Picton Property Income — Record FY22 with positive outlook

The strength of the FY22 result may be seen as exceptional, benefiting as it did from a bounce-back in property valuations as pandemic restrictions were progressively eased. Nonetheless, it was consistent with Picton’s track record of outperformance, driven by a total return strategy with a strong income focus. Despite growing headwinds from rising inflation, only partly explained by the war in Ukraine, Picton remains positive about the outlook. The underpinning for this optimism is covered throughout this report but in summary includes:

In this section we discuss the FY22 financial and operational performance. Our forecast and valuation analysis are discussed later in the report.

Key features of the FY22 financial results include:

Operationally, we highlight:

The accounting total return1 has been positive in each of the past 10 years other than in FY13 when Picton was negatively affected by a weak economic and sector performance combined with relatively high gearing at the time. Despite this, the cumulative 10-year return has been 164.4%, or an average 10.2% pa. Reflecting Picton’s total return investment strategy, capital returns have contributed c two-thirds of total returns.

In common with the sector, the across-the-cycle income return has been much more stable than the capital return. Successful asset management is thus key to a sustainably enhancing total return.

A trend decline in the cost ratio,2 the result of economies of scale and tight cost control, has further supported returns, while gearing has also steadily reduced with the end-FY22 net loan to value ratio (LTV) at 21.2%. With a strong balance sheet, Picton continues to explore opportunities for further growth. This includes property acquisitions, but the company is also conscious of the significant discounts that exist across parts of the REIT sector and the opportunities that this may provide. The open-ended sector has in some cases faced challenges that emanate from the long-term nature of real estate investment and the mismatch between asset liquidity and variable capital.

The key driver of Picton’s performance has been the consistently strong property portfolio return, measured before the impact of gearing or non-property costs. The company has outperformed the MSCI Quarterly Property Index for the past nine years and produced an upper-quartile performance over three, five and 10 years and since inception. The FY22 total return of 24.3% compared with 19.6% for the market was only marginally outside the upper-quartile return starting at 24.9%.

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

Among the factors supporting this strong performance we note:

Picton’s approach to buying and selling assets is predominantly opportunistic and driven by asset rather than sector selection. Significant transactional activity in recent years reflects capital recycling and other strategic portfolio changes. During FY14–17 Picton took advantage of positive market conditions (increasing rents and rising valuations) to significantly grow and reposition the portfolio. This included the disposal of central London assets and other non-core properties, deliberately increasing the average lot size while reducing gearing. Ahead of the pandemic, Picton was a net seller of assets, reducing an already low high street retail exposure and further reducing gearing. Taking advantage of the market recovery, in FY22 (and FY23 year to date) it has been a net buyer and continues to monitor further opportunities across all market sectors.

The end-FY22 ERV of £49.8m was £11.1m or 29% ahead of the annualised contracted rent roll of £38.7m. Void reduction represents £3.6m of the potential upside, with the balance comprising the upside from lease incentive run-off (c £4.5m) and the potential to increase existing rents to market levels at lease expiry (c £3.0m).

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, despite strong letting progress in FY22, considerable upside remains from void reduction. In retail and leisure, retail warehouse parks (65% of Picton’s sector exposure) are trading well and driving overall sector rent growth, but there remains an oversupply of space in high street retail and rents remain above market levels.

At 92.8% at end-FY22, EPRA occupancy is in line with the five- and 10-year averages but remains c 3pp below recent peaks. The top five voids within the portfolio accounted for c £2.5m (65%) of the upside potential from void reduction. In part, the current level of occupancy reflects the recent increase investment in refurbishment and asset repositioning, including sustainability projects. More than half of the vacant buildings were under refurbishment with the remainder available to let and being actively marketed. Even if void reduction were to stall there would still be an opportunity for rental income to increase through reversionary capture3 as well as from a full-period contribution from recently acquired assets.

While lease maturities reflect an element of income risk, they also provide an opportunity to reset rents towards or ahead of ERV, as was the case in FY22. Across the portfolio, the FY22 weighted average lease term (WAULT) to first termination was 4.8 years with c 40% of rental income due to mature over the next three years (Exhibit 10), representing a reasonable balance of risk and opportunity in our view. In the industrial sector, 41 lease events are forecast for the coming year, with an overall ERV that is 10% higher than the current passing rent of £2.7m, proving the opportunity to grow income. In the office sector the focus will be on reducing voids although 33 lease events are forecast with an average ERV 4.0% above passing rent.

Across the broad UK commercial property sector, over the medium term, income returns have been relatively stable compared with the volatility displayed by capital values. We therefore believe it reasonable to expect medium-term rental growth to broadly match inflation. Over shorter periods, this may not be the case as the relationship will be influenced by the incidence and nature of rent reviews as well as the timing of lease maturities.

As inflation rates have increased, investment flows into those companies with long, inflation-linked leases have remained strong. These generally provide a high level of income growth certainty and although indexed rent increases are typically capped at around 4%, below current inflation levels, this does have the additional advantage of ensuring rent levels remain affordable to tenants.

An alternative perspective is that shorter-term, open-market leases with a typical term of five years to first break provide an opportunity for landlords to rebase rents towards market levels, which may further adjust for inflation. Good-quality properties, attractive to tenants, with strong sustainability credentials should have the capacity to benefit from open-market rental growth to mitigate the impacts of inflation.

During FY22 Picton published its net zero carbon pathway and became a signatory to the Better Buildings Partnership (BBP) Climate Commitment.4 The pathway sets out the company’s plan to achieve net zero carbon (NZC) for both operational and embodied emissions5 by 2040, 10 years ahead of the government target, including the emissions of occupiers. Alignment with the BBP NZC pathway framework will provide transparency to this approach. Picton will initially focus on Scope 1 and 2 emissions but also intends to work with occupiers to reduce the most significant part of the portfolio’s emissions, which fall under Scope 3.

From 2040 onwards, all operational emissions will be reduced as much as possible through energy efficiency measures and renewable energy, with any residual emissions offset. From 2040 onwards, all completed refurbishment projects will have reduced their embodied and operational carbon as much as possible, with any residual emissions offset at practical completion.

71% of properties (by ERV) are currently rated EPC6 A-C, up from 64% in 2021, with the remainder rated D or E. From 2023, MEES7 regulations prohibit the leasing of space that is rated F or G and it is proposed that from 2027 a rating of at least C will be required. The company expects that most of the investment required to meet its EPC targets will form part of the existing rolling programme of asset enhancement and will work with occupiers that share similar environmental performance goals.

Picton’s balance sheet is strong and substantially protected against further interest rate increases. 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 c 10 years. A shorter term, floating rate revolving credit facility8 of £50m, providing flexibility to take advantage of further growth opportunities when identified, was c £5m drawn at end-FY22. The £13.7m acquisition of a mixed use property in London announced on 16 May was funded by existing cash resources (£38.5m at end-FY22).

The refinancing included the extension of Picton’s Canada Life facility from £80m to £129m. The new £49m tranche was priced at 3.25% and the cost of the original £80m tranche was reduced to a similar level from 4.1%, a reduction of c 20%. Out of the proceeds, the £31m that had been drawn from the shorter-term, floating rate NatWest RCF to fund recent acquisitions was substantially repaid (£4.9m outstanding at end-FY22), although the entire £50m facility remains available to the company. As a result, total debt facilities increased to £264m, with £222m drawn at end-FY22. The redemption fee to reset the interest rate on the £80m tranche was £4m, equivalent to a modest 0.8p reduction in NAV per share.

At 31 March 2022 (end-FY21), the externally assessed fair value of the investment portfolio was £849.3m (the balance sheet value includes an adjustment for lease incentives and finance leases), comprising 47 assets let to more than individual occupiers, reflecting a net initial yield of 4.0% and a reversionary yield of 5.4%.

Despite active positioning, the diversity of the portfolio and occupier base spreads risk and is a key factor in supporting a stable income stream. Industrial property and retail warehouse assets represent c two-thirds of the portfolio by value and have been strong drivers of performance.

Although the pandemic has significantly accelerated some of the ongoing structural shifts in the property market, market fundamentals and consensus point to a continuation of existing trends. In this context Picton believes its portfolio is well placed in respect of both its sector allocations and the quality of its assets, although it expects FY23 returns to slow from the exceptional level of FY22, with less polarisation across sectors.

Demand for industrial properties remains robust with supply constrained, reflected in a high level of occupancy and growing ERVs for Picton’s smaller multi-let estates. Key drivers of occupational demand are the continued growth of e-commerce and the importance of managing supply chains. Picton expects its industrial assets to continue to contribute strongly to performance.

Although the pandemic has raised many questions about the future role of the office, Picton believes the ‘death of the office’ has been vastly overstated and notes the important role that the office plays in company culture and productivity, being a place for both concentrated work and collaboration, connection, innovation and social interaction. Most office occupiers are now working on a flexible basis, with staff typically present in the office for two to three days a week, but the company has seen no significant reduction in the overall floorspace demanded. A ‘flight to quality’ is leading to occupiers wanting to upgrade their space, attract staff and enhance their ability to meet their own sustainability targets. With a limited market supply, Picton expects a pick-up in rental growth for good quality space. For similar but opposite reasons, poor quality space is in less demand.

Retail warehousing valuations have been improving, with retailers preferring out of town sites over the high street, not least because of the convenience to shoppers including ease of parking and ability to support online purchases through click and collect. Picton’s retail warehouse assets are now fully occupied. Although high street retail has begun to stabilise an oversupply of floor space remains.

The FY22 NAV was well ahead of our forecast while recurring EPRA earnings were broadly in line with our expectations (Exhibit 1). For FY23 our forecast for NAV is increased while our EPRA earnings are very modestly reduced, driven mainly by the impact of inflation on property and administrative costs. We have not changed our DPS forecast.

Our last published forecasts included a part-year FY22 contribution from the acquisition of the Madleaze Trading Estate in Gloucester in October 2021 (initial annualised rental income of £0.75m) but did not reflect the acquisition of Mill Place Trading Estate, also in Gloucester, in February 2022 (initial annualised rental income of £0.68m). The refinancing that was completed at the end of March 2022 had no material impact on FY22. Our revised forecasts also include the May 2022 acquisition of the Charlotte Terrace mixed-use property in Hammersmith Road, London (initial annualised rent of £0.5m). We expect further accretive net acquisition investment but have not assumed this in our forecasts.

Forecast growth in gross rent roll is primarily driven by reversionary capture in industrial and further void reduction in offices, partly offset by rent pressure in retail, where for some properties current rents are above market levels. At the group level we look for annualised rent roll to increase from £38.7m at end-FY22 to £41.4m at end-FY23 and £41.4m at end-FY24. We estimate this implies an increase in portfolio occupancy from 93% at end-FY22 to 95% by end-FY24. We forecast 3.5% growth in net rental income in FY23 with the underlying growth rate held back by a non-repeat of rent provision reversals, at least not on the same scale as in FY22)9.

Increased inflation suppresses our forecasts and although the March 2022 refinancing has lowered the average cost of debt, average debt has increased with recent investment.

Although we forecast only a modest increase in FY23 EPRA EPS, given the strong level of dividend cover we continue to anticipate an increase in FY23 DPS to 0.9p per quarter or an annualised 3.6p (versus a Q422 annualised annualise rate of 3.5p). For FY24 we forecast aggregate DPS of 3.66p.

Although the UK commercial property market has entered FY23 with good momentum, particularly for the industrial sector, we are conscious of the economic and political challenges that are evident in the UK and globally and assume a significant slowdown in capital growth in FY23 and in FY24. This may prove to be overly prudent. We have assumed gross like-for-like revaluation gains of 4.5% in FY23 and just 0.5% in FY24. Adjusting for capex and acquisition costs this represents gains per share of 8.9p in FY23 and 2.8p in FY24 or total returns of 10.8% and 5.5% respectively including DPS paid.

We estimate that each 1% increase/decrease in the total portfolio value is equivalent to an increase/decrease in NAV per share of c 1.7p.

The current level of quarterly DPS (0.875p) represents an annualised rate of 3.5p or a 3.8% yield. We forecast further increases in quarterly DPS during FY23 and FY24.

The current P/NAV10 per share is 0.77x. Although there has been a significant recovery from the early pandemic levels this is well below the 10-year average of 0.95x and a high of c 1.1x.

Exhibit 17 shows a summary performance and valuation comparison of Picton and what we consider to be its closest diversified income-oriented peers. Over three years, Picton’s share price performance is ahead of the group average, which shows a wide spread of performances, in some cases reflecting differing financial and operational performance during the pandemic. As market conditions have normalised, over 12-months the Picton share price performance is below the average. 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. With its share price failing to keep pace with NAV growth, Picton’s P/NAV is now below the peer, average having been at a meaningful premium a year ago. The company’s 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 are all potential triggers for Picton’s share price to re-rate.

Picton Property Income is an internally managed UK REIT that invests in a diversified portfolio of commercial property assets from the main commercial property sector across the UK. It is total return driven with an income focus and aims to generate attractive returns through proactive management of the 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 REITS.

The board comprises six members: four non-executive and two executive directors. The non-executive directors bring considerable experience from across the real estate, real estate financing and financial services sectors. The board is chaired by Lena Wilson CBE who brings a wide range of business and board experience to the group; she is on a number of boards in a non-executive capacity, including NatWest Group and Argentex Group, and is chair of Chiene + Tait LLP; she was chief executive of Scottish Enterprise from 2009 until 2017 and prior to that, was a senior investment adviser at The World Bank. The other non-executives are Mark Batten (chair of the audit and risk committee and the senior independent director), Maria Bentley (chair of the remuneration and nominations committees) and Richard Jones (chair of the property and valuation committee).

The executive board members are CEO Michael Morris and FD Andrew Dewhirst. Michael Morris has more than 25 years’ experience in the UK commercial property sector and has worked with the group since it was launched in 2005. Andrew Dewhirst joined Picton in 2011 and has over 30 years’ experience in the real estate and financial services sector. Brief biographies of the key members of the leadership team may be found on page 15 and detailed board biographies may be found on the company website.

Including the CEO and CFO, the broader Picton management team comprises nine individuals, of whom five are property professionals.

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. From a sector viewpoint we 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. Picton is not a developer, but is exposed to similar but lesser uncertainties, as it actively invests in improvements to existing assets with the aim of enhancing long-term income growth and returns. More generally we note the sensitivity to: