Picton Property Income — Income is now the driver of returns

As described in detail in our June Outlook note, Picton’s strategy is total return driven with an income focus. It aims to generate attractive returns through pro-active management of its portfolio, investing in assets where it believes there are opportunities to enhance income and/or value. Its dividend policy is to distribute most of the recurring income earnings to shareholders via quarterly dividends, maintaining full cover, and generating surplus cash for reinvestment back into the portfolio. The company’s aim is to be one of the consistently best-performing diversified UK real estate investment trusts (REITs).

After a long period of rising property values, interrupted for a time during the pandemic, rising bond yields, economic and political uncertainty, and sharp reduction in investment demand for UK commercial property, this reversed in Q223 despite many sectors reporting good occupier demand and increasing rents. Although low transactional activity provides limited evidence as to where values may settle, yields continued to widen in October, and we expect this to continue.

In common with the sector, Picton’s across-the-cycle income return has been much more stable than the capital return. Successful asset management is thus key to sustainably enhancing total return, driving further income growth and supporting valuation.

Picton observes continuing robust occupational demand in the industrial sector, with good quality offices still attracting occupiers, and stable occupier conditions in the retail warehouse and prime high street markets. This is also reflected in rental growth, with ERV growth of 9% in the company’s industrial portfolio and 1% in offices, while retail and leisure ERV declined 1%.

During H123, 12 new lettings were completed, securing annualised income of £0.5m, in line with March ERV; five leases were renewed/regeared retaining £0.3m pa of income, 49% ahead of previous passing rent and 25% above ERV; and eight reviews were completed, securing a £0.1m pa uplift in income, 1% ahead of ERV.

In addition, Picton reported a current pipeline1 of 12 new lettings, totalling £1m pa, agreed subject to contract.

Including c £0.9m of additional income from acquisitions (see below) and an uplift from the expiry of rent free periods, passing rent increased to £40.7m pa (end-FY22: £38.7m). The like-for-like increase was 3%. The portfolio ERV increased to £53.8m (end-FY22: £49.8m), including a like-for-like increase of 5%. End-H123 occupancy of 90% was down from 93% at end-FY22. Around a third of this resulted from acquisitions (with strong asset management potential), discussed below, while ERV growth on some vacant space was also a factor.2

ERV is significantly (£13.1m or 32%) above annualised passing rent of £40.7m (+3% like-for-like). Void reduction represents £5.4m of the potential upside, with the balance coming from rent-free run-offs and stepped up rents (c £5.1m) and the potential to increase existing rents to market levels at lease expiry (c £2.7m).

By sector, the greatest potential is within the industrial and office sectors. With occupancy close to full in the industrial sector, the upside is from reversion to market rents (which continue to increase), while in the office sector, considerable upside remains from void reduction. Across the portfolio, the five largest voids account for £3.1m of ERV, or more than 50% of the total.

At 90%, EPRA occupancy is c 3pp below the five- and 10-year averages and c 6pp below recent peaks. The majority of the current void in the portfolio is relatively recent in origin rather than ‘stubborn’. Around 50% arose in this calendar year and a further 30% in calendar 2021. In part this relates to units becoming available during the pandemic that have subsequently been refurbished to enhance letting prospects.

The industrial vacancy represents just six units, four of which became available this year. All the units are either recently refurbished or where work has commenced on site, while occupier demand remains robust.

Occupier demand in the office sector is not as strong as for industrial, with a focus on quality. The flexible lease offering, SwiftSpace, has been introduced to the majority of remaining office vacancy, providing shorter-term leasing opportunities (typically two years with rolling six-month break options) to provide immediate income, with the potential to convert to more traditional leases (typically five years) over time. The SwiftSpace proposition has already helped to grow occupancy on smaller units with seven lettings across five assets.

Within retail & leisure, the retail warehouse portfolio is fully leased and there are two vacant high street shops, both under offer. The predominantly leisure asset at Regency Wharf in Birmingham includes a fully refurbished office element for which Picton has occupier interest that it is progressing.

Early in H123 (May), Picton completed the acquisition of Charlotte Terrace, a mixed-use property in Hammersmith, London, for £13.7m. It is located close to Olympia, which is currently undergoing a £1bn redevelopment to deliver a new creative district and enhance the area. The annual rental income on purchase of £0.5m pa reflected a modest net initial yield (NIY) of 3.3% off a low capital value, well below replacement cost. The company expects this to rise to over £1.1m pa once the remaining units are leased, reflecting a yield of 8%. A first letting has already been secured and, to improve office occupancy further, additional space is being upgraded for the rolling out of SwiftSpace, Picton’s flexible lease offering.

The acquisition of a second mixed-use property in Cheltenham, for £5.3m, was completed in August. It is well-located within Cheltenham’s pedestrianised town centre, adjacent to John Lewis, and, having been comprehensively refurbished in 2020, benefits from good environmental credentials. It is leased to four occupiers with an average lease length of 12 years to expiry and eight years to break. The annual rental income at acquisition was £0.4m, reflecting an NIY of 7.2%, and with most leases containing fixed rental uplifts this will increase to £0.5m pa by 2026, an NIY of 9.0%.

Picton has available debt capital resources of £38m with which it could selectively take advantage of further acquisition opportunities that may arise, particularly where vendors may be under pressure to realise liquidity. However, given the current level of uncertainty and volatility of debt markets, we have not forecast this.

Picton’s balance sheet is strong and substantially protected against further interest rate increases, and gearing is moderate. Of total debt facilities of £263m, £225m was drawn at end-H123 (95% of which fixed rate), reflected in a net loan to value ratio of 24.1%. Other than the partly drawn revolving credit facility (RCF), which matures in May 2025, the earliest significant re-financing event is in July 2031. All loan covenants continue to be met, with significant headroom, while a further £80m of uncharged assets provide additional flexibility. This should remain the case despite the increase in LTV to around 28% reflected in our forecasts, due to an assumed further weakening in property values.

Following a late-FY22 debt refinancing, both the company’s long-term credit facilities are fixed rate with a blended average cost of 3.7% and a blended average maturity of more than nine years. A shorter-term, floating rate RCF of £50m, providing flexibility to take advantage of further growth opportunities when identified, was c £12m drawn at end-H123 with £38m available to the company.

Picton’s minimal exposure to further interest rate rises would increase if it utilises undrawn funds available from the RCF. The Bank of England base rate (increased on 3 November to 3.0% from 2.25%) is closely tracked by SONIA, the reference rate for variable rate borrowing. Money market expectations for the future development of SONIA/base rate, reflected in the SONIA swap curve, have been volatile, indicating a peak of 4.5–6.0% by the middle of 2023 before steadily declining towards a long-term level of 3–4%. Current rates are at the lower end of this range. Our forecasts reflect an average SONIA rate of c 4.0% through FY24, with little impact on borrowing costs. At this level of SONIA, the cost of further drawing from the RCF would be c 4.9% (the 1.5% facility margin, less 0.6% commitment fee on undrawn balances, plus the SONIA benchmark), but would increase if interest rates continued to increase. Given the level of uncertainty that exists, we expect Picton to proceed cautiously and selectively with respect to further investment.

Like-for-like portfolio valuations reduced by 1.9% in H123, having increased by 1.9% in Q123 (and by 21% in FY22) and the EPRA NIY widened slightly to 4.2% versus 4.1% at end-FY22.

With a weaker demand-supply balance, rising bond yields and limited market transactions, there is much uncertainty about future capital values, despite many sectors reporting good occupier demand and increasing rents. This is particularly the case for industrial/logistical assets, which saw the largest pull back in quarterly valuation, after exceptionally strong past growth, despite continuing firm occupier demand, constrained supply and rising rents. The office and retail sectors have seen relatively stable capital returns in the year-to-date but were also negatively affected by yield widening in Q223. The performance of Picton’s portfolio broadly mirrors these market-wide trends and in such an environment the benefits of a diversified investment approach are clear. Market-wide valuation pressure has continued since September, and in our forecasts we have assumed that the portfolio’s valuation falls by 10% from the 30 September 2022 level by year-end, reflected in a 60 basis point widening of the NIY, including a positive impact from leasing. For FY24 we have assumed no further valuation movement, positive or negative.

Although valuation yield tightening has been the significant driver of capital growth in recent years, asset management also contributes. Investment to reposition and improve properties, enhancing their attractiveness to occupiers and income potential, also contributes to capital growth and we expect this to continue. At the portfolio level. driven by positive asset management and portfolio positioning, the company has a strong, long-term track record of outperformance versus the MSCI Quarterly Property Index, over one, three, five and 10 years and since inception. It also produced an upper-quartile index performance over three, five and 10 years and since inception. This continued in a challenging H123 environment, with Picton’s ungeared portfolio total return of -0.2% outperforming the index return of -1.3%. Its income return of 2.1% was 0.2% ahead of the index.

Exhibit 6 also demonstrates the relative stability of property income returns over the longer term.

The changes to our headline EPRA earnings and DPS forecasts are modest compared with the balance sheet impact of widening property yields.

Our forecast EPRA earnings are c 2% lower in FY23 and c 5% lower in FY24 compared with those last published, comprising:

Reflecting the level of financial market and economic uncertainty, we have adopted a slightly more cautious stance on DPS growth, deferring an increase in quarterly DPS until Q124, with a slightly smaller uplift to maintain a strong level of DPS cover.

Our forecasts for FY23 and FY24 EPRA NTA per share are c 22% and c 24% lower, respectively, at around 101p in each year (end-FY22: 120p).

Additional to our forecasts, each 1% fall/increase in the end-FY23 portfolio value would reduce FY23e EPRA NTA per share by c 1.4%.

Over the past 10 and a half years Picton’s aggregate accounting total return3 has been 161.0%, or an average 9.6% pa. Reflecting the total return investment strategy, dividend returns have contributed around one-third of total return and capital growth around two-thirds.

H123 total return was a negative 1.7% as property valuations weakened. We expect DPS to increase in FY24 while capital values weaken further, generating a dividend return of 2.9% and 3.3% in FY23 and FY24, respectively, but total returns of -16.2% and +0.5%.

H123 EPRA earnings of £10.7m were broadly stable, a little below H122 (£10.9m) and a little ahead of H222 (£10.3m). The overall IFRS loss of £10.4m reflected negative valuation movements of £21.1m (positive gains of £43.0m in H122 and £86.8m in H222). The drivers behind this result include:

At the current annualised rate of quarterly DPS of 3.5p, Picton’s FY23e yield is 4.2%. Meanwhile, the shares trade at a c 23% discount to the Q223 NAV per share of 117p and a 17% discount to our FY23 forecast NAV per share of 101p. The five-year average discount of c 6% is significantly affected by the pandemic and, more recently, the market’s derating of the sector due to rising bond yields and economic concerns. As recently as 12 months ago, the shares were trading at a small premium.

Compared with those companies that we consider to be its closest diversified income-oriented peers, Picton’s share price performance is above the peer group average and the broad UK property index over one year and three years. The sector has underperformed the UK equity index over the same periods. Based on 12-month trailing DPS declared, Picton shares trade on a lower yield than the group average, which in part reflects its strategy of balancing sustainable dividends with the capital requirements of active management, as well as relatively low gearing. Picton’s P/NAV is above the peer average, which we attribute to its strong track record of property level performance, the future income and valuation growth potential embedded in its portfolio, and its strong balance sheet with relatively modest gearing.