Picton Property Income — Resilient performance with positive returns

Picton’s diversified portfolio of commercial property across the UK is actively managed for total returns but with a strong focus on income (historically c 70% of UK commercial property market returns) and dividends. Through its occupier-focused, opportunity-led approach, the company aims to be one of the consistently best-performing diversified UK REITs. And at the property level it has built a strong and consistent track record, in recent years benefiting from an overweight position on office and industrial sectors (c 88% by value). On an ungeared basis it has outperformed the MSCI UK Quarterly Property Index over one, three, five and 10 years to 30 September 2020 (H121). NAV total return in the five years to end-FY20 was a compound annual average 10.0% and, although COVID-19 has created more challenging market conditions, we expect returns to remain positive and benefit from significant reversionary potential and asset-management opportunities within the portfolio.

Continued positive returns despite COVID-19 challenge

The H121 property portfolio outperformance of the MSCI Quarterly Property Index was across all sectors, but particularly benefited from a positive performance from industrial assets, strongly overweighted in the portfolio. Estimated rental value (ERV) increased slightly (0.2%) to £45.3m and annualised contracted rent roll of £36.8m ended the period above the end-FY20 level of £36.2m, with occupancy increasing to 90% (end-FY20: 89%) as a result of strong tenant retention and leasing progress in industrial. Leasing has continued into H221 and management is optimistic about further progress. With the 12% increase in Q221 DPS (0.625p) to an annualised 2.8p, distributions have begun to rebuild (3.5p of DPS was paid in each of FY19 and FY20) and H121 dividend cover was strong. We have lifted our FY21 forecasts, and this provides a solid foundation for the recovery we forecast in FY22 and FY23, including a return to annualised DPS of 3.5p. Forecast growth is driven by the capture of the reversionary potential in the portfolio through new lettings and lease renewals at market rents.

The end-H121 estimated market rental value at full occupancy was £8.5m or 23% above the passing rent of £36.8m. Void reduction represents £4.4m of the upside potential, substantially represented by a small number of key completed office refurbishments. Our forecasts build in c £2.5m growth in annualised contracted rent roll by end-FY23, comprising reversion to market rents in industrial (effectively fully occupied already) and leasing of available, refurbished office space, partly offset by further weakness in retail and leisure. Gearing is low (LTV c 22%) and existing drawn debt is long term and fixed rate. A £50m low-cost, flexible revolving credit facility is undrawn and available to support accretive acquisitions as opportunities may arise.

We review the main sensitivities on page 13. We consider these to be related mainly to the broader macroeconomic background and the cyclical nature of the commercial property market, with the pandemic and Brexit continuing to increase near-term uncertainties. 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.

For those familiar with the company, in this section we provide a brief overview of the recently reported interim results for the six months ended 30 September 2020 (H121); details of our increased forecasts can be found in the Financials section on page 10; and an update on valuation can be found on page 12.

In the challenging environment created by the COVID-19 pandemic, the H121 results were strong and we have significantly increased our full year FY21 forecast. Sector positioning, asset management and a good level of rent collection all contributed to a relatively strong portfolio performance, well ahead of the MSCI UK Quarterly Property Index, and positive NAV total returns, and underpinning the first steps in restoring the level of DPS towards pre-COVID-19 levels.

At the time of reporting the interim results (12 November 2020), Picton had received 90% of the March quarter’s rents, expected to increase to 96% under agreed deferred payment plans, and 90% of the June quarter’s rent, expected to increase to 93% with deferred payments. For the September quarter, 93% had either been collected or was expected to be received under monthly payment plans.

With Picton’s annualised contracted rent roll of more than £36m, we estimate that outstanding rents (for which no repayment agreements were in place) amounted to c £0.8m in respect of the March and June quarters and c £0.6m in respect of the September quarter. In addition to unpaid rents there will be outstanding service charge contributions. At end-H121, aggregate provisions (taken as an income deduction) against these amounts and other receivables taken during Q420 (c £0.5m) and H121 (c £1.7m) amounted to c £2.2m, which Picton describes as prudent. Our forecasts allow for an additional net £0.75m in H221, representing additional gross provisions adjusted for recoveries. Outstanding balances are concentrated within the retail and leisure sector and are likely to include a mix of distressed tenants that are currently unable to pay and tenants that have chosen not to pay, taking advantage of the temporary suspension by government of the ability of landlords to pursue recovery. The company has indicated that it will take a patient approach with landlords where this is appropriate and consistent with optimising longer-term recoveries and occupancy.

Exhibit 2 provides a summary of the H121 financial results. Despite the challenges posed by COVID-19, the underlying performance was robust, with EPRA earnings and NAV at a similar level to H120.

In particular we highlight:

Gearing remained low at 22.4% with £50m of flexible borrowing facilities undrawn and available for investment opportunities that may arise.

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 pro-active 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.

Picton was originally launched in October 2005 as the ING UK Real Estate Income Trust in an offshore structure and listed on the London Stock Exchange. In 2011, the company name was changed to Picton Property Income and in January 2012 the investment management function of the company was internalised. On becoming a UK REIT in October 2018, it also changed its technical listing status from an investment company to a commercial company, bringing it more into line with other internally managed property company peers, although with no material impact on the way that the portfolio is managed.

The board comprises six members: four non-executive and two executives. The non-executive directors bring considerable experience from across the real estate, real estate financing and financial services sectors. Nicholas Thompson is currently the non-executive chairman but will retire in February 2021. 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). Richard Jones joined the board in September 2020, replacing Roger Lewis who retired. Lena Wilson CBE will join the board in January 2021 and will replace Nicholas Thompson as chairman. Lena Wilson 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, Intertek 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 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.

At 30 September 2020 (H121), the fair value of the investment portfolio was £661.6m (the balance sheet value of £646.6m includes an adjustment for lease incentives and finance leases and excludes £4.0m of properties held for sale), diversified across 47 assets and let to a broad spread of around 350 occupiers, providing stability to the income base.

The held for sale asset is a retail property in Peterborough where contracts had been exchanged at end-H121. The c £4.0m sale price for the partly vacant asset (and soon to be fully vacant) was a 30% premium to the end-FY20 valuation.

At the portfolio level Picton has built a strong track record of outperformance versus the MSCI IPD Quarterly Property Index, generating above index income returns and total property returns on an ungeared basis over the one, three, five, seven and 10 years (to 30 September 2020). Exhibit 7 also demonstrates the relative stability of property income returns over the longer term.

We attribute this strong performance to both successful asset management and an active unconstrained approach to portfolio construction that adapts the sector and asset weighting to changing market conditions. Picton describes itself as ‘occupier focused and opportunity led’. Occupier focused refers to working closely with tenants to understand their needs, enhance occupancy, improve retention and maximise income. Picton continues to invest in its assets, improving the quality of the space and ensuring it meets occupier demand. In a broader sense, it also applies to the overall occupier market, which Picton closely monitors to help drive portfolio strategy and asset selection. This drives an ‘opportunity led’ approach to acquisitions and disposals, as well as asset-management decisions, seeking to buy, manage and sell effectively. The portfolio is actively positioned compared with the MSCI IPD Quarterly Benchmark (‘the index’). Throughout the past year, performance has continued to benefit from the portfolio being strongly overweight in industrial (49.5% at end-H120, compared with 29.2% for the index) and office properties (38.2%, compared with 27.5% for the index), and taking an underweight position in retail and leisure property, now down to just 12.3% (less than half the index weight). Geographically, the portfolio has a regional focus.

Combining these property level returns with an effective use of gearing and efficient operation, over the five full years to end-FY20 Picton has generated an aggregate EPRA NAV total return, or accounting return, of 61.1%, equivalent to a compound annual return (no dividend reinvestment assumed) of 10.1%. Due to the effects of the pandemic, the H121 total return was below the historical trend but remained positive at 0.7% or an annualised c 1.4%. The loan to value ratio (LTV) has averaged a conservative level of c 27% over the five years to end-FY20 and was a modest c 22% coming into the pandemic.

Going into the pandemic there was a clear polarisation of sector performance across the UK commercial property market and this has become more accentuated. Both the industrial and regional office sectors had been benefiting from a positive demand-supply balance, while the retail sector was struggling with rising costs and the structural impact of online competition.

In the six months ending 30 September 2020, the MSCI Monthly UK Property Index showed a total return for All Property of -1.6%, with an income return of 2.7% and capital growth of -4.2%. Rental growth was -1.7% for the six months to September 2020, compared to -0.5% for the six months to March 2020. Of the three main property sectors, industrial was the only sector to produce a positive total return for the period; the total return was 1.7%, comprising 2.4% income return and -0.7% capital growth. In the office sector, the six-month total return was -0.8%, comprising 2.4% income return and -3.2% capital growth. The All Retail total return was -5.8%, comprising 3.6% income return and -9.1% capital growth.

Across each of the main sectors, valuation performance has improved month by month since April with positive monthly valuation performance in the industrial sector since July, stabilising office valuations and retail valuations declining at a slower pace.

Picton’s strong overweighting in the industrial and office sectors and strong underweighting in retail was positive for performance but it also outperformed within each sector during H121. The expected bounce back in economic activity in 2021 should be further supported by the recent progress on COVID-19 vaccination. In this context the positive fundamentals of steady occupier demand and limited new supply that have supported Picton’s industrial assets seem likely to remain in place. Its UK-wide distribution assets are fully let and its multi-let industrial estates have minimal vacancy.

Although the pandemic has raised many questions about the future role of the office, Picton believes there is continuing demand for quality space and that the ‘death of the office’ has been vastly overstated, highlighting 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. It is difficult to predict an end to the pressures on the retail sector, although Picton’s exposure is relatively low and is focused on retail warehouses (7%) that should continue to fair better than high street retail (less than 4%), given their convenience, ease of parking and ability to support online purchases through click and collect.

The end-H121 ERV of £45.3m was £8.5m or 23% ahead of the annualised contracted rent roll of £36.8m. With an EPRA occupancy rate of 90%, c £4.4m of this upside potential relates to void reduction and the balance represents the upside from lease incentive run-off (c £3.3m) and the potential to increase existing rents to market levels at lease expiry (c £0.8m).

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, while market rents continue to increase. In the office sector there is considerable upside from void reduction. In retail and leisure there is scope to increase occupancy, although currently contracted rents are on average above ERV while ERV remains under pressure from market conditions.

Although the pandemic has slowed letting activity across the market, during H121 Picton completed nine lettings securing income of £1.2m pa, 2.8% ahead of the March ERV. A positive indication for the effectiveness of the Picton Promise was the upsizing of three existing occupiers. There were also 16 lease renewals or regears, retaining income of £2.3m pa, an increase on the previous passing rent of 12.1%, and 14.3% above ERV. Additionally, break options were removed or pushed back in three leases, securing £0.5m pa for a further period. Five rent reviews were concluded, securing a £0.3m per annum uplift in income, 16.3% above ERV. Retention during the period was good, with only £0.1m pa of rental income lost through occupiers vacating and EPRA occupancy increased to 90% from 89% at end-FY20. Around half the increase in occupancy relates to the short-term letting of a distribution unit in Rugby to UPS, which left the industrial portfolio with just two small vacant multi-let units, one of which is under offer.

Five office assets, mostly refurbished, represented c 70% of the void opportunity at end-H121. This includes the Stanford Building in Covent Garden, London, where the refurbishment is now substantially complete, with an ERV of £1.6m at end-H121, of which £0.4m has since been let. The formerly retail asset was reclassified as an office following the planning application to convert the first floor from retail to office space.

Early in FY20 Picton provided details of more than 20 identified asset management initiatives within the portfolio, representing an aggregate investment of c £15m, which it expected would be spread over several years. These initiatives are aimed at improving the quality of the existing portfolio assets with the intention of delivering higher occupancy, rental income and capital values and include:

During FY20 it invested £8.9m across a range of projects and during H121 a further £2.5m, with several projects completed and available for letting as noted above. There are several projects, underway, each individually smaller than the Stanford Building (substantially completed) and the Swiftbox distribution unit in Rugby (where the refurbishment is complete and the building let). We expect Picton to take a flexible approach to the remaining identified opportunities, taking into consideration evolving market developments.

With rent collection performance and occupancy stronger than we had allowed for, and property expenses lower, our income forecasts for the current FY21 year are quite considerably increased. Similar factors drive an increase in the FY22 forecast, although we had already assumed recovery from FY21. Our FY23 income forecast assumes further progress driven by capturing a part of the reversionary potential contained within the existing portfolio. The pandemic impact on capital values in H121 has been less than we had assumed and this feeds through into our NAV increase.

Our forecasts are based on an unchanged portfolio, although with modest gearing and undrawn borrowing facilities the company is well placed to seize accretive opportunities. Picton says that it is actively looking for acquisition opportunities, particularly where the vendors are in distress, perhaps because of a heavy debt burden.

The factors that will determine future rental income include:

In our forecasts we have assumed no increase in office/industrial ERVs and a decline in retail and leisure. Our forecast income growth is driven by void reduction (in office) and reversion to market rents in industrial, partly offset by occupancy/rent reduction in retail and leisure. We estimate that our assumptions represent an increase in EPRA occupancy from 90% at end-H121 to just over 93% at end-FY23.

For FY21 we have assumed:

For FY22 and FY23 we have assumed:

Our previously published forecasts had expected an increase in quarterly DPS during H221 and the increase in Q221 DPS came sooner and takes the full year DPS to broadly the same level. We continue to assume a further increase in DPS in FY22, taking the annual aggregate back to the pre-pandemic level, followed by further growth in FY23 Relative to our EPRA earnings forecasts, dividend cover is 140% for FY21, 113% for FY22 and 110% for FY23. The REIT distribution requirement is that at least 90% of property income is paid out within 12 months of the accounting period. The calculation of property income may differ somewhat from the calculation of EPRA earnings, including the impact of capital allowances, but our forecasts imply a c 80% distribution of the aggregate FY21/22 EPRA earnings.

Taking account of recent market trends and the unusually wide range of market forecasts, we have assumed some further weakness in the aggregate portfolio valuation in H221 (0.5%), no change in FY22 and a modest uplift (1.5%) in FY23. The outcome may differ quite materially from this. We expect the leasing progress that we forecast to support valuation but have only partially reflected this. We believe our assumptions are consistent with an increase in the net initial yield from 5.0% at end H121 to 5.2% at end-FY23 and a slight reduction in the reversionary yield from 6.5% to 6.2%.

Each 1% increase/decrease in the total portfolio value is equivalent to an increase/decrease in EPRA NAV per share of c 1.3p. For the end-H121 EPRA NAV per share (93p) to fall to match the current share price (75p) would require a c 14% reduction in the portfolio value.

At end-H121 borrowings amounted to £166.8m, comprising long-term (first maturity 2027), fixed-rate loan notes with Aviva and Canada Life. Having repaid all drawings under its flexible revolving credit facilities (RCF) with the proceeds from disposals during the last financial year, in June 2020, the existing facility was replaced with a new £50m RCF, extending duration and reducing cost. For now, it too remains undrawn.

H121 cash was £18.9m and with net debt of £147.9m the net LTV was 22.4%.

The average fixed cost of the drawn debt was c 4.2% with a weighted average term to maturity of 9.4 years at end end-H121. The undrawn RCF has a low margin over Libor of 1.5%.

Given the current low level of market interest rates, the disclosed fair value of the secured loan facilities at 30 September 2020 of £197.9m was above the carrying value and while it would be possible to refinance the existing debt at a lower annual interest cost, it would also be necessary to compensate the existing lenders. We would expect the result of refinancing to be broadly value neutral with the benefit of any reduction in annual interest cost offset by the early termination costs in net present value terms. For this reason, we do not assume any refinancing.

The borrowing covenants provide a good level of headroom and Picton estimates that, on average, rental income or asset values would need to fall by more than 40% for there to be any impact. In any case Picton is in constant dialogue with its lenders, who remain fully supportive of the company.

Our forecast 2.73p FY21 DPS represents a 3.6% prospective FY21 yield (also 3.6% based on the current quarterly rate of DPS of 0.7p or 2.8p annualised). Our FY22 DPS forecast of 3.5p in FY22 represents a yield of 4.7%. Meanwhile, the 19% discount to the H121 NAV compares with an average 3% discount over the past five years.

Our forecasts imply a positive but modest (2.8%) NAV total return for the current year (FY21), increasing through FY22 (4.1%) and FY23 (6.3%). Although these prospective returns are below the 10% compound annual average return in the five years to end-FY20 we believe they are attractive in the context of a continuing low-rate environment. The yield on the 10-year UK gilt remains below 0.3%.

In Exhibit 15 we show a summary performance and valuation comparison of Picton and what we consider to be its closest diversified income-oriented peers. In terms of valuation, we show the trailing yield based on aggregate declared DPS over the past 12 months, as well as the forward-looking yield based on the most recently declared DPS annualised. Neither is entirely satisfactory as the sector remains in a state of flux; most companies reduced DPS payouts during the pandemic and some postponed payments altogether for a time, and it will be a while before the full-year prospective DPS outlook becomes clearer and a true comparison can be made. Picton shares have outperformed the peer group over the past year, which we attribute to its 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.

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. In particular we note: