Custodian REIT — It’s all about income

CREI has a balanced investment portfolio of UK commercial real estate, diversified by sector, location, tenant and lease term, with lower volatility versus London focused peers. It has low exposure to office and a relatively high exposure to industrial and alternative sectors like leisure, which offer income diversification. The objective is to grow the dividend on a sustainable basis, at a rate which is fully covered by projected net rental income, with conservative gearing. CREI is managed by Custodian Capital, a subsidiary of Mattioli Woods (MW), which holds 8% of CREI on behalf of its clients, through its discretionary portfolio management service. The initial £95m portfolio of 48 properties was previously held by MW’s pension clients in syndicated structures.

The portfolio of 133 assets focuses on smaller properties valued between £2m and £10m. CREI believes this provides it with a competitive advantage, as larger funds tend not to look at properties below £10m and private investors are driving yield compression in sub-£2m properties. It targets single let properties with high-quality tenants on long leases and an average unexpired lease term of over five years. No tenant should represent more than 10% of rentals, unless a government body. The current largest tenant represents just 2% of the rent roll. The focus is on areas with high residual values, strong local economies and favourable supply-demand characteristics. CREI does not focus on development or refurbishment to drive NAV growth.

The regions were slower to recover than London after 2009 and secondary property recovered more slowly than prime. However, regional property attracted a record investment level of £22bn in 2015 and £17bn in H116, due to the higher yields on offer. The yield spread between the regions and London remains historically wide at c 2%. At the peak of the market in 2008 it was just c 0.5% (see Exhibit 14). Although this seems likely to narrow, it is not a driver of CREI’s strategy. New supply has been limited and occupier demand has been strong, due to the relative attractions of the regions, the strength of the economic recovery, growth in employment and business relocation away from London. This has supported rental growth in regional office and industrial sites.

CREI trades at a small premium to the sector averages for regional and London-focused REITs on P/NAV, which is in line with its main peers in our sample. However, CREI’s premium can be justified by its dividend yield of nearly 6%, one of the sector’s highest. It also has the widest yield spread over its cost of debt, so should have among the most secure dividend streams. The premium to NAV has also been very stable, due to the steady income yield. Our dividend discount model produces a fair value range of 109-131p, using a discount rate of 7% and DPS growth of 1.6%.

Some of the inherent cyclical risk of the property sector has been reduced via the large diversified portfolio, multiple tenants, with low exposure to the South East and minimal exposure to London. The regional property markets have shown less volatility than London recently. Voids are limited currently, but we forecast an increase to 4% in FY18-19, in line with management assumptions. Specific sensitivities show a 1% rise in rents would increase EPRA earnings by 1% in FY18 and 2% in FY19. A 1% fall in valuation yields would increase EPRA NAV by 19% in FY18-19.

CREI has a nationwide portfolio of 133 assets, with a current value of c £420m and 250 tenants, across all commercial sectors, targeting income and long-term capital growth, with a fully covered dividend and conservative gearing.

CREI is managed by Custodian Capital, a property management and investment business, regulated by the FCA. Custodian Capital is a subsidiary of Mattioli Woods, the specialist wealth management and employee benefits consultants, with £7.5bn of assets under management or advice. The company originated from MW and its clients provided the initial £95m portfolio of 48 properties, which was previously held in syndicated structures. The portfolio was diversified across the main commercial sectors: office, retail, industrial and distribution, as well as a range of alternatives. These now include leisure, car showrooms, trade counters and day nurseries.

The portfolio had been built up over 12 years before the IPO in March 2014, for SIPP and SSAS clients, who invested via their pension schemes in direct property through syndicated structures, to generate an annual yield of c 6%. By 2014 converting to a REIT made sense with the combined pressures of liquidity, growth, administrative efficiency and the demand from MW clients who wanted to continue investing.

All of the 1,200 investors in the syndicated structures sold their property to Custodian REIT and became shareholders at the IPO. The strategy of generating income, with low volatility and conservative gearing was always the priority for CREI, making it an attractive investment for pension schemes.

This strategy has provided a ready source of demand for the shares and of subscribers for new share issues to fund the steady growth in the portfolio, producing capital raises of £213m since IPO. The most recent placing programme ended last November, but CREI is still able to use tap issues to raise funds from wealth managers and other retail and pension clients.

CREI’s low correlation with the FTSE All-Share Index, as shown in the chart below, suggests that management has been successful in its mission of building a portfolio with low volatility.

CREI’s target is to find value in UK commercial property by focusing on properties between £2m and £10m. The objective at IPO was to provide a long-term secure income, with a targeted dividend yield of 6.25% on the IPO price from year two, up from 5.25% in year one. Management is not, therefore, as focused on generating short-term NAV growth. Exhibit 15 shows how important income is forecast to be towards generating total returns over the next few years, which supports management’s strategy.

The strategy has various aspects to it:

Management believes that targeting sub £10m lot sizes provides a competitive advantage, because the larger funds tend not to look at properties below £10m and private investors are driving yield compression in sub-£2m properties. Therefore, there are trading opportunities in the £2-10m price range.

Although income is the main priority, NAV is expected to continue growing as the portfolio experiences rental growth, despite the increased shares in issue from fund-raisings and the high dividend payout ratio.

Management of the fund is fully delegated to Custodian Capital. This includes at least an annual inspection of all properties and rent collection. CREI does use a number of property advisers for lease renewals and new lettings and outsources service charge management.

The manager takes a long-term approach to investment and does not trade CREI’s properties regularly (£9m in sales this year). The focus is on properties with low obsolescence and low capital expenditure requirements. It also prefers properties with high residual values, rather than just focusing on the terms of the lease contracts. It has a strategic exposure to the alternative sectors listed above (14% of the portfolio) and forward funding of pre-let properties (3% of the portfolio).

Gearing is deliberately low, such that management’s sensitivity analysis suggests it would not exceed a 40% LTV in a property sector downturn like that of 2008. Debt is used to reduce the cash drag of raising equity to fund acquisitions, but the company prefers to sit on undrawn debt, rather than cash. The outstanding debt is secured on a pool of assets, up to a 50% gearing level and CREI uses equity fund-raises to pay down additional debt post acquisition.

CREI’s nationwide portfolio of 133 properties covers the main commercial sectors: industrial, office and retail, but also a number of the alternative sectors as mentioned above, mainly including restaurants, leisure, car showrooms and trade counters. The portfolio is deliberately underweight in offices (15% at H117), which management regards as having more obsolescence risk and so requiring more capital expenditure. It is also overweight in the industrial sector (44%) and the alternatives (14%) relative to its peers.

The portfolio was valued at £384m on a net initial yield of 6.95% as at H117, with an occupancy rate of 98%. The reversionary yield was 7.09%.

The portfolio is also well diversified geographically, with minimal exposure to London, but exposure to every other region. 23% of the leases have fixed or inflation-linked uplifts. The remainder are subject to open market reviews.

The table below shows seven typical properties. They are also the seven most recent acquisitions, all of which have been completed during H217. CREI has invested £38m in H217 on these properties, with an average value of just under £6m. All but Shrewsbury are within the £2-10m target range, but that reflects the multiple property nature of the Shrewsbury transaction. They were acquired at an average net initial yield of c 7%, in line with the target.

Generally, CREI acquires single assets, but one example of a recent portfolio acquisition was the Light Industrial Fund, which was acquired last September. This was a national portfolio of 10 properties ranging from the south coast to Newcastle. The passing rent of £2.2m implied a net initial yield of 7.86% at an acquisition price of £26.8m. The portfolio was acquired via a corporate transaction, saving £0.3m of acquisition costs compared with a direct property transaction.

CREI has only made four disposals so far this year. One of these was a Kia car dealership in Solihull, sold last September for £1.9m. This produced a gain on disposal versus the last valuation of £0.35m, or 22%. Management believed the property was over-rented and would, therefore, see a fall in its value over time. The acquirer was an owner-occupier so not driven by the same return considerations as CREI. The others were a Premier Inn in Dudley and a student site in Lenton. They were sold at an average yield of 5.8%. The fourth was a pub in Southsea sold recently for £1.7m.

The portfolio has over 250 separate tenancies. The current tenant list includes Tesco, Wickes, Honda, Superdrug, Royal Mail, Regus and B&Q. Exhibit 10 below shows the top 10 tenants, which together make up just 18% of the total rent roll, with the largest representing just 2%. Indeed, the top 20 tenants account for less than 32% of total rental income.

The income profile of CREI is intended to be long term and, as shown in Exhibit 11, nearly 50% of the leases are over five years. As at September last year the weighted average unexpired lease term (WAULT) to first break was 6.2 years. There is 12% of income due within the next 12 months and a similar proportion is due annually over the next few years.

The investment management team members are executive directors of Custodian Capital, while the board has three independent non-executives and one from MW.

Richard Shepherd-Cross: MD of Custodian Capital and the fund manager of Custodian REIT. Since joining MW in 2009 he has been responsible for the syndicated property initiative, which was the precursor to CREI.

Nathan Imlach: FD of Custodian Capital with responsibility for all financial matters, as well as the financial strategy and operations of MW, where he is CFO.

David Hunter: independent chairman. Mr Hunter is a strategic adviser focused on UK and international real estate. He qualified as a chartered surveyor in 1978 and has over 25 years’ experience as a fund manager, including as MD of Aberdeen Asset Management’s property fund business. He is a former president of the British Property Federation and was actively involved in the introduction of REITs to the UK.

Ian Mattioli: non-executive director. Mr Mattioli has over 30 years’ experience in the financial services industry and founded Mattioli Woods with Bob Woods, which now has over £7.5bn of assets under management, administration and advice. He is responsible for the vision and operational management of Mattioli Woods and instigated the development of the investment proposition, including the structured products initiative.

Barry Gilbertson: independent non-executive director. Mr Gilbertson is an international consultant focusing on real estate, strategy and risk, who has over 40 years’ experience advising on property. He was an adviser to the Bank of England from 2003 to 2014 and was global president of the Royal Institution of Chartered Surveyors in 2004/05. He has been a non-executive consultant to Knight Frank LLP, and has held advisory appointments with the United Nations and the UK government. Barry is an independent non-executive director of Granite REIT, quoted on the NYSE and TSX.

Matthew Thorne: independent non-executive director. Mr Thorne is an independent non-executive director of Bankers Investment Trust, chairing the audit committee, and since May 2007 has been an advisor to Consensus Business Group (led by Vincent Tchenguiz). He is also a finance member of the advisory board and audit committee chair of Greenwich Hospital. His previous executive roles have included group FD of McCarthy & Stone (1993 to 2007), FD of Ricardo (1991-92) and investment director of Beazer (1983-91).

UK commercial property recovered well after the 2008-09 crisis and recession, despite a dip in 2011, but the regions were slower to recover than London and secondary property recovered slower than prime. Indeed, total investment volumes in 2014-15 exceeded the peak years of 2004-07, with Cushman & Wakefield reporting investment of £61.5bn in 2015. Foreign investment has accounted for 45% of the total on average since 2009. Regional property attracted a record level of £22bn in 2015, as shown in Exhibit 13 below, due to the higher yields on offer. Although the EU referendum increased uncertainty in the market, even before the vote (Exhibit 13), CREI believes there is still ample opportunity in the asset class. Management believes this to be especially the case in sub £10m lot size properties, in industrial and other asset segments.

There are several ways to look at the relative attractions of regional real estate. The first is the yield gap between the regions and London. The spread remains wide on a historical basis at c 2%. At the peak of the market in 2008 it was just c 0.5%. Although this seems likely to narrow, it is not a driver of CREI’s strategy. The higher income return means that total returns do not need to be driven by capital growth, although there is the potential to see valuation gains if yields do compress.

Secondly, as the chart below shows, yield movements generally follow the London market, but they are significantly less volatile. So the regions could outperform London as the cycle comes to an end and either way could see less of a correction. Also, regional assets, especially in sub £10m lot sizes, generally attract less attention from institutional investors, so there is less competition for assets and the yields have not been driven down. Finally, the regions are not as exposed to national issues like the changes in business rates or international influences like secondary investment, the fate of financial services and the direct effects of the Brexit vote.

Exhibit 15 shows the effect of this higher return on the sector’s dividend yields, which are one of the main drivers for owning the majority of these stocks. This shows the yield spread over the 10-year gilt for the sector as a whole, but clearly the spread is wider again for the regional property sector.

The second factor is the relative attractions of the regions to occupiers and investors. Because of limited new supply in the regions, the strength of the economic recovery, growth in employment and business relocation away from London, tenant demand has been strong. This has helped to improve rents for regional office and industrial sites. Brexit has increased uncertainty, especially in London, and has led to delayed business decisions in general. However, there is a view that sterling weakness could turn out to be positive for industrial exporters and in turn support economic activity outside London, with a positive knock-on effect on regional industrial property.

CBRE predicts that take-up records may be broken in 2017, due to government pre-lets in the regions, which can often exceed the normal annual demand in a city. Plus, business confidence generally is looking robust, as evidenced by manufacturing PMI data in December, which surprised on the upside. This showed all regions other than Scotland exhibiting growth.

As well as occupational demand being good, supply is very tight. There has been very little new building, especially in industrial. Big box logistics have been the main area of supply growth recently and there may be a danger of oversupply in that segment. CREI estimates that new mid-sized logistics and industrial developments would require rentals 15% above current levels to be viable, which is adding pressure to rental growth.

Regional markets are thus expected to deliver higher returns in the latter stages of the cycle than London, as income drives the majority of total returns from 2017 to 2020. Also, offices and industrial property outside London should be less exposed to the knock–on effects of the Brexit vote than London or the wider retail sector.

The third aspect to examine is the relative share price performance of regionally orientated stocks versus their more London-exposed peers. As the chart below shows, the wider sector had recovered all the ground lost since 2008 by the middle of 2015, since when there has been a correction, which was exacerbated by the Brexit vote in June. There was a minor recovery, but the sector is still trading well below its 2015 peak and c 20% below the level before the EU referendum.

However, Exhibit 17 shows that regionally orientated stocks have outperformed the London-exposed shares significantly and were trading above their pre-referendum level in the autumn last year and again early this year. It also shows that the sell-off was not as marked in July last year, while the recovery was steadier and less volatile. Indeed, the outperformance for the regions in the period is currently over 15% and the performance has been relatively stable since the autumn.

CREI trades at a premium of 7% to our forecast FY17 NAV, which is not out of line with the more income-orientated listed peers. As it has one of the highest dividend yields in the sector this premium looks justified. Given the business model is focused on all sectors of the market nationally and in small lot sizes, with a wide tenant base, CREI’s risk profile is significantly reduced, which also supports the NAV premium in our view.

We have valued CREI using both absolute and relative valuation methods. As the company is an income-focused REIT we regard a dividend discount model to be a useful method of valuation, as it is derived from the income CREI is actually generating.

Our dividend discount model incorporates a cost of equity of 7.0%, which implies a significant risk premium over bond yields of c 5% and a dividend growth rate of 1.6%. The latter is the long-term dividend growth rate we are forecasting from 2018. The equity risk premium adjusts a standard market risk premium of 4% for factors including the stock’s liquidity, gearing and the cyclicality of the sector. Our sensitivity table below shows a fair value range of 109-131p, upside of up to 19% from current levels. This implies a fair value P/NAV range of 1.06-1.27x.

We have compared CREI to the other listed regional REITs and property companies, plus some of the larger London-orientated REITs, to give a range of sector comparatives. It is clear that CREI trades at a small premium to NAV and to both the regional and national sector averages on a P/NAV basis. However, its premium to NAV is not out of line with its peers in the sample, and it does have the second highest dividend yield. Regional REIT has the highest, but is really an outlier, as it targets yields of 7-8%. CREI’s NAV premium can therefore be justified by its current dividend yield of 5.8%. It also has the widest yield spread over its cost of debt at 3.8%, so should in theory have one of the most secure dividends.

As CREI also has one of the lowest LTVs in the sector, with only four companies being lower, it is one of the least risky stocks in the selection. With an occupancy rate of over 98% at the end of H117, it also has the second lowest level of vacancy in the sector, which again reduces its risk profile and makes the dividend more secure. The final conclusion to draw from the table above is that the higher a company’s exposure to London, the higher its discount to NAV. In general, the regional stocks have lower discounts or, as in the case of CREI, trade at a premium to NAV. Again, this can be partly explained by the negative debt spread of most of the London stocks shown in the table above.

This section sets out the basis for our forecasts. We have tried to be conservative in our occupancy and rental growth assumptions, although the main driver of earnings for FY17-18 is the asset acquisitions added in the past year, which are likely to continue.

CREI reported interims in November, with a 32% increase in EPRA earnings, but a 13% fall in EPRA EPS. The total per share return was 3.4% for H117. Dividends of 3.25p were paid and 1.5875p was proposed for Q2. The company raised £43m of new equity in the first six months and invested £67m in 18 new acquisitions and developments. The portfolio was valued at £384m, using a net initial yield of 6.95% and the NAV per share was up slightly from March 2016 at 101.7p.

CREI produced 21% growth in EPRA earnings per share in FY16 and a 21% increase in target dividends in the two years since listing. Although EPRA earnings grew 40% in FY16, the additional shares in issue from the fund-raisings diluted the growth to 21%. Nevertheless, the acquisitions thus far in FY17 have been agreed at net initial yields of nearly 7.4%, which should make them earnings enhancing from FY18.

We are forecasting earnings growth to pick up next year as the recent acquisitions fully feed through to rental income during FY18. We have factored in all the acquisitions thus far in FY17, which total £105m, and added nearly £8m of additional passing rent. As mentioned above, there have also been £9m of disposals so far in the current year.

We have made the following assumptions in our forecasts:

Free cash flow (pre-capex) is forecast to increase significantly, from £7m to £15m this year and £23m in FY18, following the increased investment. This is the key measure for paying dividends, as acquisitions are largely funded via equity fund-raising and the debt facilities. We forecast total dividends of £19m this year and £22m next year. Therefore, dividends should be covered by free cash flow from FY18. We also expect the conversion of net rental income to operating cash flow to improve from 45% last year to 70% this year and over 80% next year.

The asset base has grown from £95m at IPO to c £420m currently. This has been achieved largely by acquisitions, which have totalled £320m since IPO. As CREI generally acquires individual assets rather than portfolios in corporate structures, it incurs purchase costs (mainly stamp duty), which have so far offset any revaluation gains since acquisition. It is quick to deploy funds, due to its flexible credit facilities, aiming for 10 days from agreement to completion.

We have discussed the portfolio above, but it is worth adding that as at H117 the investment properties were valued using an average net initial yield of 6.95%, which is approximately 40bps below the yield at which CREI has been acquiring its assets during FY17. The assets are valued quarterly by Lambert Smith Hampton Group, which has experience of the categories and locations of the properties in the CREI portfolio. The equivalent yields applied ranged from 5% to over 11%.

We have only estimated revaluation gains to reflect the rental growth in the asset base in each year, which we have assumed to be 2%. We have not factored in any yield compression in our valuations. We are also not forecasting any further acquisitions, despite the company having available capital and a pipeline of potential opportunities. Indeed we are forecasting a year-end cash balance of £9.6m and a gross LTV ratio of 17.5%, so CREI has significant capacity to make further acquisitions to drive earnings and dividend growth.

CREI has raised £49m so far in H217 and £92m in the financial year to date. This has generally been via small incremental issues, with the occasional larger placing, as with the £24m raise in October. They have all been completed at a premium to NAV and are not carried out to fund specific acquisitions. However, if we assume the £25m raise in October funded the £27m industrial portfolio acquired in September and that it was funded entirely with equity, then the transaction would have produced an EPS uplift of 0.66p, assuming no additional administrative expenses. To put this in context, earnings in H117 were 3.05p per share.

The main aim of CREI’s debt strategy is to achieve the target loan to value (LTV) ratio of 25%. The other notable aspect of the debt structure is that the average debt term of 9.3 years easily exceeds the average unexpired lease length, which is 6.2 years. With an average cost of debt of 3.28% as at September 2016 and a current LTV of just 18%, the balance sheet looks conservative.

In this section we consider some of the main risks and sensitivities affecting CREI and its sector.