Custodian REIT — Robust EPRA earnings but decreased NAV

Strong leasing activity is supporting EPRA earnings and fully covered DPS. Five new leases were signed during Q223 at an average 9% ahead of estimated rental value (ERV), adding £0.4m to annual rent, with a weighted average 6.3 years to first break (Q123: 13 new leases adding £1.8m of rent for 6.8 years). Lettings momentum has continued into H2231 with a further five new leases completing since end-Q323, adding £0.6m of annual rental income for an average 7.0 years. The two rent reviews settled during Q223 generated an aggregate 22% increase on previous rents, adding £0.1m to annual rent.

Q123 EPRA occupancy increased to 89.3% after a Q123 dip to 88.7% and is now close to the 89.9% at the start of the year. A significant share (54%) of remaining vacancy at end-Q323 was subject to refurbishment, with a further 25% under offer for sale or lease, both positive indicators for further void reduction. Meanwhile, ERV continued to increase during Q223, by 0.8% (industrial by 1.6%; office 2.2%; and retail -0.8%).

The quarterly data shown in Exhibit 2 indicate H123 EPRA EPS of c 2.8p (H122: 3.0p), fully covering DPS paid of 2.75p. Reflecting the material change in market conditions during Q2, property valuation movements and NAV were noticeably weaker than in Q123. Across all main sectors of the UK commercial property market, general economic and political challenges and uncertainties, including the war in Ukraine, are weighing on asset valuations. The 10-year UK gilt yield has increased from below 1% at the beginning of the year to c 3.1%, having recently been as high as 4.5%. Adding to asset pricing uncertainty, investment demand for commercial real estate assets has fallen sharply after a strong start to the year. The open-ended property retail funds sector is again under pressure to raise liquidity and even the pension fund sector has been forced to reappraise sector weightings.

For CREI, during Q123 property revaluation movements (excluding gains on disposal) represented 2.6p per share, followed by a loss of 8.9p in Q223. Although asset management initiatives, new lettings in particular, had a positive impact, this was dwarfed by wider market influences. The aggregate H123 loss of 6.3p compared with a gain of almost 8p in H122.

The commercial property sector is cyclical, but income returns have historically been significantly more stable than volatile capital values and have provided a more consistent measure of value.

The relative stability of income returns can be seen clearly in CREI’s NAV total return record since listing in March 2014. Despite the strains of the pandemic, particularly in early FY21, NAV total return has been positive each year since IPO in March 2014, with an average annual total return of 6.1% up to end-H123. Reflecting CREI’s strong dividend focus, income return has represented three-quarters of total return, broadly in line with the wider market split of returns across the cycle. In the current market environment, we expect income to remain the driver of return.

Like-for-like portfolio valuations reduced by 5.4% in Q223 versus a 1.7% gain in Q123. Including modest impact from capex and transactions, the portfolio net initial yield (NIY) increased from 5.5% at end-Q123 to 5.9%. With a weaker demand-supply balance, rising bond yields and limited market transactions, there is much uncertainty about future capital values, despite many sectors reporting good occupier demand and increasing rents. This is particularly the case for industrial/logistical assets, which saw the largest pull back in quarterly valuation after exceptionally strong past growth, despite continuing firm occupier demand, constrained supply and rising rents. High street retail, where CREI has focused on prime locations, was the strongest performer in Q223, despite the obvious pressures on consumer disposable incomes and continuing modest declines in rents. In such an environment, the benefits of a diversified investment approach are clear.

Recognising that there is more uncertainty than usual about the future course of property valuation movements, we have assumed a further 10% like-for-like reduction in property values in H223, representing a widening of the NIY by 0.6% (to 6.5% from 5.9% at end-Q223). For FY24 we have assumed no further valuation movement, positive or negative

During Q223, CREI invested £26.5m in five acquisitions at an accretive blended NIY of 6.8% and disposed of one industrial property for £8.5m, 67% above book value, generating a gain of £3.4m. Acquisitions comprised two industrial assets, two retail warehouses and two drive-through restaurants. Net investment increased the annualised rent roll by 4.5% to £43.0m. So far in Q323, CREI has sold a shopping centre (part of the FY22 DRUM Income REIT acquisition) for £9.3m, 3.5% above its apportioned purchase value, and an industrial unit at auction for £1.4m, 12% ahead of valuation. The unit’s environmental credentials did not fit with CREI’s ESG objectives and it was not considered practical to mitigate these risks.

CREI has a strong pipeline of asset management projects, which it expects to enhance earnings and increase valuation in excess of capital expenditure. During the next 12 months it expects to complete:

CREI operates with moderate gearing and for most of its debt the interest rates are fixed. During Q223, the net loan to value (LTV) ratio increased to 25.4% (end-Q123: 21.5%), reflecting the £18.0m (before costs) of net deployment in the period and negative valuation movements. Adjusting for Q323 disposals, net gearing had reduced to 24.3%3 and the LTV is now 23.8% on a pro forma basis. Our forecasts assume further downwards property revaluation and indicate that as a result, LTV will rise to almost 30% versus the company’s 25% medium-term target. This would remain well within banking covenants (see below) and we do not expect this to materially impact investment or dividend policy.

Total agreed debt facilities amount to £180m (Exhibit 6), with a blended yield to maturity of more than six years. This comprises £140m of fully drawn fixed-rate debt with a blended cost of c 3.6% and average term to maturity of just under eight years, and a £40m shorter-term, flexible, floating rate revolving credit facility (RCF) with Lloyds Bank. The RCF may be increased to a maximum £50m with lender approval. At end-Q223, £178m of debt had been drawn, of which fixed rate debt represented 79%, and following the Q323 disposals (and RCF pay-down) the proportion of fixed-rate debt was 84%.

Including the 3 November increase in the Bank of England (BoE) Base Rate to 3.0% (from 2.25%), and allowing for Q322 RCF paydown, the blended average cost of borrowing remains at a similar level to end-Q222 (3.5%). BoE Base Rate is closely tracked by SONIA, the reference rate for CREI’s variable rate borrowing. Money market expectations for the future development of SONIA/the base rate, reflected in the SONIA swap curve, have been volatile, indicating a peak of 4.5–6.0% by the middle of 2023 before steadily declining towards a long-term level of 3–4%. Current rates are at the lower end of this range. Our forecasts reflect a SONIA rate of 4.5% during FY23 and 4.0% through FY24. Were SONIA to be 0.5% higher than we forecast through FY24, this would reduce our FY24 EPRA earnings forecast by a little less than 1%.

Each debt facility has a discrete security pool, comprising a number of individual properties, over which the lender has security and covenants. LTV covenants for these discrete pools are in a range of 45–50%, with an overarching covenant on the property portfolio of a maximum 35% LTV. Additionally, net rental receipts from each discrete security pool, over the preceding three months, must exceed 250% of the facility’s quarterly interest liability. Including FY22 group-level interest cover, Custodian operates well within these covenants.

The changes to our headline EPRA earnings and DPS forecasts are modest compared with the balance sheet impact of widening property yields. Our forecast EPRA earnings are c 5% lower in FY23 and c 3% lower in FY24 compared with those last published, comprising:

Reflecting the uncertain market environment, we have taken a slightly more cautious stance on DPS growth, deferring an increase in quarterly DPS until Q124, with a slightly smaller uplift, maintain a good level of DPS cover.

Our forecasts for FY23 and FY24 EPRA NTA per share are c 20% lower at c 99p in each year (end-FY22: 120p).

In addition, a 1% fall/increase in the end-FY23 portfolio value would reduce FY23e EPRA NTA per share by c 1.4%.

CREI’s target DPS for FY23 of at least 5.5p represents a prospective yield of 5.9%. Meanwhile, the shares trade at a c 18% discount to the Q223 NAV per share of 113.7p. For most of the period until the pandemic, CREI traded at a premium to NAV, reflected in an average over the whole period of 3%.

Compared with those companies that we consider to be its closest diversified income-oriented peers, CREI’s share price performance is above the peer group average and the broad UK property index over one year and three years. The sector has underperformed the UK equity index over the same periods. CREI’s P/NAV is above the average of the group, as it has been for most of the period since IPO, and its trailing yield is below average. Factors supporting CREI’s valuation include uninterrupted quarterly DPS during the pandemic (albeit at a reduced level), moderate gearing and a focus on smaller lot size properties with a yield premium that has historically supported risk-adjusted income returns.