers. We show a summary of the latest quarterly results, generated between the latter part of February and mid-May 2018, in Exhibit 10. For some time, the consensus has been for income to become the driver of continuing positive overall sector returns, with capital growth waning or even becoming mildly negative. Participants remain most positive about industrial property. City of London and West End office rental growth is expected to be negative over the next couple of years, which implies positive expectations for the regional contribution.

Picton has to date been listed as an investment company, managed and controlled by a board, based in Guernsey, with its own UK-based investment management subsidiary, Picton Capital, authorised and regulated by the Financial Conduct Authority. Picton Capital operates the group’s investment objectives, subject to the overall supervision of the board. As has been flagged by the company for some time, this corporate structure will change later this year, when Picton converts to REIT status, subject to shareholder approval. A key requirement for conversion is that management and control of Picton shifts to the UK, and in order to satisfy this requirement a number of changes to the board composition and internal management structures will take effect. At the same time, Picton will seek shareholder approval to change its technical listing status from that of an investment company to that of a commercial company, a change that would bring it more in line with other internally managed property company peers. A circular to shareholders will be released with the annual report later in June and an EGM will be held in July, when shareholders will be asked to approve the changes, planned to take effect from 1 October 2018.

The conversion to REIT status is a logical response to changes in UK tax legislation, to become effective over the next couple of years, which would otherwise be expected to materially increase the company’s tax burden. From 1 April 2020, non-resident landlord companies, as Picton currently is, will be brought into the scope of UK taxation, while additionally, from 1 April 2019, its capital gains from the disposal of commercial property would become subject to UK tax. In addition to tax efficiencies, management also anticipates potential administrative cost savings.

The changes are not expected to have any impact on Picton’s investment or portfolio strategy and there are no plans to change the quarterly dividend and reporting cycle. A condition of REIT status is that 90% or more of its tax-exempt income profits (not capital gains) are distributed, and the board intends to review the level of dividends post-conversion. However, although the FY18 dividend was 1.22x covered by earnings on an EPRA basis, management indicates that it does not believe the current distribution policy is materially out of line with REIT distribution conditions. Our forecasts indicate continuing DPS growth, but with dividend cover maintained at a similar level to FY18.

Nicholas Thompson is the non-executive chairman of the board, which also includes Robert Sinclair, Roger Lewis, Vic Holmes, Mark Batten and Michael Morris. Robert Sinclair and Vic Holmes will both retire after the AGM in September 2018, providing an opportunity for the board composition to adapt to Picton’s new status as a UK-managed and controlled REIT. Michael Morris currently serves on the board as a non-executive director, although he is chief executive of Picton Capital, the group’s property management subsidiary. He will become chief executive of the group, Picton Property Income, from 1 October, remaining on the board as an executive director. Andrew Dewhirst, currently finance director of Picton Capital, will also join the board as group finance director and executive director. From 1 October 2018 it is intended that the board will comprise six members, four of whom (including the chairman) will be non-executive, and two executive. From next year, the AGM will shift from Guernsey to the UK, with the potential to strengthen links between the company and its shareholders.

The investment management team that is responsible for the day-to-day implementation of Picton’s investment strategy and management of its assets will not change. In addition to Michael Morris and Andrew Dewhirst, the senior management team of Picton Capital includes the head of asset management, Jay Cable, and investment director, Fraser D’Arcy, and in total comprises 10 permanent employees and includes five real estate professionals, three qualified accountants and two support employees. The interests of all staff are aligned with shareholders through a deferred bonus structure linked to shareholder total return, and long-term incentive share plan (LTIP), additionally linked to growth in EPRA earnings and total property return relative to the MSCI IPD Quarterly Benchmark.

As noted earlier in this report, in the financial year ended 31 March 2018 (FY18) Picton produced strong results, with an EPRA NAV total return for the year of almost 15%. Net rental income, EPRA earnings and EPRA NAV were all slightly ahead of our expectations.

In our forecasts we assume an unchanged portfolio. Management says that it remains alert for new investment opportunities, but equally may make selective asset sales over the coming months, reducing gearing further.

Our rental income forecasts reflect a blended increase in the annualised rent roll of 1.3% in FY19 and 1.1% in FY20, driven by the industrial assets. We do not assume any change in occupancy across the portfolio given the already high level. In view of the £6.5m reversionary potential inherent in the portfolio, the £1.0m increase in our forecast for annualised contracted rents by end FY20 may well prove conservative. We have assumed modest increases in property valuation, in line with rental growth, maintaining the implied net initial yield at around 5.5%. The gains add 3p to NAV in FY19 and 2p in FY20.

Non-recurring REIT conversion costs of £307k were taken in FY18. Some further costs are likely, but we have made no specific allowance for this. Finance costs are based on the current 4.1% average cost of debt (95% fixed) and no change in drawn debt. Given the growth in portfolio value and modest positive net cash flow, we expect net LTV to drift lower, below 25% by end-FY20.

The changes to our FY19 forecasts, shown in Exhibit 11, are modest (the small reduction in net rental income relates to a slightly reduced assumption for dilapidation receipts) and we have introduced an FY20 forecast for the first time. Our FY20 forecast looks for EPRA earnings and DPS to grow further, by c 3%.

Taking our forecasts for changes in EPRA NAV and DPS together, the implied EPRA NAV total return is 7.8% in FY19 and 6.7% in FY20.

With its strong income focus, Picton pays quarterly dividends that currently annualise at 3.5p per share, a yield of c 4% at the current share price. With dividend cover of 1.22x in FY18 (and our forward-looking estimates show a similar level of cover with growing DPS), the payout could be higher, but management chooses to reinvest into the portfolio in ways designed to support occupancy and income growth, with the specific goal of enhancing total return over the long run. As noted above, its goal is to be one of the consistently best performing, diversified, UK-focused property companies listed on the Main Market of the London Stock Exchange.

A comparison of Picton with a broad range of listed property companies shows that its yield is below the median, albeit it is very well covered in a sector context.

A similar comparison of P/NAV shows Picton, which trades at around its EPRA NAV per share, positioned around the median position.

This broad peer group contains a wide variety of property companies, REITs and non-REITSs, and specialist vehicles (healthcare property, student accommodation), and covers a wide range of strategies, from a pure focus on income and collecting rents to varying degrees of asset management and capital growth, extending to property development. In Exhibit 14 we show a summary valuation comparison of Picton and what we consider to be its closest peers.

As a result of its strong dividend cover, Picton’s prospective yield is below the median yield for the group of 5.0% (which includes Regional REIT at 8.5%), while its P/NAV per share is similar to the median. Picton has showed a stronger share price performance than the peer group median and the FTSE All-Share Index over the past 12 months. However, the market valuation that investors appear to be giving Picton for its track record of returns in recent years is relatively modest.

Bringing together dividend distributions and the impact of reinvesting for growth, in Exhibit 15 we show the trend in EPRA NAV per share in the five years ended FY18. Total return has been 117% over the period or a compound annual return of 16.8% pa.

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but fluctuating with tenant demand and rent terms. From a sector point of view, we would 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. With its income focus, Picton is not a developer and avoids such risks, but does actively invest in improvements to existing assets with the aim of enhancing long term income growth and returns. We consider that the main sensitivities include: