Regional REIT — FY19 momentum and COVID-19 defences

2019 was another active year for RGL, delivering further growth in the portfolio, part-funded by the £62.5m (before costs) equity capital increase in July 2019, in rent roll, and in underlying earnings. Total DPS for the year increased (by 2.5%), as it has in each of the four years since IPO.

Before discussing the FY19 results in more detail, we provide an update on the COVID-19 impact, and RGL’s preparedness and responses.

As at 6 April 2020, 81.6% of rents invoiced had been collected (an increase from 68.2% as reported in the 31 March trading update). The drop in collections at the same point in FY19 (83.1%) is relatively modest. Tenants who have agreed to switch to monthly payments represent an additional 4.8% of invoiced rents and RGL said that it expected a further 2.3% of rents due to be settled within seven days. Overall, RGL said that it was expecting to receive more than 90% of invoiced rents in the near-term and is hopeful of receiving all agreed rents by mid-year.

RGL points to the granular, fully integrated asset management approach employed by the external asset manager, London & Scottish Property Investment Management (LSPIM), which helps it to stay close to tenants, providing useful support, and is likely to assist the company in optimising occupancy/rental collection during this crisis. LSPIM is responsible for the day-to-day management of the asset and debt portfolios, and operates from its base in Glasgow with a regional office network in Leeds, Manchester and London. The senior management team has worked together for a long time and has experience of managing portfolios for cash in downcycles.

Alongside LSPIM, Toscafund Asset Management (Toscafund) is the investment manager for RGL, responsible for the management functions of the company. Recognising the contribution the asset and investment managers to RGL’s performance and the importance of providing continuity of management, especially at this challenging time, it has been agreed with the company that the management agreements will remain in place beyond the scheduled expiry later in 2020, until November 2023.

Portfolio diversification, by geography, property and individual occupiers (as well as the industries in which they operate) is a key element of the company’s strategy to mitigate the cyclical risks to income that are inherent in the commercial property sector and that have been brought rapidly to the fore by COVID-19. As at 31 December 2019, the portfolio comprised 160 properties with 904 tenants (the largest representing 2.5% of rent roll). Around 41% of the tenants are multinational or FTSE 350 and above sized companies, and c 51% of tenants provide services that are classified as essential in the government’s COVID-19 lockdown guidance. Around 94% of the portfolio by value represents office and light industrial units located in the regional centres of the UK outside of the M25 motorway, market segments that were continuing to benefit from increasing occupational demand, rising rents and positive supply-demand fundamentals ahead of the COVID-19 crisis (see below).

Significant refinancing activity, particularly over the past year, has increased the amount of available funding, while rationalising the number of facilities has increased average debt maturity and lowered the average cost. From a peak of c 49% in 2017 immediately after the Conygar acquisition, loan to value (LTV) has been steadily reduced in line with the group’s medium-term target of c 40%.

At 30 December 2019 (FY19), RGL had debt facilities of c £372m (including unamortised debt arrangement costs), of which c £344m was drawn and outstanding. Allowing for c £37m of cash, net debt was c £307m and the LTV was 38.9%. The weighted average term to maturity was 7.3 years with no near-term maturities and an average cost (including hedging costs) of 3.5% pa. Since end-FY19, RGL has drawn down the available funding on the Santander and Royal Bank of Scotland facilities, taking total gross borrowing at 31 March 2020 to £369.1m and increasing the cash balance to £69.1m. Based on the end-FY19 gross property asset value, the 31 March 2020 LTV remained at c 39%. Allowing for the unsecured Retail Eligible Bond debt, the end-FY19 LTV ratios on the secured debt facilities were mostly below the group average LTV.

RGL has a target that at least 90% of the loan portfolio is hedged using fixed-rate facilities or interest rate swaps, and at end-FY19 the portfolio was more than 100% hedged.

Each of the secured debt facilities has its own distinct covenants, which generally include historic interest cover (tested quarterly), LTV cover (tested annually), and debt service cover (tested quarterly). RGL was in compliance with all of these throughout FY19 and expects the same at 31 March 2020 (Q120) and says that at the end of the year had substantial borrowing headroom in relation to the covenants. Depending on rent collections the rent cover position in Q220 may be more challenging but RGL says that it enjoys strong and close relationships with its lenders and that it expects no issues to arise.

Regional offices represented 79.9% of the 31 December 2019 portfolio by value and light industrial assets 13.7%, with retail assets accounting for just 5%. During 2019 and early 2020, supply-demand fundamentals for both regional office and industrial sectors remained positive with robust occupier demand, despite Brexit uncertainty and some weakening in overall economic growth prospects and limited new supply. In the investment market, UK-wide commercial real estate investment volumes weakened in H119, although there are some signs that the impact in the regions was more muted than for London. Overall UK volumes were lower during 2019 (13% below the five-year average according to Lambert Smith Hampton), but accelerated in the second half of the year, and in the regions outside London, the fourth quarter pick-up in volumes was notable.

Regional office rents continued to experience upward pressure, contributing to an ungeared total property return of 8.6% according to CBRE, outperforming the central London total return of 5.8%, as has been the case over the past four years.

Occupier demand in the industrial market softened in 2019, but remained positive and sufficient to absorb new supply, supporting continuing rental growth but at a slower pace than in 2018.

In 2019, RGL’s annual gross contracted rent roll increased from £59.7m to £64.3m including a c £6.3m net addition from acquisitions and disposals. Disposals, primarily in H119, amounted to £24.3m (net of costs), reflecting an average net initial yield of 6.8% and achieving an average uplift on the end-2018 valuation of 10.3%. Acquisitions, primarily in H219, amounted to £87.1m (before costs), adding £8.0m to annualised gross contracted rental income and reflecting an average net initial yield of 8.6%. EPRA occupancy across the portfolio was flat at 89.4% (slightly up in industrial and slightly down in offices as two properties became vacant), but on a like-for-like basis was slightly lower at 88.1% compared with 89.6% at the end of 2018. Together with the reduction in contracted rents on the small retail exposure in the portfolio (5% by value) and partly offset by rent uplifts on leasing events, this explains the c £1.8m like-for-like reduction in contracted rent roll. Lease renewals for office and industrial assets achieved an uplift in gross rent roll of 9.8% on average, while 71 new lettings (356k sq ft) were completed, providing a gross rental income of £3.8m when fully occupied.

The portfolio value increased by 9.4% to £788m, primarily reflecting net acquisitions, but also including capital expenditure and a net negative unrealised valuation movement of £3.5m (including c £2.8m of property acquisition costs, mostly related to deployment of the proceeds of the July capital raise). The like-for-like value of the group’s core office and industrial assets (93.6% by value) increased by 1.4% after adjusting for capital expenditure and disposals during the period. Including retail, the overall portfolio value was down an underlying 0.1%.

It remains too early to be able to assess the longer-term impact of COVID-19. In the near term, the focus is on optimising the collection of contracted rents while providing support to tenants where this is appropriate. The most obvious immediate effect is on cash flow, for which the strong cash position provides an immediate cushion. Depending on the extent and duration of the pandemic, the longer-term impact on tenants and the broader economy, and the implications of this for occupancy and contracted rents, will become clearer. A swift and significant rebound in activity following the period of lockdown is to be hoped for but, despite significant efforts by government and the central banks to support economies, the occupational market seems likely to be softer than before the pandemic. Positively, in contrast to the last major economic and commercial property downturn in 2018, interest rates remain low and rents have not risen so far as to encourage widespread speculative development activity. RGL’s focus on the regional property and light industrial sectors and its highly diversified tenant base are positive factors.

The potential impact of COVID-19 on property valuations and NAV is similarly unclear at this stage, although RGL’s Q120 trading update scheduled for 21 May 2020 may provide an update on the immediate impact on its own property valuations. Given the lack of representative transactions taking place from which to extract pricing evidence, a statement highlighting material uncertainty has recently introduced by external valuers across the sector.

In Exhibit 2 we summarise the FY19 financial performance. Net rental income and underlying earnings were slightly ahead of our last published forecasts and EPRA NAV per share slightly below, but consistent with the portfolio valuation update contained in the late-January trading update.

The key features of earnings on an underlying basis were:

Given the immediate sector-wide uncertainty regarding cash flows, rental income and property valuations, we have temporarily withdrawn our forecasts and will seek to reinstate these as soon as a clearer picture emerges. In addition to our observations above regarding portfolio diversification, secure funding and a strong level of current liquidity, we would also note that net property acquisition activity in 2019 made only a partial contribution in the year. We estimate a potential further uplift to gross rental income of more than £1m in 2020. Additionally, the end-FY19 estimated rental value at full occupancy was £72.2m, well ahead of the £64.3m gross contracted rent roll, suggesting that there will be continuing opportunities to support income through continued active asset management even in a likely softer letting market.

Given the sector-wide uncertainties, we are unable to provide a meaningful, forward-looking comparison with peers, but based on the FY19 DPS of 8.25p, RGL has a trailing dividend yield of c 11% and trades at a more than 30% discount to end-FY19 EPRA NAV per share. This valuation is clearly building in material sustained negative impacts from the COVID-19 crisis. We estimate that for the EPRA NAV per share to fall to the current share price (such that the share price would then represent 1.0x NAV), a c 23% reduction in the portfolio value would be required. As a result of the recent share price decline, the trailing dividend yield has increased from c 7.5% at the time of our November 2019 outlook note) and reflects sector-wide uncertainty about cash flows and future dividend pay-outs. At the current share price, a prospective 7.5% dividend yield would imply a reduced 5.25p DPS. If based on the FY19 income statement we estimate that this would be consistent with a c 12% reduction in the gross rental and other income (including service charge income) reported in the year and a full pay-out of the resulting adjusted earnings. Our analysis suggests that the same result could actually be achieved with a larger underlying reduction in rental income if allowance is made for the expected increased contribution to FY20 rental income from a full period contribution from the FY19 acquisitions and ongoing asset management initiatives.