Channel Islands Property Fund — Sound income stream

D2 Real Estate (D2RE, which also acts as CIPF’s property manager) expects the Channel Islands market conditions to improve relatively quickly as interest rates are forecast to start to fall towards the latter part of the year. It also sees investors in mainland UK adopting a ‘wait and see’ approach, given the structural reshaping of the industry prompted by the increasing popularity of hybrid work arrangements – a factor far less relevant in the Channel Islands though. According to the National Bureau of Economic Research, there is a clear correlation between the popularity of working from home and average daily commuting time (the more time it takes to get to the office, the more employees are willing to work from home). This implies that office working is more popular in the Channel Islands due to its short commuting times. On top of that, the property stock in the Channel Islands is far more limited than in the UK, which means the right opportunity still attracts an active pool of buyers.

An important advantage of the Channel Islands market is the limited number of new properties being developed, due to its geographical limitations. Naturally, this translates into higher competition for quality assets and lower tenant turnover, aiding market stability. Having said that, several larger investments were brought to the market in the second half of 2022, allowing the current, more uncertain market conditions to be reflected in property transactions, as investors tend to compare returns against other jurisdictions. This is visible in the higher yields reported on new leases with a tenure of 15+ years (ie for new properties), as presented in Exhibit 2 below.

At the end of 2021, Jersey’s occupational market comprised c 3m sq ft office space, of which CIPF had a c 5.5% market share. According to D2RE, as of February 2023, there are 214k sq ft of office space under construction:

The take-up in Jersey decreased visibly in 2019 and has been gradually increasing since then. According to D2RE, the lower take-up figures reflect a lack of stock rather than a lack of demand. The vacancy rate in St Helier is around 8%, but, according to D2RE, much of the vacant space is in secondary locations and/or buildings not fit for purpose and the vacancy rate on the Esplanade (the financial centre of the island) is only 2%. These figures compare to CIPF’s 4% vacancy rate across the whole portfolio, across all locations.

The recent activity in Jersey has been around second-generation buildings (ie built in the 2000s) in prime locations of St Helier. This is likely due to the limited amount of new buildings entering the market and wide rent differentials, which recently stood at £40/sq ft in new buildings and £28–30/sq ft in second-generation buildings. As a result, some upward pressure on second-generation rents is seen; as an example, CIPF’s Liberation House had average rent of £28.5/sq ft pre-pandemic, while latest lettings and re-gears reached £32/sq ft.

At the end of 2021, the Guernsey occupational market comprised c 2m sq ft office space, of which CIPF had a c 13.7% market share. Only one building is currently being developed in St Peter Port (Plaza House, due for completion in Q324), comprising 60k sq ft, of which 60% has been pre-let. This pre-letting has driven the highest take-up in Guernsey since 2018, at c 80k sq ft. The overall vacancy rate in Guernsey stood at 9.4% in 2022, down from 11.0% in 2021, but the grade A vacancy rate is as low as 2.9%. Even that is an inflated number due to the remainder of Plaza House being on offer (2021: 1.7%).

The Isle of Man is the smallest property market CIPF operates in, being roughly one-third of the size of Jersey and half the size of Guernsey. The location is supply constrained and, according to CIPF, no new investments entered the market during FY22. Simultaneously, yields on the Isle of Man are visibly higher than on the Channel Islands (see Exhibit 4), which we believe may stem from lower tenant and investor interest. Having said that, the largest office building in Douglas (Douglas Bay House) completed a lease re-gear during the last year.

Commercial real estate tends to be adversely affected as economic conditions worsen, driven by a combination of yields available in the gilt and bond market plus a discount for liquidity – it takes longer to sell physical real estate than bonds. Recent movements in the share prices of listed real estate investment trusts (REITs) suggest a fall in pricing of property over the next 12 months at least.

According to CIPF’s management, the fund will undoubtedly be affected by changing conditions in the wider market, however the underlying portfolio has been constructed to be defensive in times of turbulence, with high-quality assets in a market lacking oversupply of stock, let on long leases to good tenants, with 100% rent collection throughout the pandemic. In contrast to many UK regional cities, offices in the Crown Dependencies are operating with a high level of staff occupancy, partly because of short commuting distances on the islands.

Crucially, rental growth in St Helier and St Peter Port is still in evidence and this is one of the key drivers for value in a real estate portfolio. Another value driver is tenant demand, and the manager has seen new lettings in the portfolio over the last two quarters, in addition to take up in other new-build properties in the Crown Dependencies.

CIPF’s portfolio consists of 12 properties: five in Guernsey, four in Jersey and three in the Isle of Man. All are A-grade properties with long-term leases, which collectively had a WAULT to expiry of 11.6 years at 30 September 2022 and as high as 23 years at 17a–18 Esplanade (with the earliest possible enactment of break clause in 2024). The property mix remains stable, with the latest addition to the portfolio being 18–22 Grenville Street, acquired in September 2020. This long-term visibility gives investors confidence that the fund will be able to pay its expected future dividends, which is one of CIPF’s major attractions.

Two-thirds of CIPF’s portfolio (value-wise) is located in Guernsey, a quarter in Jersey and the remaining 12% on the Isle of Man (see Exhibit 5). The yields earned on Jersey and Isle of Man are visibly higher than in Guernsey, which translates into their higher share in overall contracted rent compared to their share in the total property portfolio value.

The annual rental income of CIPF portfolio was £18.3m as at 31 December 2022 (compared to £17.6m in July 2021). The three largest properties (in terms of value, data as at 30 September 2022) are in Guernsey and generate 49% of contracted rent. All are multi-tenant offices, rented predominantly to financial institutions:

The single largest tenant exposure in CIPF’s portfolio is Mourant, representing 14% of CIPF’s contracted rent. It rents roughly half of the abovementioned Royal Chambers and the entire office space in 18–22 Grenville Street in Jersey. Mourant is one of the largest offshore law firms, with offices in the British Virgin Islands, Cayman Islands, Channel Islands, Hong Kong and the UK. None of the other 26 tenants represent more than 10% of the contracted rent. The tenants in the portfolio are mostly blue-chip financial and legal firms and, as such, can be considered good quality.

Six of CIPF’s 12 portfolio properties are let to single tenants. These represent 29% of the portfolio in terms of property value and 28% in terms of generated rent as at 30 September 2022.

CIPF’s portfolio is almost fully let, with a vacancy rate of 3.7% at 30 September 2022 (down from 4.8% a year earlier), which compares to, for example, a 7.5% vacancy rate at CLS Holdings. A third of CIPF’s contracted rent has an earliest termination date after more than 10 years, while 22% has a termination date below three years. However, we do not see the shorter-term agreements as a risk, considering the lack of new space coming to the market, and the attractiveness of the locations, implying a steady stream of interested occupiers. We believe that five- to six-year lease terms are more common in the UK office space, compared to longer durations common in the Channel Islands, as well as in the CIPF portfolio. These characteristics highlight the attractiveness of the Channel Islands market.

CIPF listed in 2010 at 100p and has remained broadly at that level for over 12 years. It briefly dipped to 96p during the initial outbreak of the COVID-19 pandemic and related turmoil in financial markets, but rebounded subsequently to the current 100p. We believe this stability is driven primarily by the fund paying out most of its earnings as dividends; the trade-off for growth in the underlying assets is a dependable dividend stream.

The defensiveness of CIPF’s stock has proved beneficial for investors in the bear market. CIPF shares did not follow the recent sell-off, as seen in the broad index (see Exhibit 8), leading to its significant relative outperformance against the index. CIPF’s average annual NAV total return to 31 December 2022 is 8% pa over the last five years, compared to a 5% decrease pa of the EPRA Nareit UK office index. We believe that CIPF’s defensiveness stems, at least partially, from low share liquidity. Nevertheless, looking at the period before the sell-off (the five-year period ending 31 December 2021), CIPF still visibly outperformed the broader UK office market, with a 8.0% NAV total return per annum, compared to 6.4% for the index.

CIPF’s rental income amounted to £17.1m in FY22, compared to £16.4m in FY21, which was an 11-month period due to a reporting period change. It is important to note that CIPF collected 100% of contracted rent in FY20 during the period of lockdowns, highlighting the strength of its tenants. The property costs (utilities, maintenance, etc) are passed on to tenants through a service charge collected quarterly in advance, based on the budgeted amount for each year, while CIPF needs to cover costs related to the vacant space on its own. In FY22, CIPF incurred £4.2m in service charge expenses (up 13% y-o-y) of which only £0.3m was non-recoverable (though up 10% y-o-y). The remaining operating expenses comprise management costs (FY22: £1.7m) as well as other expenses (including administration, legal and remuneration, among others) of £1.6m in FY22. The slight cost inflation resulted in a decline in operating margin to 64% of total income, from 69% in FY21.

CIPF’s net income for FY22 was £14.5m, up 43% y-o-y on an annualised basis. The year-on-year change (given broadly stable operating income) stemmed from revaluations. The £8.3m downward revaluation of investments was fully offset by a £14.2m profit recognised on revaluation of derivative instruments (see more in the Gearing section below). We calculate net income, excluding the impact of derivatives revaluation, stood at £0.3m (FY21: £9.3m).

CIPF does not have any direct peers, but we list below a selection of REITs and funds that have similar characteristics, that is, they tend to hold office, commercial or retail property portfolios. CIPF’s NAV performance ranks above the group average over the periods of one to five years to 31 December 2022. We note that CIPF’s property portfolio is relatively stable valuation wise and did not follow the recent downward revaluation seen among peers. Similarly, it withstood the pandemic well compared to peers and was not subjected to subsequent rebound in valuations. We also note that the average share price discount to NAV widened recently among peers to 22% (compared to 10% in November 2021), most likely reflecting higher yield expectations of investors in the environment of higher interest rates. CIPF’s dividend yield now stands at 6.6%, which is below the peer group average; however, we note that the average peer yield increased to 7.2% from 4.7% in November 2021.

We consider CIPF’s regular dividends as one of the stock’s most important features for investors. Since 2017, CIPF has distributed a dividend of 6.6p per share every year in equal quarterly instalments, which implies a 6.6% yield at the current share price. The dividends are paid in February, May, August and November. The company distributes most of its income through dividends, and the relation of dividend to net income stands at 89% on a three-year average. The last dividend payment was made on the last day of February (ex-dividend date was 6 February).

CIPF tends to trade at a slight premium to its NAV while its peers trade at a double-digit discount. We believe this is because its assets and tenants are high quality. Therefore, the rental income is very predictable and, even in the pandemic, CIPF collected all rent due in every quarter. It follows then that investors value the company on a dividend yield basis.

The company was established in 2010 with the objective of providing shareholders with a total return from a combination of capital growth and an appropriate dividend policy through the acquisition and active management of commercial property, predominantly in the Channel Islands. CIPF distributes most of its income in the form of dividends, and its net asset value remains relatively stable over time.

The company was initially set up with a limited life, but at the 2018 AGM shareholders voted to extend the life of the company indefinitely, subject to a continuation vote every five years. The shareholders representing at least 15% of issued shares had the opportunity to request such a vote at the next AGM to be held on 2 March 2023; they did not exercise this and the next vote may be requested at the 2028 AGM.

The company’s investments are not subject to any geographical or other limitations or restrictions, although its investment objective is to hold properties predominantly located in the Channel Islands. The company may invest directly or indirectly in commercial property including property development as long as no single investment is more than 25% of the portfolio. Investment in property related funds, derivatives and financial indices is also permitted. Leverage is targeted at 40–65% of total acquisition cost. Day-to-day management is delegated to Ravenscroft as the investment manager, and to D2RE as the property manager.

CIPF seeks to ensure that sustainability considerations are integrated into investment decisions and the ongoing management of the portfolio. CIPF promotes social responsibility, acting with integrity in governance and aiming to ensure that its actions fully take into account their effect on the environment, and it has developed its own ESG objectives, which are:

CIPF works collaboratively with its tenants, which have their own ESG agendas, to deliver results together. CIPF encourages green leases with all incoming tenants and is working on memoranda of understanding with existing tenants to develop deliverable initiatives in this area, which is of great importance to them as occupiers and for staff expectations and occupier experience.

CIPF as a company has a limited footprint, but it seeks to reduce travel with the use of video conference calls. The day-to-day management of its portfolio is undertaken by D2RE, and examples of how D2RE incorporates ESG include:

According to CIPF, ESG issues are at the forefront of decision-making both for occupiers and investors. While valuers are not yet directed to explicitly consider ESG in deriving their opinion of property valuations, it is an inevitable factor in the future, with the possibility of ‘green premia’ and ‘brown discounts’ being applied to values. The manager actively monitors the market and acts in a timely fashion to ensure that buildings will be compliant with relevant legislation in the future. The States of Jersey has introduced energy performance certificates (EPCs), with standards expected to follow closely those that have been in place in the UK for many years. CIPF has already obtained EPCs for most of its properties, with good overall results.

In FY22, CIPF amended its loan facility from Royal Bank of Scotland International (RBSI) to enlarge it to £125m (from £120m), of which £5m remained undrawn at 30 September 2022. The loan matures in June 2027 and bears a variable interest, which at 30 September 2022 was 5.50% (the current margin was not disclosed, while it was 2.39% at 30 September 2021). The commitment fee stands at 1.00% of the undrawn amount.

The loan has five covenants in place (see Exhibit 15), all of which were met as at 30 September 2022. Having said that, the increase in interest rates during the year (eg three-month sterling Libor increased from 0.08% on 30 September 2021 to 3.34% on 30 September 2022) translated into lower property valuations and in turn had a negative impact on the covenant ratios.

CIPF’s current indebtedness implies a loan to value ratio (excluding lease incentives) of 49.3%, up from 47.9% at 30 September 2021. We calculate that to reach the 55% covenant threshold, CIPF’s property portfolio would have to be revalued downwards by 11%. Considering that over the last year, which has seen a significant hike in interest rates, the portfolio was revalued down by only 3.1% and given current expectations of gradual policy easing, we see that level as relatively safe.

Additionally, CIPF actively manages its interest rate exposure and entered into two derivatives agreements over the last financial year. The derivative arrangements were signed with NatWest Markets and cover £90m out of CIPF’s overall £120m loan exposure. CIPF has an interest rate swap in place for £45m (carried out at 1.67%) and an interest rate cap with a strike rate of 1% on the other £45m. During the year, the derivative instruments were revalued by £14.2m, which significantly improved CIPF’s bottom line.

CIPF’s ongoing charge amounted to 2.10% of average NAV in FY22 (FY21: 1.97%). The charge includes the management fee paid to the investment manager (0.6% of the gross asset value of the company), as well as other ongoing costs of administration, regulators and auditors, among others. The manager does not charge any performance fees and property management costs are mostly covered by the service charge.

CIPF was established in 2010 as a closed-ended collective investment scheme authorised by the Guernsey Financial Services Commission. It has a single class of share, of which there are now 159.9m shares in issue. Its biggest shareholder is Huntress (CI) Nominees, which holds 87% of the issued share capital. Huntress (CI) Nominees is the vehicle through which the clients of Ravenscroft (CI) Limited hold stock in CIPF. We understand that within Huntress there are 736 shareholders, none of which holds more than 10% of the share capital.

The board of CIPF consists of the chairperson and three directors, all of whom are considered independent. For more details, see our initiation report from November 2021.