Palace Capital — Poised to unlock value

Palace Capital (PCA) is an internally managed UK real estate investment trust (REIT), focused on commercial properties in major cities and university towns in the UK, outside London. It has an entrepreneurial approach to investment and operates a total return model, targeting attractive income returns and capital growth. PCA has a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development and other asset management opportunities. Although currently focusing on regional office and industrial assets, over a longer time frame the investment strategy is sector-agnostic, adapting to shifting market opportunities. The existing portfolio contains strong reversionary potential and offers significant refurbishment and development opportunities. We expect the now completed flagship HQ development in York to significantly enhance income and capital values, while freeing capital for higher-yielding reinvestment.

Financials: Capital recycling will drive near-term returns

PCA expects completion of the sale of the HQ apartments (by end-FY23) and the £30m non-core asset disposal programme will free at least £50m for reinvestment, while maintaining net LTV at around the mid-30% level. The apartment sales will deliver trading gains (we estimate an additional £4.5m on top of the £2.8m reported in H122) and, with the assets non-yielding, redeployment of the proceeds (c £28m now that the development loan is effectively repaid) will be highly accretive. Letting the HQ office space should add c £0.9m to income and generate revaluation gains (we estimate c £3m), and PCA hopes to have let more than half the space by end-FY22. Redeployment of the proceeds of the non-core disposals should at least replace lost income and improve overall asset quality. Additionally, the portfolio includes c £2.2m of reversionary potential (excluding HQ), the majority of which represents the letting of vacant refurbished office space. Our forecasts imply NAV total returns of at least 9% pa for the next two years.

Based on the current quarterly rate of DPS (3.25p), the minimum payout that the company anticipates for the balance of FY22, the annualised yield is an attractive 4.9%. We forecast DPS to be fully covered by adjusted earnings. The yield compares favourably to the risk-free yield on offer (10-year UK gilt yields remain less than 1%) and the almost 30% discount to H122 EPRA NTA remains clearly below the peer average. The PCA valuation continues to appear undemanding, particularly in view of the significant asset management potential embedded in the portfolio. Letting existing refurbished or developed vacant space would lift current rent roll by up to £3.2m or c 20% and enhance capital values, while continuing residential and non-core asset sales will allow up to £50m capital to be recycled into accretive acquisition or asset management opportunities.

We review the main sensitivities on pages 12–13. We consider these to be related mainly to the broader macroeconomic background and the cyclical nature of the commercial property market. Commercial property has historically exhibited substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. Development activity brings additional risks and PCA’s exposure has been significantly reduced by completion of HQ. The pandemic continues to generate uncertainty, but rebounding GDP growth, currently low interest rates and lockdown easing are supporting strong commercial property returns, still led by industrials, but broadening across all sectors.

IFRS profits of £8.0m in H122 showed a strong rebound from the H121 loss and substantial progress on H221. Development profits, valuation increases and disposal gains drove the result, but leasing activity contributed towards an increase in underlying occupancy and rent roll since the start of the year, and supported a robust recurring earnings performance. With rent collection remaining strong (96% in H122 and 95% already for the September quarter1), quarterly DPS was increased from 3.0p to 3.25p for Q222, well covered by adjusted earnings and, more importantly, fully covered by cash. PCA says 3.25p is the minimum that it expects for the rest of FY22. With the Hudson Quarter development in York completed on 20 April 2021, sales of residential apartments and progress with the £30m non-core disposal programme saw net gearing reduce to 36% from 42% at end-FY21, allowing PCA to look at potential investment opportunities.

Key highlights of H122 included:

The flagship HQ development in York2 was completed on budget on 20 April 2021. In this report, we refer to the total development as HQ, although PCA has branded the residential development as Hudson Quarter and the office assets as HQ. HQ is a large project for PCA (the gross development value represents c two-thirds of market capitalisation) and completion has provided the potential to crystalise sales profits on the residential apartments, recognise development gains on the commercial space and earn recurring income as it is let, while significantly de-risking the portfolio. Including sales to date, our forecasts include c £10m of total development/trading gains from HQ (c £7.4m trading profit from the residential sales and the balance from revaluation of the office assets) by the end of FY23, c 20p per share. We expect the commercial space to add c £0.9m to rental income on an annualised basis, in line with ERV, once fully let.

The pace of residential sales has accelerated as lockdown restrictions have eased and at the time of reporting, sales had completed or exchanged on 64 of the 127 apartments for a total value of £21m. A further eight apartments were under offer with a value of £3m. Aggregate gross sales are expected to be c £52m and PCA is confident that this will be achieved by end-FY23 at the latest. With the Barclays development facility effectively repaid, the net (of sales costs) proceeds from the remaining £28m of expected sales will be fully available for redeployment into income-generating assets.

For the commercial space, although the pandemic slowed pre-letting activity, this too is picking up. Initially, 4,700 sq ft of office space, on the ground floor of one of the residential buildings, was pre-let to Knights, a quoted law firm, at a record rent for York of £25 per sq ft. Of the remaining 35,000 sq ft of standalone office space, 11,280 sq ft is under offer and PCA hopes the lease will be signed early in December. The letting of a further 3,500 sq ft has just been agreed and management hopes to have completed the letting of half the office space by end-FY22.

PCA is an internally managed UK REIT, listed on the Main Market of the London Stock Exchange (LSE). It focuses on commercial property in major cities and university towns in the UK, outside London, and at 30 September 2021 had a property portfolio externally valued at £262m. It has an entrepreneurial approach to investment and operates a total return model, with a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. This strategy is aimed at providing both attractive income returns and exposure to capital growth from the repositioning of value-add properties. PCA is currently focused on regional office and industrial assets, where it has identified the most attractive opportunities, although the investment strategy is sector-agnostic. Over a longer time frame, we would expect the portfolio to adapt to shifting market conditions. The existing portfolio contains strong reversionary potential and offers significant refurbishment and development opportunities. We expect the now completed Hudson Quarter development in York to contribute materially to income and income capital growth.

The management team has considerable experience in the real estate sector, across cycles. Its extensive networks and strong industry relationships have been an advantage in sourcing opportunities to grow the business. Palace was established in its current form in July 2010 when Stanley Davis (the current non-executive chairman, due to step down at the end of 20213) and Neil Sinclair (CEO) acquired board control of an AIM-listed vehicle for the purpose of property investment. The growth of the portfolio and the company’s performance since then has been significantly driven by corporate acquisitions, including the £39.25m acquisition of a subsidiary of Quintain in 2013 and the £32.0m acquisition of Property Investment Holdings (PIH) in 2014. Both these transactions had the added attraction of being tax efficient with minimal purchase costs (stamp duty) to absorb and their availability was in part due to the high leverage of both companies.

Over the past year, PCA has been focused on rent collection and completion of the HQ development but, with market conditions improving, it remains keen to grow further. With gearing on a downward trajectory, PCA indicates, and we forecast, that capital will be redeployed into new investment opportunities including acquisitions from distressed vendors. Management is attuned to the need for consolidation in the sector and is very open to further growth via corporate acquisitions, although for now the share price discount to NAV is an obstacle. PCA says that although it has not disregarded share buybacks as a way to manage the discount and deploy capital, its preference remains for accretive investment for as long as these can be identified.

Exhibit 3 provides a summary of the PCA portfolio as at 30 September 2021 (H122).4 The portfolio was externally valued at £262.0m and comprised 45 completed/standing commercial properties (which now include the HQ commercial space) and ‘development properties’, which represents the fair value of the yet to be sold HQ residential apartments.5 The standing commercial assets had a gross annualised contracted rental income of £16.9m and, after non-recoverable property costs that mostly relate to voids, the net contracted rental income was £15.6m. The weighted average unexpired lease term (WAULT) was 4.9 years to first break and on an EPRA basis occupancy was 84.3%. This headline occupancy rate was affected by completion of the yet to be let HQ office space and adjusting for this (as presented in Exhibit 3) occupancy improved to 87.9% from 86.4% at end-FY21.

Underlying occupancy and contracted rents both benefited from new lettings, lease renewals and rent reviews, all on average ahead of estimated rental value (ERV). In aggregate, 29 lease events provided £0.6m of additional income at a blended 3% premium to ERV. PCA reports strong letting activity since the end of H122.

The ERV of the portfolio of £20m represents a significant income opportunity, which we discuss below. The reduction in ERV during H122 reflects primarily the impact of non-core commercial asset disposals. As part of its £30m non-core asset disposal programme, discussed below, during H122 PCA exchanged or completed on £12.0m of asset sales 6, generating realised gains of £0.4m net of disposal costs. Year-to-date sales and completions have since reached £21.3m with another c £5m of sales under offer.

Regional offices and industrial assets account for 63% of the H122 portfolio by value and PCA indicates that this will increase further as it completes its divestments and recycles capital.

Exhibit 5 tracks the change in portfolio value during H122. Capital expenditure of £2.3m and the revaluation gain of £1.3m increased the portfolio but were more than offset by the £14.0m (book value) sale of HQ residential apartments and £9.9m (book value) sale of non-core investment property assets that were completed in the period. Those sales that were exchanged but not completed by end-H122 will affect the H222 portfolio valuation.

The like-for-like property revaluation increase of 0.5% was driven by industrial assets, following the market trend, but was nevertheless broadly spread across all sectors other than retail. Note that the £1.1m gain shown in Exhibit 6 differs from the £1.3m reported gain because it excludes assets disposed of during H122.

With an annualised contracted rent roll at H122 of £16.9m and an externally estimated market rental value of £20.0m there is significant income upside potential embedded in the portfolio, with capital values likely to follow. As can be seen from Exhibit 4 above, void reduction/letting vacant space in the office sector assets represents the single largest opportunity to increase portfolio income at £2.8m, including the HQ office assets (£0.9m). As a result of PCA’s total return strategy, voids are inevitable in the portfolio as vacancy is deliberately targeted ahead of asset management projects. However, COVID-19 has slowed the letting of refurbished assets, primarily in the office sector, and available space has increased with the completion of HQ. At a portfolio level, the bridge from contracted rents to ERV is shown in Exhibit 7. There is a small amount of void reduction potential outside of the office assets and upside from lease incentives running off. The industrial assets are fully occupied with some small upside in rents to ERV, while the leisure assets, now effectively fully let, are ‘over rented’ with contractual rents above ERV. The retail assets also show upside to ERV, although across the sector ERVs remain under pressure.

Having grown the portfolio primarily through portfolio acquisition, non-core disposals have been a regular feature, enabling capital deployment to be optimised and supporting operational efficiency. Disposals are typically driven by completion of the business plan for the asset or where the risk-return balance favours disposal, in some cases generating an immediate saving on property operating costs. PCA is targeting disposals with an aggregate value of at least £30m in the current year to reinvest in better quality assets. It is making good progress and says it is well on track to meet its target. Including the most recent sale of an industrial building in Aldershot for £2.4m, an aggregate £21.3m of transactions have completed or exchanged (of which £12.0m during H122 and the balance since), all at a premium to book value. A further c £5m is currently under offer. Allowing for repayment of the debt against which the assets are charged, the completed and exchanged sales to date have freed £10.4m of equity for reinvestment and PCA expects a further £5.6m will be freed by the end of the programme.

When completed, the sale of the HQ residential apartments should generate net proceeds of c £30m after repayment of the Barclays development facility. Repayment of the facility was substantially complete at end-H122 and it was fully repaid at the end of November. All proceeds from the remaining apartment sales will then be available for reinvestment. Including the £30m non-core asset sales, PCA estimates that it will be able to reinvest more than £50m into income-generating investments and new asset management opportunities, adding c £3.0m to annualised rental income at an expected yield of 6%. This will more than replace the net income forgone on the non-core disposals. A c £10m acquisition is currently in legals and is expected to complete by the end of FY22.

Management has indicated that it will take advantage of the capital recycling to further focus the portfolio on offices and industrial assets in line with its regional strategy, and to increase the weighting of core income-generating assets. Once all the HQ residential assets have been sold and the £30m disposal programme completed, PCA estimates that offices (32.3%) and industrials (17.8%) will represent 70.1% of the portfolio total compared with 62.9% at end-H122. Reinvestment will increase this further.

While retaining its total return strategy, in tandem with the office/industrials focus, PCA intends to increase the weight of core income-generating assets within its portfolio while reducing the share of ‘value-add’ and development properties. To a large extent, this shift reflects the completion of the HQ development as well as management’s expectations for rental growth in the regional office and industrial sectors.

Regional offices offer relatively high yields, which is a combination of low rents and low capital values. Capital values are well below new build cost and this has inhibited most new development in recent years. Meanwhile, re-purposing of existing space towards residential, student and hotel accommodation, has worked to reduce supply. Structural demand factors remain in place, such as office migration from (more expensive) London to the regions and the political goal of rebalancing economic activity from South England to the North likely to remain, possibly reinforced by a shift to ‘localism’ (smaller, regional offices located in towns and cities outside the capital).

PCA expects the return to the office to gather momentum, as evidenced by letting progress at HQ. A great many tenants may adopt a hybrid model of working, at least initially, whereby employees spend perhaps three days per week in the office and two days at home, but this seems unlikely in itself to materially affect space requirements which must cater for peak usage. As an alternative, hot desking is typically unpopular with staff, who value their own space, the certainty of being in proximity to close colleagues, and may stifle the collaboration and creativity required by many employers. Where changes in working practices do reduce demand for space, this is likely to be mitigated by a reduction in office density (the number of employees per square meter), accelerating a trend that was in place prior to the pandemic.

The industrial sector also benefits from good levels of occupier demand and a limited supply of space. The pandemic has accelerated the trend towards e-commerce and distribution, and consumer demand for swift delivery is leading to strong demand for distribution facilities close to city centres. Rents remain relatively low and typically below new build costs, providing scope for further growth.

PCA ‘s portfolio will continue to include several identified medium-term asset management opportunities that it plans to phase in over a number of years, potentially providing counter-cyclical opportunities to add value to the portfolio should market-wide rents and capital returns stall. However, it does not anticipate commencing any development projects during the next three years.

As well as repositioning the portfolio, asset disposals in combination with a rolling capital expenditure programme (£2.3m in H122) will continue to support a needed improvement in the environmental performance of portfolio properties. By 2023 it will not be possible to let properties with an EPC7 rating below E and by 2027 properties will need be C rated or better, increasing further to B or better in 2030. During H122, PCA removed all G-rated properties from the portfolio and reduced E-rated properties from 7.45% at end-FY21 to 2%. More details of the actions to be taken and the potential capex needs will be provided with the FY22 results, expected to be released in June next year.

Reflecting a stronger H122 than we had expected, we have increased our forecasts for FY22 adjusted PBT and adjusted EPS by c 5% with smaller increases for FY23 and FY24, driven by small changes to net rental income, administrative costs before share-based payment costs and net finance expense. The increase in Q222 DPS and PCA’s forward guidance leads to an increase in FY22e DPS, but we maintain our expected increases for FY23 and FY24.

The key component of our adjusted PBT forecast is net rental income, for which we assume:

Our IFRS earnings and the change in NTA include the following capital valuation assumptions:

Our forecasts for DPS are consistent with adjusted earnings cover of c 1.2x. With the forecast proceeds of residential sales and non-core disposals exceeding our assumed reinvestment, our forecast net loan to value ratio (LTV) for end-FY24 is 33%.

PCA will have total borrowing facilities of c £118m on full repayment of the Barclays development loan facility by the end of November 2021. On a pro forma basis, adjusting for the Barclays repayment, end-H122 borrowings were c £102m. Around £16m remained undrawn from its revolving credit facility (RCF) with NatWest. Allowing for £13.7m of cash, the end-H122 net loan to value ratio was 36%. The average cost of debt was 3.0% with costs fixed by hedging on 58% of debt. Liquidity, comprising immediately available debt and cash resources, amounted to £18.7m.8 The average term of PCA’s debt was 2.3 years at end-H122, with the first maturity (other than the Barclays development loan) being the £25m Santander facility in August 2022, for which PCA has already agreed terms for a refinancing on what it says are competitive terms. PCA notes that across the market, the availability and cost of debt will increasingly become linked with progress on EPC ratings.

Our forecasts imply net LTV remaining slightly below the mid-30% level that PCA is targeting in the current market environment.

Unlike REITs that focus wholly or predominantly on generating income returns, PCA’s total return model relies significantly on generating capital growth from the repositioning of value-add properties, as well as seeking an attractive level of income. Capital returns do not emerge with the same regularity as contracted rental income but are targeted to enhance overall return. Since its first major post-IPO transaction in H214, PCA has built a proven track record of acquiring properties where it can extract value by enhancing sustainable recurring income and generating capital growth through refurbishment and development opportunities. During this period and up to end-H122, it has generated cumulative accounting/EPRA NTA total returns of 118.0% or a compound annual average return of 10.2%. This is a good level of return despite the negative impact of COVID-19 on late FY20 and FY21.

Based on the minimum 3.25p quarterly DPS that PCA targets for the balance of FY22, the prospective yield is c 4.9%. We forecast FY22 DPS to be well covered by adjusted earnings and for DPS to increase further during FY23 and FY24. Meanwhile, the shares continue to trade at a significant discount of c 26% to H122 EPRA NTA per share of 362p.

In Exhibit 12 we show a summary performance and valuation comparison of PCA and a peer group of UK commercial real estate investment companies with a strong regional focus. For comparative purposes, the valuation data are based on last reported EPRA NTA/NAV and trailing 12-month DPS declared. On this basis, PCA trades at a clearly lower P/NTA than the group average and despite its total return focus its trailing dividend yield is only modestly below the average.

the Palace valuation continues to appear undemanding in view of:

The commercial property market is cyclical, historically exhibiting substantial swings in valuation through cycles. Income returns are significantly more stable, but still fluctuate according to tenant demand and rent terms. We would also highlight the increased risks and uncertainties that attach to development activity, including planning consents, timing, construction risks and the long lead times to completion and eventual occupation. In particular we note: