Channel Islands Property Fund — Income is the name of the game

The outlook for the Channel Islands in terms of investment activity is encouraging as the world begins to come out of lockdown; CIPF has demonstrated resilience during the pandemic, when all anticipated rents were collected, as well as to the working from home (WFH) trend, albeit this has had less of an impact given minimal commuting times. However, this is not the only reason why this location is attractive. Firstly, investment assets on the islands have defensive qualities, which include longer than average leases (c 15 years) versus similar assets on the mainland (c five years), and because the occupiers tend to be resilient finance industry companies so the strength of their covenant is also high.

Secondly, during the pandemic, the strength of the covenants was tested. In the event, D2 Real Estate (formerly BNP Paribas Real Estate (Jersey)), the fund’s property manager, collected 100% of anticipated rents, underscoring the strength of the covenant. There were no deferrals or incentives granted.

Thirdly, yields tend to be c 75bp higher than for comparable regional UK markets. We believe this is partly due to lower anticipated capital appreciation and partly to a liquidity premium, the idea being that it is harder and takes longer to sell assets in the Channel Islands. In isolation, this yield premium is attractive, but it also offers scope for Channel Islands yields to trend closer to regional levels, which offers potential for capital appreciation. This may happen post the pandemic as investors are beginning to wake up to the idea of investing in the islands. This is evidenced by new investors, including US REITs, beginning to acquire assets there. That said, when the cost of rates is added to the headline rent, the total occupier cost in the Channel Islands is lower than for most large English cities according to research from D2 Real Estate.

In 2020, c £61m of office stock changed hands, less than one-third of the levels in 2018 and 2019, reflecting a lack of availability rather than a lack of demand, and due to the effects of the pandemic. Buyers across the two islands included a listed fund, a syndicate and some private investors.

Demand in 2021 remains strong, with a key client focus on buildings with attractive working environments, which are rated using the Building Research Establishment’s Environment Assessment Method (BREEAM), with occupiers looking for buildings that can deliver on individual ESG initiatives.

Jersey’s occupational (office) market runs to approximately 3m sq ft, of which CIPF owns c 165,000 sq ft, implying a market share of 5.5%. According to D2 Real Estate (D2RE), as of April 2021 there was approximately 390,000 sq ft of potential space in the pipeline including 140,000 sq ft at the International Finance Centre, 50,000 sq ft at 8/9 Esplanade and 200,000+ sq ft, subject to pre-lets, at J1 St Helier. The potential increase in space amounts to 13%, four times more than is being developed in Guernsey.

In recent years, demand has matched the level of new development, with the take-up of 200,000 sq ft and 250,000 sq ft in 2017 and 2018 respectively. Since then, take-up has fallen away as the pipeline has been subdued. That said, 2020 did record c 69,000 sq ft of take-up, which was an increase over the 50,000 sq ft of take-up in 2019, a result seen by some as encouraging given the hiatus in the market. According to D2RE, the lower take-up figures reflect a lack of stock rather than a lack of demand.

One notable feature of the market in 2020 was that of re-gears – where some tenants downsized and others expanded – and this has led to the signing of long-term leases with unbroken terms of nine to 15 years being common.

Despite good levels of overall demand seen in 2020, the outlook for rents for BREEAM-rated buildings appear to be under some pressure as enquiries have been at subdued levels and the rental rate for prime, second-generation’ space is at around £30/sq ft, a c 25% discount to BREEAM-rated property which has been attracting rents of £39–40/sq ft. Secondary office space is cheaper still at c £20–24/sq ft outside the Esplanade and is attracting attention.

Guernsey’s occupational (office) market runs to approximately 2m sq ft, of which the CIPF owns c 253,000 sq ft, implying a market share of c 13.7%. According to D2RE, as of April 2021 there was approximately 93,000 sq ft of potential space in the pipeline, including Phase 1 (30,000 sq ft) and Phase 2 (55,000 sq ft) at Admiral Park where 24,000 sq ft was pre-let to Julius Baer, and, c 18,000 sq ft at St James’ Place where 14,000 sq ft was pre-let to Grant Thornton. The potential increase in space amounts to c 5%.

Take-up has generally been considerably lower in Guernsey than Jersey because there has been very limited supply of new space, although in 2020 take-up stood at c 57,000 sq ft, roughly in line with the five-year average. Generally speaking, if the product is available, there is a ready market for the space.

Rental rates for prime/BREEAM-rated property in St Peter Port/Guernsey are at similar levels to St Helier/Jersey, although D2RE believes well-appointed space with car parking tends to attract a modest premium to the £39–40/sq ft level. The same is true of good-quality older space, which attracts a rate of c £30–33/sq ft.

The Isle of Man total office stock extends to around 1m sq ft which makes it around one-third the size of Jersey and half the size of Guernsey’s office market by capacity. CIPF owns c 100,000 sq ft, which implies it owns roughly 10% of the market. The main occupiers tend to be those companies operating in insurance, finance and corporate services, as well as gaming and software supplies. Notable occupiers include Barclays, Zurich, Flutter Entertainment and Microgaming Software Systems.

The market is supply-constrained which limits the supply of new Grade A office space, but this has encouraged several owners to refurbish premises in recent years. Average office take-up in good years tends to be in the range of 60,000–90,000 sq ft (ie 6-9% of the total stock). Grade A rents are around £21.50 to £23.50/sq ft which is around 50% lower than rental rates in Jersey and Guernsey and around a third lower than in other regional prime UK cities.

The attractions of the office markets in the Channel Islands have been highlighted and enhanced by the pandemic. First of all, the quality of the covenants has been amplified by the fact that all rent due was collected on time and in full during every period since the start of the pandemic. This is in sharp contrast to other multi-let office landlords, eg CLS Holdings, which saw rent collections of only 87% in Q220. That said, across the board, rent collected from multi-let office property was much higher than in sectors that were affected far harder such as retail and leisure which, in many cases, were closed down completely for long periods.

Secondly, given the modest size of the islands and the restrictive planning rules, the supply of new space is extremely constrained. Tenants therefore tend to be content to renew leases when they come up for renewal and to sign leases of a much longer duration than is likely to be agreed in other financial hubs like London. As discussed below, leases of five to seven years might be normal elsewhere, but on the islands leases of twice this length are not unusual. In Q221, CIPF agreed two rent reviews, both at uplifts to the passing rent. At 12 August, there was 25,426 sq ft of vacant space in two buildings, most of which had been refurbished and was available to rent. This was 4.9% of total floor space, ie CIPF’s occupancy is running at c 95%. CIPF is witnessing good levels of interest in the vacant floors at Royal Bank Place Regency Court and discussions are ongoing.

We are currently aware of only two properties under construction in Guernsey, both being developed by Comprop:

Comprop has leased 14,000 sq ft of St James’ Place development on a 15+ year lease to Grant Thornton, which gives some indication of the lengths of leases and the implied quality of earnings that this gives landlords and in turn investors. Only one floor remains available.

Thirdly, both Guernsey and Jersey closed their borders and then locked down early on in the pandemic, which meant that spread of the virus was limited and that the number of COVID-19 cases on the islands was low. There have been 78 deaths in Jersey and 19 in the Bailiwick of Guernsey. These firm actions have invited praise for the governors of the islands and enhanced the attractions to corporates.

The increased attractiveness of the islands to both investors and tenants is in part reflected in the falling yields, which were discussed earlier. It is likely that yields could continue to fall as demand is solid and interest rates remain low, thus supporting the valuations of the CIPF portfolio. In recent years, some notable developments have been bought to the market such as Gaspe House (£90m), Trafalgar Court (£55m) and Dorey and Martello Courts (£60m), which have attracted overseas investors. In addition, the islands have attracted some very wealthy residents, who have bought assets of more than £40m, thus improving market liquidity. The attractiveness of the islands is further enhanced by the similarity of commercial property law to UK’s with the exception that the Landlord and Tenant Act 1954 does not apply, which means tenants have no right of renewal at lease expiry.

As mentioned earlier, the Channel Islands were less affected by the pandemic and a majority of employees within tenant organisations having already returned to the office environment. This situation was noted/underpinned by a major survey undertaken by D2RE in which 85% of all companies surveyed gave the importance of the office to efficiency, collaboration and training a score of 4 out of 5. This has led to greater investment in premises, which insulates the offices from WFH culture and led to long leases on pre-lets and new developments being agreed at the height of the pandemic.

CIPF will continue to monitor the market and assess the opportunities available within the portfolio to deliver increases in shareholder value that fit with the investment guidelines and, ultimately, enhance the dividend for shareholders.

CIPF’s current property portfolio consists of 12 properties – five in Guernsey, four in Jersey and three in the Isle of Man. All are Grade A office properties, often multi-let to internationally well-known financial, legal, technology and shipping companies. This spread of tenants ensures that risks to rental income are lower, as does the long-term nature of the leases, which collectively had a weighted average unexpired lease term (WAULT) of 12.7 years at the end July 2021. This long-term visibility gives investors confidence that the fund will be able to pay its expected future dividends, which is one of the fund’s major attractions.

CIPF’s underlying property portfolio is relatively well spread between the three islands of Guernsey, Jersey and the Isle of Man, with two-thirds located in Guernsey, and a quarter located in Jersey. This is a modest improvement on 2019 as the fund bought 18–22 Grenville Street in Jersey, which had a value of £19m at 31 March 2021, and the more modest-sized Oak House in Guernsey, which had a value of £8.2m, thus shifting the weighting of the portfolio.

The Isle of Man has remained at c 12–13% of the portfolio.

That said, the yields achieved in the Isle of Man are a lot higher than those achieved elsewhere in the portfolio, so the rental exposure is a little more balanced than the capital value. Guernsey accounts for 58% of contracted rent, Jersey 27% and the Isle of Man 15%.

In terms of rental income, the three largest properties in Guernsey – Regency Court, Glategny Court and Royal Chambers – account for just shy of 50% of the total and have an average yield of nearly 7%. Despite the concentration of property represented by these three properties, it is worth describing the range of tenants within the three properties:

The portfolio includes high-quality covenants and unexpired lease terms of long duration. At 31 July 2021, the whole portfolio had a WAULT of 12.7 years, which is very long for a multi-let office portfolio. We believe a WAULT of around five years is more typical (for example, CLS Holdings’ WAULT is currently 4.7 years).

Within this long WAULT, 46% of contracted rent has a WAULT of 10 years or more, and another c 28% has a WAULT of five to 10 years. Only around a quarter of contracted rents have a WAULT of less than the five-year average, and only around 8% have a WAULT of less than three years. However, we do not see the shorter-term agreements as a risk, considering the lack of new space coming onto the market, and the attractiveness of the locations implies a steady stream of interested occupiers.

The tenants in the portfolio are mostly blue-chip financial and legal firms and, as such, can be considered good-quality covenants. The largest tenant by total rental income is the legal firm Mourant, which has offices in many offshore locations including Guernsey, Jersey, the Cayman Islands and the British Virgin Islands.

Other leading tenants are the Bank of Butterfield, which has offices in the Channel Islands, Bermuda, the Cayman Islands, the Bahamas, Singapore and elsewhere, and accountancy firm Ernst & Young, which has a global presence. Collectively, these three clients account for more than 30% of CIPF’s contracted rent.

CIPF’s share price has been remarkably stable for most of the 11 years since it listed in 2010 at 100p. It has hovered around the listing price for most of the period, dipping briefly in December 2014 to 97p, and increasing to 104p in May 2017. We believe this stability is driven primarily by the fund paying away most of its earnings as dividends – the trade-off for growth in the underlying assets is a dependable dividend stream.

The long-term stability of the share price also reflects the lack of growth in reported net asset value (NAV). The NAV has been affected by a number of issues including the Brexit referendum result, which hit property valuations that have since struggled to recover, and subsequent valuers’ assessments that reflect forthcoming breaks and expiries as well as potential voids, capex and incentives.

More recently, of course, there has been more volatility, with the share price dipping in March 2020 to 96p as the pandemic took hold. It has since recovered all the lost ground and is now trading at 101.5p.

The charts below highlight the longer-term performance of CIPF’s share price in absolute terms, the NAV (including dividends) and the total return of the FTSE EPRA Nareit UK Office Index, all rebased to 100. Again, the share price has been very stable over the extended period, increasing by just 1.8% pa over the last five years, partly because the fund pays out most of the income as dividends, and partly due to liquidity issues, we believe. However, the NAV total return has been better and broadly in line with the benchmark over the longer term. It has increased steadily over the period as the portfolio has generated a steady income stream, and produced a total return of 42.7% over the five-year period to end October, vs the benchmark FTSE EPRA Nareit UK Office Index, which produced a total return of 68.8%.

The right-hand chart above highlights the returns over multiple historical time frames. In particular, it shows that the benchmark has performed very strongly over the last 12 months as stock prices have recovered post lockdown. We believe this highlights the volatility of the market versus the stability of portfolio NAV and therefore the attraction of the island property markets.

Exhibit 13 shows the share price and NAV performance versus office and property benchmarks. Over the longer term the share price has lagged, which highlights the potential for some ‘catch-up’ in the future. The NAV has performed better, underperforming the office benchmark by 26.1% over five years, but comfortably outperforming the wider property benchmark by 5.9% over the same period. This is despite capital expenditure of c £6m on three properties over the last three years, including roof repairs and plant replacement at Regency Court, Royal Bank Place and Liberation House. The NAV has also been hampered by a revaluation reduction in 2016 of £6.0m due mainly to Brexit and a further £3.6m in 2017. Dividend payments generally account for the majority of profits thus limiting NAV growth.

The short-term underperformance of both the share price and the NAV versus the benchmarks reflects the recovery of other markets that were more profoundly affected by the pandemic.

Exhibit 14 below tracks CIPF’s NAV total return versus the FTSE EPRA Nareit UK Office Index total return, again highlighting the long-term stability of the fund and its total return performance.

CIPF does not have any direct peers, but we list below a selection of REITs and funds that have similar characteristics, that is, they tend to hold office, commercial or retail property portfolios that have good-quality covenants. CIPF compares well in terms of its one-, three- and five-year NAV TR performance versus the average, ranking fourth over one and three years and second over five years. It also has an above average yield of 6.5%, an annual charge of 1.94% and no performance fee that would eat into the shareholder returns if it existed.

The dividend paid out by CIPF is one of the most important features of the fund. Over the last six years it has consistently paid quarterly dividends to shareholders as the chart below describes. It paid 6p/share in ordinary dividends in both 2015 and 2016, and a total of 6.6p/share in all subsequent periods. It has also continued with quarterly dividends of 1.65p/share declared for Q1 and Q2, which suggests that the total ordinary dividend payments for FY21 are likely to be the same in FY20, ie 6.6p. This implies a dividend yield of 6.5% at the current price.

Exhibit 16 also shows that a special dividend of 2p/share was declared in respect of 2016, again in line with CIPF’s investment objective.

CIPF tends to trade at a premium to its NAV. We believe this is because assets are high quality and the covenants of the tenants are equally elevated. Therefore, the rental income is very predictable and, even in the pandemic, CIPF collected all rent due in every quarter. It follows then that investors value the company on a dividend yield basis.

Currently, CIPF is trading on a yield of 6.5%, which will be attractive to a range of income-seeking investors in the current low interest rate environment and could explain why the shares usually trade at a 3–9% premium to NAV.

The company has not issued any shares in the last three years but remains open to the potential to do so in the future, should an attractive opportunity arise. CIPF remains focused on developing and improving the existing portfolio to maximise the value and quality of the rental income stream.

The company was established in 2010 with the objective of providing an investment opportunity that aims to provide shareholders with a total return from a combination of capital growth and an appropriate dividend policy through the acquisition and active management of commercial property predominantly in the Channel Islands.

The NAV of the fund has tended to fluctuate in a narrow band between c 92p and 96.4p over the last two and a half years, so the total return has mainly consisted of the quarterly dividends that have been declared at 1.65p/share each quarter since the end of the 2016 financial year. On the current price, this implies a yield, and in effect a total return, of c 6.5%.

The company’s investments are not subject to any geographical or other limitations or restrictions. The company may invest directly or indirectly in commercial property including property development as long as no single investment is more than 25% of the portfolio. Investment in property related funds, derivatives and financial indices is also permitted. Leverage is targeted at 40–65% of total acquisition cost.

CIPF’s board has overall responsibility for its environmental, social and governance (ESG) policy and for delivering on its objectives. The policy applies at all stages of the investment process and to all management activities. Central to CIPF’s ESG strategy is the ambition to achieve carbon neutrality. Day-to-day management is delegated to Ravenscroft as the investment manager, and to D2 Real Estate as the property manager.

CIPF’s ESG objectives are as follows:

A few examples of how CIPF’s ESG policy is incorporated by D2 Real Estate into the management of the portfolio are given below.

CIPF targets a gearing level of 40% debt to market value, and it has been making progress towards this. In October 2020, the ratio stood at 46.16%, and it fell to 43.72% by April 2021. In September, CIPF agreed a new floating facility with RBSI for six years at slightly improved rates. This may be subject to an arrangement that will effectively fix the rate to reduce the risk of rising interest rates.

The target ratio is well below the covenant level of less than 55%. There are a number of other covenant tests relating to the banking facilities and CIPF remains well within all of them.

The fund has an ongoing change figure (OCF) of 1.94% of NAV. The OCF covers the costs of investment management, administration and other fees for custodians, trustees, regulators and auditors for example. For historical reasons it does not have a performance fee. The only other income is a modest service charge that is recoverable from tenants.

CIPF was established in 2010 as a closed-ended collective investment scheme authorised by the Guernsey Financial Services Commission. It has a single class of share, of which there are now 159.9m shares in issue. Its biggest shareholder is Huntress (CI) Nominees, which holds 85.2% of the issued share capital. Huntress (CI) Nominees is the vehicle through which the clients of Ravenscroft (CI) Limited holds stock in CIPF. We understand that within Huntress there are 704 shareholders, none of which hold more than 10% of the share capital.

The board of CIPF consists of Chairman Shelagh Mason and three directors, being Steve Le Page, Paul Le Marquand and Paul Turner.

Shelagh Mason is a solicitor specialising in English commercial property. She is the non-executive chairman of Riverside Capital PCC; a board member of Skipton International, a Guernsey licenced bank; and a non-executive director of The Renewables Infrastructure Fund, a FTSE 250 company, the Ruffer Investment Company and Starwood European Real Estate Finance.

Steve Le Page is a chartered accountant and chartered tax advisor and was a partner with PricewaterhouseCoopers for nearly 20 years until his retirement in 2013. He now sits on the boards of a number of funds as chairman of the audit committee in each case. Paul Le Marquand is a chartered surveyor and was head of property management at Heathrow Airport until 2001. Since then, he has been heavily involved with the establishment, operation and administration of offshore property funds and holding structures working with Mourant International Financial Services and Sanne Group. Finally, Paul Turner has extensive experience at the operating and board levels of real estate companies in the UK, the Channel Islands and South Africa, and in the manufacturing sector.