Palace Capital — Net asset value growth

Real Estate

Palace Capital

Net asset value growth

Portfolio update

Real estate

2 May 2017

Price	355.00p
Market cap	£89m

Net debt at 30 September 2016 (£m)		73.5

Shares in issue	25.2m
Free float	94%
Code	PCA

Primary exchange	AIM
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	1.4	0.0	3.7
Rel (local)	2.3	(2.3)	(10.0)

52-week high/low

375.0p

307.5p

Business description

Palace Capital is an AIM-quoted property investment company focused on commercial real estate in the UK outside London. The portfolio is diverse, with the largest weighting in offices. Management aims to increase capital value and provide a sustainable and growing income stream.

Next events

FY17 results	6 June 2017
Final dividend paid	July 2017

Analysts

Julian Roberts	+44 (0)20 3077 5748
Andrew Mitchell	+44 (0)20 3681 2500

financials@edisongroup.com

Edison profile page

Palace Capital is a research client of Edison Investment Research Limited

Palace Capital (Palace) has released a positive portfolio and trading update detailing disposals made in FY17, significant ongoing projects at ten properties and the possible acquisition of a fully let office building for c £20m, which would more than replace rents at properties sold in the year. These developments demonstrate Palace’s ability to add shareholder value through active management and to recycle capital efficiently. We have revised our estimates and note that management expects the March 2017 NAV to beat market expectations.

Year end	Revenue (£m)	Adjusted EPRA earnings* (£m)	Adjusted EPRA EPS* (p)	EPRA NAV/share (p)	DPS (p)	Yield (%)
03/15	8.6	4.8	28.3	396	13.0	3.7
03/16	14.6	4.6	18.9	414	16.0	4.5
03/17e	14.0	5.0	21.0	431	18.0	5.1
03/18e	13.7	5.6	22.2	437	18.0	5.1
03/19e	14.7	6.9	27.5	447	18.0	5.1

Note: *Adjusted EPRA earnings exclude revaluation gains, profits or losses on disposals of investment properties and surrender gains on early lease terminations.

Asset management adding value

Thirteen disposals were made in the year to 31 March 2017 for a total consideration of £12.6m, which is a £3.4m (37%) gain on the book value of the properties (£9.2m), equivalent to c 13p per share before tax. These disposals have helped reduce net LTV to 39% of the September 2016 portfolio valuation. LTV may be lower still vs the March 2017 NAV, which Palace has stated is likely to beat market expectations. The portfolio update also detailed ten property management projects, most significantly one at Hudson House in York where a new planning application has been submitted to replace the existing building with 127 apartments, 34,000sqft of offices and 5,000sqft of commercial space. Full details of all the projects are available here, and while we have increased our FY17 forecasts we expect these initiatives may still have contributed to a portfolio valuation in excess of our new EPRA NAV estimate of 431p per share (previously 430p).

Reinvestment to enhance income

Although the disposals have reduced the contracted rent roll to £12.8m pa at 31 March 2017 (£10.9m net of head rent and void costs), Palace has also agreed terms for the corporate acquisition of a fully let office building for c £20m. It is reported that if completed, this would more than replace income lost through disposals. We have assumed the acquisition is made with 5% purchaser’s costs, at a 7.5% net initial yield and 50% LTV with debt costs in line with existing debt: our FY18 EPRA EPS forecasts have risen to 22.2p and to 27.5p in FY19.

Valuation: more NAV gains likely

With the potential acquisition likely to mean that rental income levels are sustained and the probability of a NAV uplift beating market expectations, there is significant potential for the shares to appreciate. Regional peers tend to trade at premiums to reported EPRA NAV averaging c 4% and the completion of the acquisition and/or the FY17 results could be catalysts for Palace’s c 18% discount to narrow.

Changes to estimates

Exact details of the asset management initiatives and disposals undertaken in the period can be found in Palace’s announcement here. We have substantially revised our estimates as a result of the portfolio update and in light of the likely acquisition, and have taken into account mechanical changes to the model such as the recent share buyback, the exercise of options and passage of the 2014 LTIP deadline. The principal changes to our assumptions are listed below.

Rental income

■

The change in contracted rental income falls less than previously assumed because the acquisition replaces income lost through disposals. Assuming a £20m consideration, costs of £1m and a 7.5% net initial yield, gives gross rental income of £1.6m per annum.

■

We have also allowed for the new lettings at Ovest House in Brighton and the Copperfield Centre in Dartford, where annual rents are now £0.3m. We also note that letting recently refurbished space at Solaris House in Milton Keynes, Bank House in Leeds and Boulton House in Manchester could add a further c £0.8m of annual rent and reduce void costs. We have allowed for this to be achieved in FY18 so that all three make a full contribution in FY19. Fixed rental increases of £0.15m at Broad Street Plaza in Halifax and have also been taken into account.

Void costs

■

The sales of vacant buildings in Maldon, Stoke and Stockport will reduce void costs sooner and therefore more than we had previously assumed.

■

We have assumed that the Hudson House planning application will be successful, given the previous successful applications for variations of use and the close consultation with Historic England, York City Council and other stakeholders: so far there has been positive support of the plan submitted to the planning authority. We expect demolition of the existing building to occur in 2018, reducing void costs by £0.7m.

Finance costs and dividend

■

We have assumed that the new acquisition will be 50% funded with debt at a similar rate to the existing weighted average cost. We have left our Libor assumption unchanged at 0.4%.

■

We have assumed that the dividend will remain flat and forecast dividend cover of 1.48x in FY19, implying scope for a higher distribution or for further investment.

The effects of these changes on our estimates are summarised in Exhibit 1 below.

Exhibit 1: Changes to estimates

	Rental income (£m)			EPRA EPS* (p)			EPRA NAV per share (p)			Dividend per share (p)
	Old	New	Change (%)	Old	New	Change (%)	Old	New	Change (%)	Old	New	Change (%)
03/17e	14.0	14.0	0.0%	20.4	20.4	0.5%	430	431	0.2%	18.0	18.0	0%
03/18e	13.5	13.7	1.6%	21.2	21.4	1.0%	433	437	0.9%	18.0	18.0	0%
03/19e	13.1	14.7	12.5%	22.4	26.7	19.2%	439	447	1.9%	18.0	18.0	0%

Source: Edison Investment Research. *This is lower than the adjusted figure on page 1 because it includes share-based payments.

Valuation

Palace’s shares trade at a discount of c 18% to our estimated FY17e EPRA NAV, and we note that management expects the 31 March portfolio valuation to exceed market expectations. In Exhibit 2 we show the last reported EPRA NAV per share and, where available, forecast EPRA NAV per share for a selection of investors in regional commercial and industrial property. This shows that Palace trades at a considerable discount to peers, which trade at an average premium to last reported EPRA NAV of c 4%, as at the time of our initiation note in January. Regional property markets are less exposed to Brexit-related risks than London ones and occupier demand is reported to be robust in regional cities. The market appears to expect growth (although forecasts of EPRA NAV per share are only available for four companies) which may explain the premium. Palace’s discount could narrow as the market recognises the company’s ability to deliver returns by growing capital values as well as providing a stable and diversified income stream.

Exhibit 2: Peer comparison

Company	Price (p)	Last reported EPRA NAV/share (p)	Price/reported EPRA NAV/share (x)	Prospective NAV/share	Price/prospective NAV/share
Palace	355.5	419.0	0.85	431*	0.82
Custodian REIT	111.8	101.5	1.10	103*	1.08
Mucklow	493.8	448.0	1.10	455	1.09
Picton Property Income	84.0	81.8	1.03
Real Estate Investors	61.0	66.2	0.92
Regional REIT	106.8	106.9	1.00	110*	0.98
Schroders REIT	65.0	61.1	1.06
Average ex-Palace			1.04		1.05

Source: Company data, Bloomberg (prices at 26 April), Edison Investment Research. Note: *Edison estimates.

Sensitivities

As we have noted before, property markets are cyclical and capital values tend to be more volatile than rental income. Palace’s policy of investing outside London may shield its portfolio to some extent from macroeconomic risks, and recent upgrades to the UK’s GDP forecast by the Bank of England and the EC, among others, may give further confidence.

The sale of some vacant assets and further lettings in the retained portfolio have reduced vacancy risk and other asset management initiatives have also made Palace’s properties more attractive to occupiers, further reducing that risk.

Palace’s debt remains low cost (2.9%), has a weighted average term of 4.6 years and, as noted above, net LTV of 39% against the 30 September property valuations is likely to fall further when the portfolio is revalued.

For those reasons, we believe Palace’s main sensitivities are to the upside: management appears confident of beating market expectations of EPRA NAV, we forecast that earnings will continue to rise and the full year results due to be announced on 6 June may be a catalyst for a re-rating.

Exhibit 3: Financial summary

Year end 31 March	£'000s	2014	2015	2016	2017e	2018e	2019e
		IFRS	IFRS	IFRS	IFRS	IFRS	IFRS
PROFIT & LOSS
Revenue		3,252	8,637	14,593	13,969	13,687	14,712
Cost of Sales		(648)	(1,200)	(1,624)	(2,320)	(1,429)	(744)
Gross Profit		2,604	7,437	12,969	11,649	12,258	13,968
Administrative expenses		(649)	(1,439)	(2,048)	(2,626)	(3,028)	(3,037)
Operating Profit before revaluation		1,955	5,998	10,921	9,023	9,230	10,930
Revaluation of investment properties		19,501	9,769	3,620	32	1,500	0
Costs of acquisitions/profits on disposals		270	(461)	(525)	3,400	(1,000)	0
Operating Profit		21,725	15,306	14,016	12,455	9,730	10,930
Net Interest		(573)	(1,398)	(2,264)	(2,794)	(3,009)	(3,037)
Profit Before Tax (norm)		1,652	4,139	8,132	9,629	6,221	7,893
Profit Before Tax (FRS 3)		21,153	13,908	11,752	9,661	6,721	7,893
Taxation		81	107	(953)	(1,390)	(840)	(1,184)
Profit After Tax (norm)		1,733	4,246	7,179	8,239	5,381	6,709
Profit After Tax (FRS 3)		21,234	14,015	10,799	8,271	5,881	6,709
EPRA earnings		1,463	4,707	7,704	4,839	5,381	6,709
Adjusted for:
Surrender premium		0	0	(3,172)	0	0	0
Share-based payments		0	114	110	145	200	200
Adjusted EPRA earnings		1,463	4,821	4,642	4,984	5,581	6,909
Company adjusted PBT		1,382	4,828	5,705	6,374	6,421	8,093
Average undiluted number of shares outstanding (m)		5.3	17.1	24.6	25.7	25.2	25.2
EPS - normalised (p)		32.9	24.8	29.2	32.1	21.4	26.7
EPS - FRS 3 (p)		403.4	82.0	43.9	32.2	23.4	26.7
Adjusted EPS		29.7	28.3	18.9	21.0	22.2	27.5
EPRA EPS (p)		27.8	27.5	31.3	20.4	21.4	26.7
Dividend per share (p)		0.0	13.0	16.0	18.0	18.0	18.0
Dividend cover (x)		N/A	2.12	1.96	1.14	1.19	1.48
BALANCE SHEET
Fixed Assets		60,086	104,470	175,738	180,021	201,521	203,521
Investment properties		59,440	102,988	174,542	179,011	200,511	202,511
Goodwill		6	6	0	0	0	0
Other non-current assets		640	1,475	1,196	1,010	1,010	1,010
Current Assets		7,060	15,653	11,903	16,475	3,792	6,138
Debtors		1,937	3,375	3,327	3,170	3,170	3,170
Cash		5,123	12,279	8,576	13,305	622	2,968
Current Liabilities		(4,171)	(3,487)	(9,048)	(11,193)	(11,193)	(11,193)
Creditors		(2,971)	(3,087)	(6,815)	(7,952)	(7,952)	(7,952)
Short term borrowings		(1,200)	(400)	(2,233)	(3,241)	(3,241)	(3,241)
Long Term Liabilities		(18,599)	(36,620)	(71,778)	(76,825)	(84,089)	(86,053)
Long term borrowings		(17,384)	(35,407)	(69,711)	(74,759)	(82,023)	(83,987)
Other long term liabilities		(1,215)	(1,214)	(2,067)	(2,066)	(2,066)	(2,066)
Net Assets		44,376	80,016	106,815	108,478	110,031	112,413
Net Assets excluding goodwill and deferred tax		44,370	80,010	106,815	108,478	110,031	112,413
Basic NAV/share (p)		219	395	414	431	437	447
EPRA NAV/share (p)		219	396	414	431	437	447
CASH FLOW
Operating Cash Flow		1,297	4,388	12,287	9,664	8,450	11,150
Net Interest		(390)	(1,593)	(3,421)	(2,501)	(3,009)	(3,037)
Tax		(13)	(15)	(158)	(916)	(840)	(1,184)
Preference share dividends paid		(18)	0	0	0	0	0
Net cash from investing activities		2,532	(2,922)	(50,012)	(1,055)	(20,020)	(2,020)
Ordinary dividends paid		0	(1,766)	(3,221)	(4,612)	(4,527)	(4,527)
Debt drawn/(repaid)		(21,266)	(10,600)	21,272	6,291	7,264	1,964
Proceeds from shares issued		23,009	19,664	19,114	38	0	0
Other cash flow from financing activities		(66)	(2)	(2)	(2,180)	0	0
Net Cash Flow		5,085	7,155	(4,141)	4,729	(12,682)	2,346
Opening cash		39	5,123	12,278	8,576	13,305	622
Other items (including cash assumed on acquisition)		0	0	439	0	0	0
Closing cash		5,123	12,278	8,576	13,305	622	2,969

Opening net debt/(cash)		1,724	13,476	24,742	65,435	66,761	86,708
Closing net debt/(cash)		13,476	24,742	65,435	66,761	86,708	86,326

Source: Company data, Edison Investment Research

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United Kingdom

New York +1 646 653 7026

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Level 12, Office 1205

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NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

245 Park Avenue, 39th Floor

10167, New York

Sydney +61 (0)2 8249 8342

Level 12, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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