Palace Capital — Strategic progress underscores potential

Real Estate

Palace Capital

Strategic progress underscores potential

Company update

Real estate

24 January 2022

Price	256p
Market cap	£119m

Net debt (£m) at 30 September 2021		93.2
Net LTV at 30 Sept. 2021		35.6%

Shares in issue	46.3m
Free float	99%
Code	PCA

Primary exchange	LSE
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	(1.5)	4.5	34.7
Rel (local)	(3.2)	1.6	21.5

52-week high/low

290p

190p

Business description

Palace Capital is a UK property investment company listed on the Main Market of the LSE. It is not sector-specific and looks for opportunities where it can enhance the long-term income and capital value through asset management and strategic capital development in locations outside London.

Next events

FY22 year-end

31 March 2022

Analyst

Martyn King

+44 (0)20 3077 5745

financials@edisongroup.com

Edison profile page

Palace Capital is a research client of Edison Investment Research Limited

Palace Capital (PCA) has recently disclosed several positive developments covering the near completion of its non-core disposal programme, the commencement of capital redeployment into opportunities with more attractive return profiles and leasing progress at its attractive York development, completed earlier in FY22. A highly experienced new chairman has also been appointed.

Year end	Net rental income (£m)	Adjusted PBT* (£m)	Adjusted EPS* (p)	EPRA NTA**/ share (p)	DPS (p)	P/NAV (x)	Yield (%)
03/21	14.9	7.5	16.4	350	10.5	0.73	4.1
03/22e	14.1	6.9	15.1	370	12.8	0.69	5.0
03/23e	15.2	7.7	16.7	390	14.0	0.66	5.5
03/24e	17.5	10.0	21.6	404	18.0	0.63	7.0

Note: Adjusted for revaluation gains, share-based payments and non-recurring items.

Positive developments on several fronts

The completed/agreed disposal of two properties in late December 2021 for a combined c £4.5m, ‘a significant premium to book value’, brings total transactions under PCA’s £30m non-core disposal programme to £28.2m. Redeployment of the disposal proceeds has commenced with the completed £10.25m acquisition of a fully let, good-quality office property in central Maidenhead, generating net income of £0.75m pa, reflecting an attractive yield of 6.83%. Combined with an additional £1.3m of annual income generated through active asset management, including lease renewals, rent reviews and new lettings, the new annualised income added to the portfolio rent roll since the start of FY22 now exceeds the income lost through the disposal programme by more than £1m pa. This includes the recently completed letting of 11.3m sq ft of grade A office space at Hudson Quarter (HQ) in York, at a headline rent of £26 per sq ft, subject to a short rent-free period. The new chairman, Steven Owen, also non-executive chairman of Primary Health Properties, brings strong financial and property sector experience to PCA.

Organic upside and capital redeployment

Organic income and capital growth potential within the existing portfolio is strong. H122 estimated rental value was £3.1m (18%) ahead of contracted rent, primarily recently refurbished/developed office assets, including Hudson Quarter, immediately available for letting. Further capital redeployment will add additional income and improve overall asset quality. Capital available for redeployment includes the remaining proceeds from the non-core disposal programme from sales of the Hudson Quarter residential apartments, which additionally generate trading gains. Our forecasts, for now unchanged, assume total capital redeployment of £50m (including Maidenhead), adding c £3m pa to rent roll.

Valuation: Not reflecting company growth targets

A c 5.0% prospective yield, with DPS fully covered by cash earnings and a c 30% discount to H122 EPRA NTA per share, is undemanding relative to peers and does not appear to reflect the potential for income and capital growth embedded in the existing portfolio or the opportunities for accretive new investment.

Highly experienced new chairman

Steven Owen has been appointed chairman with effect from 1 January 2022, replacing Stanley Davis, chairman since 2010 when he co-founded PCA in its current form along with CEO Neil Sinclair. Mr Davis had signalled his intention to retire at the end of October, but remained in place while the search for his successor was completed.

Steven Owen combines the financial skills of a chartered accountant with extensive experience of investment and development in commercial property in a listed company environment. He began his career with KPMG before moving into property with Brixton plc, where he spent 24 years. At Brixton he became finance director and then deputy chief executive. In 2014, he was appointed to the board of Primary Health Properties (PHP) and became non-executive chairman in 2018, overseeing significant corporate activity including its merger with MedicX Fund in 2019 and the internalisation of PHP’s management structure in January 2021.

Disposal programme nears completion

PCA has now almost completed its £30m disposal programme with the aggregate value of transactions completed or exchanged in FY22 year to date reaching £28.2m by end-December 2021 (end-Q322). 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. We expect the capital released by the current year disposals to be reinvested in better-quality assets by the end of FY23. Redeployment has commenced and, including disposal proceeds from the sale of Hudson Quarter residential assets,1 we forecast an aggregate c £50m of acquisitions (including Maidenhead) by end-FY23 at a blended c 6% net initial yield, adding c £3.0m to annualised contracted rents.

The Barclays development loan facility that had part-funded the Hudson Quarter was fully repaid by end-November 2021 and all proceeds from the remaining apartment sales will then be available for redeployment. Sales of residential apartments completed during H122 amounted to c £19.2m, generating trading profits of c £2.8m, and have continued since. We forecast that apartment sales will be completed by end-FY23, generating total sales proceeds of c £51.0m.

Of the 15 mature/non-core assets identified for disposal earlier in FY21, 12 have now been sold/exchanged. The two most recent transactions were:

■

The completed sale of Russell House in Walton-on-Thames in Surrey, a multi-let office and industrial building, for £2.625m. Since acquisition in 2014, PCA brought it to full occupancy and has increased rental income by 30%.

■

The now completed sale of Westminster House in Gerrards Cross, Buckingham, a multi-let office and residential building, for £1.9m.

For both assets, PCA has crystalised a significant but undisclosed uplift on both the acquisition prices and book values.

Redeployment underway

The £10.25m (before costs) acquisition of an office building in central Maidenhead marks the start of PCA’s capital redeployment plans. It is a good-quality building with an EPC2 rating of B and was recently refurbished. It is fully let, with the office space leased to Techtronic Industries EMEA, a strong tenant whose parent company is listed on the Hong Kong Stock Exchange. The lease term is 10 years, commencing on 1 August 2021, with a break option at the end of the fifth year. Including two small retail units on the ground floor, the total annual rent for the building is c £718k, reflected in the 6.83% net initial yield.

Energy performance certificate.

The acquisition is consistent with PCA’s focus on good-quality regional towns and city centres that are easily accessible and close to public transport, as well as the amenities that employees are keen to have near their place of work. Maidenhead is situated in the Thames Valley, between Reading and Slough. It is in an affluent area of the south east, well connected to the UK's motorway system and Heathrow Airport, making it an attractive location for international businesses looking for space close to London. Like many towns and cities outside of the capital, it has experienced a reduction in good-quality office space alongside rising demand.

Realising organic income potential

In addition to acquisitions, PCA has significant income potential within its current portfolio. At 30 September 2021 (H122), the externally estimated market rental value was £3.1m (or 18%) ahead of contracted rent roll of £16.9m. Void reduction/letting of vacant space in the office sector assets represented the single largest opportunity to increase portfolio income at £2.8m, primarily related to recently refurbished or developed assets, including the high-quality HQ office assets (£0.9m).3 Initially, 4,700 sq ft of office space, on the ground floor of one of the HQ residential buildings, was pre-let to Knights, a quoted law firm, at a record rent for York of £25 per sq ft, and the recently completed letting of 11,300 sq ft takes occupancy to c 41%. The new tenant is Great Rail Journeys, headquartered in York, which has leased the fourth and fifth floors, including the top floor terrace, on a 10-year lease (with a break option at the end of year six) at an average headline rent of £26/ sq ft subject to a short rent-free period. Great Rail Journeys has also taken 10 car parking spaces at an additional c £23k pa, indexed to inflation. Of the remaining 23,500 sq ft of office space, 10,400 sq ft is now currently under offer and completion would take total HQ office occupancy to c 67%.

HQ occupies a two-acre site in York, within the city walls and just a minute’s walk from York railway station, which is 105 minutes (non-stop) by rail from London. The scheme comprises three residential buildings and a commercial building. The 127 flats (c 95,000 sq ft of living space) are being sold and the commercial element, including 39,200 sq ft of grade A offices, will be retained for income. The office space is rated EPC ‘A’, BREEAM (a leading sustainability assessment) ‘excellent’, and WiredScore (digital connectivity certification) ‘platinum’.

Forecasts and Valuation

The recent positive developments in terms of leasing events and the continuing sale of assets at well above book value suggest the potential for FY22 income earnings and capital growth to be ahead of our forecasts, although we leave these unchanged pending further updates from the company.

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.

Exhibit 1: NAV total return history

	H214	FY15	FY16	FY17	FY18	FY19	FY20	FY21	H122	Cumulative return H114–H122
Opening EPRA NTA per share (p)*	218	341	388	414	443	414	407	364	350	218
Closing EPRA NTA per share (p)*	341	388	414	443	414	407	364	350	362	362
DPS paid (p)	2.5	8.50	14.00	18.00	19.00	19.00	19.00	7.50	5.50	113
Income return (%)	1.1%	2.5%	3.6%	4.3%	4.3%	4.6%	4.7%	2.1%	1.6%	51.8%
Capital return (%)	56.6%	13.5%	6.9%	6.9%	-6.4%	-1.8%	-10.4%	-4.1%	3.6%	66.1%
NAV total return (%)	57.8%	16.0%	10.5%	11.2%	-2.1%	2.8%	-5.8%	-2.0%	5.2%	118.0%
Average annual compound return										10.2%

Source: Palace Capital data, Edison Investment Research. Note: *Since FY20, EPRA net tangible assets per share and prior to FY20, the broadly equivalent EPRA net asset value per share.

Based on the minimum 3.25p quarterly DPS that PCA targets for the balance of FY22, the prospective yield is c 5.0%. 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 30% to H122 EPRA NTA per share of 362p.

In Exhibit 2, 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 strong long-term track record of total return generation;

■

the significant income and capital return potential embedded within the existing portfolio; and

■

the opportunity to recycle capital accretively and/or maintain a somewhat lower gearing level than has historically been the case and/or return capital to shareholders if attractive investment opportunities fail to emerge.

Exhibit 2: Peer group valuation and performance comparison

	Price (p)	Market cap (£m)	P/NAV* (x)	Trailing yield (%)**	Share price performance
	Price (p)	Market cap (£m)	P/NAV* (x)	Trailing yield (%)**	One month	Three months	12 months	From 12-month high
Circle Property	208	59	0.76	1.7	-2%	1%	17%	-10%
Custodian	105	465	0.99	4.7	2%	9%	19%	-2%
Picton	104	568	0.99	3.2	3%	4%	26%	-2%
Real Estate Investors	39	70	0.68	9.6	1%	-1%	12%	-9%
Regional REIT	91	470	0.92	6.9	-2%	5%	18%	-5%
Schroder REIT	56	273	0.84	4.8	6%	10%	43%	-1%
UK Commercial Property REIT	81	1056	0.90	3.4	8%	9%	25%	-4%
BMO Commercial Property Trust	115	864	0.88	3.7	10%	16%	54%	-1%
BMO Real Estate Investments	88	212	0.80	4.0	2%	4%	38%	-2%
Average			0.86	4.7	3%	6%	28%	-4%
Palace Capital	256	118	0.71	4.6	-2%	5%	33%	-12%
UK property sector index	1,922				-2%	3%	22%	-5%
UK equity market index	4,217				1%	3%	11%	-2%

Source: Company data, Refinitiv. Note: Prices as at 21 January 2022. *Based on last reported EPRA NAV/NTA per share. **Based on trailing 12-month DPS declared.

Exhibit 3: Financial summary

Year end 31 March (£m)	2018	2019	2020	2021	2022e	2023e	2024e
PROFIT & LOSS
Rental & other income	16.7	18.8	21.1	17.3	16.8	17.3	19.4
Movement in credit loss		0.0	0.0	(0.9)	0.0	0.0	0.0
Non-recoverable property costs	(1.8)	(2.3)	(2.4)	(1.5)	(2.6)	(2.1)	(1.9)
Net rental income	14.9	16.4	18.8	14.9	14.1	15.2	17.5
Gross profit from trading properties					4.1	3.2	0.0
Dividend income from listed equity investments		0.0	0.1	0.1	0.1	0.0	0.0
Administrative expenses including share-based payments	(4.2)	(4.1)	(4.3)	(4.3)	(4.5)	(4.6)	(4.8)
Operating Profit (before capital items)	10.7	12.4	14.6	10.6	13.8	13.8	12.8
Realised & unrealised gains/(losses) on properties	6.0	(1.0)	(18.0)	(13.1)	3.9	4.4	3.9
Loss on revaluation of listed equity investments	0.0	(0.2)	(0.4)	0.7	(0.1)	0.0	0.0
Operating Profit	16.7	11.1	(3.9)	(1.8)	17.6	18.2	16.7
Net finance expense	(3.4)	(4.7)	(5.2)	(3.8)	(3.4)	(3.3)	(3.2)
Profit Before Tax	13.3	6.4	(9.1)	(5.5)	14.3	15.0	13.5
Taxation	(0.8)	(1.3)	3.6	(0.0)	0.0	0.0	0.0
Profit After Tax (FRS 3)	12.5	5.2	(5.4)	(5.5)	14.3	15.0	13.5
EPRA adjustments:
Realised & unrealised gains/(losses) on properties	(6.0)	1.0	18.0	13.1	(3.9)	(4.4)	(3.9)
Deferred tax charge	(0.3)	0.2	0.0	0.0	0.0	0.0	0.0
Other adjustments	0.3	1.1	(1.8)	(0.3)	(4.0)	(3.2)	0.0
EPRA earnings	6.5	7.6	10.8	7.2	6.4	7.3	9.6
Share-based payments	0.2	0.3	0.1	0.3	0.4	0.4	0.4
Other adjustments	0.7	0.0	(2.9)	0.0	0.2	0.0	0.0
Adjusted earnings	7.4	7.9	8.1	7.5	6.9	7.7	10.0
Tax adjustments	1.1	1.0	(0.0)	(0.0)	0.0	0.0	0.0
Company adjusted PBT	8.5	8.9	8.0	7.5	6.9	7.7	10.0
Average fully diluted number of shares outstanding (m)	35.0	45.9	46.0	46.1	46.2	46.1	46.1
Basic EPS - FRS 3 (p)	35.8	11.3	(11.8)	(12.0)	30.9	32.5	29.2
Fully diluted EPRA EPS (p)	18.7	16.5	23.4	15.7	13.9	15.9	20.7
Fully diluted adjusted EPS (p)	21.2	17.3	17.5	16.4	15.1	16.7	21.6
Dividend per share declared (p)	19.0	19.0	12.0	10.5	12.8	14.0	18.0
Dividend cover by adjusted earnings (x)	1.11	0.91	1.46	1.56	1.18	1.20	1.20
NTA total return	-2.1%	2.8%	-5.8%	-2.0%	9.2%	9.0%	7.7%
BALANCE SHEET
Fixed Assets	254.0	261.1	251.7	239.3	213.8	273.3	282.2
Investment properties	253.9	258.3	248.7	235.9	213.6	273.1	282.0
Other non-current assets	0.1	2.7	3.0	3.5	0.1	0.2	0.2
Current Assets	46.3	55.3	51.8	61.9	68.1	16.6	13.6
Trading properties	0.0	14.4	27.6	42.7	18.5	(.0)	(.0)
Assets held for sale	21.7	11.8	0.0	0.0	0.0	0.0	0.0
Cash	19.0	22.9	14.9	9.4	39.8	6.8	3.9
Other current assets	5.6	6.2	9.3	9.8	9.8	9.8	9.8
Current Liabilities	(11.5)	(16.0)	(16.1)	(34.9)	(42.0)	(42.2)	(43.2)
Creditors	(8.8)	(10.0)	(14.1)	(12.9)	(11.1)	(11.3)	(12.3)
Short term borrowings	(2.7)	(6.0)	(1.8)	(21.9)	(30.8)	(30.8)	(30.8)
Long Term Liabilities	(105.5)	(120.0)	(121.1)	(108.5)	(72.8)	(71.3)	(69.8)
Long term borrowings	(97.2)	(112.0)	(117.5)	(105.4)	(70.0)	(68.5)	(67.0)
Deferred tax & other long-term liabilities	(8.3)	(8.0)	(3.5)	(3.1)	(2.7)	(2.7)	(2.7)
Net Assets	183.3	180.3	166.3	157.8	167.1	176.3	182.8
EPRA net assets	0.0	0.0	167.9	161.3	171.3	180.5	187.0
Basic NAV/share (p)	400	393	361	343	361	381	395
Diluted EPRA NAV/share (p)	0	0	364	350	370	390	404
CASH FLOW
Operating Cash Flow	9.9	11.9	15.7	11.3	37.3	33.0	14.2
Net Interest	(2.7)	(3.4)	(3.7)	(3.6)	(3.2)	(3.1)	(3.0)
Tax	(0.4)	(1.6)	(2.2)	(1.2)	(0.0)	0.0	0.0
Net cash from investing activities	(67.7)	(11.5)	(10.1)	(14.8)	26.6	(53.0)	(5.0)
Ordinary dividends paid	(6.7)	(8.7)	(8.7)	(3.5)	(5.4)	(6.2)	(7.4)
Debt drawn/(repaid)	8.2	18.0	1.4	7.6	(26.9)	(1.7)	(1.7)
Proceeds from shares issued (net)	67.7	(0.0)	0.0	0.0	0.0	0.0	0.0
Other cash flow from financing activities	(1.1)	(0.1)	(1.0)	(0.3)	(0.0)	0.0	0.0
Net Cash Flow	7.0	4.4	(8.5)	(4.5)	28.4	(31.0)	(2.9)
Opening cash	10.9	18.0	22.4	13.9	9.4	37.8	6.8
Closing cash	18.0	22.4	13.9	9.4	37.8	6.8	3.9
Restricted cash	1.0	0.5	1.0	0.0	2.0	0.0	0.0
Closing balance sheet cash	19.0	22.9	14.9	9.4	39.8	6.8	3.9
Closing balance sheet debt	(99.8)	(118.0)	(119.4)	(127.3)	(100.9)	(99.4)	(97.9)
Unamortised debt costs	(1.6)	(1.3)	(1.4)	(1.0)	(0.6)	(0.4)	(0.2)
Closing net (debt)/cash	(82.4)	(96.5)	(105.8)	(118.9)	(61.6)	(92.9)	(94.2)
Net LTV (excluding restricted cash & adjusted for unamortised debt costs)	29.8%	33.7%	38.1%	42.0%	26.0%	33.4%	32.8%

Source: Palace Capital historical data, Edison Investment Research forecasts

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New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

Frankfurt +49 (0)69 78 8076 960

Schumannstrasse 34b

60325 Frankfurt

Germany

London +44 (0)20 3077 5700

280 High Holborn

London, WC1V 7EE

United Kingdom

New York +1 646 653 7026

1185 Avenue of the Americas

3rd Floor, New York, NY 10036

United States of America

Sydney +61 (0)2 8249 8342

Level 4, Office 1205

95 Pitt Street, Sydney

NSW 2000, Australia

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