LXi REIT — Strong accretive growth continuing

We expect a continuation of strong growth at LXi, driven by rental uplifts and accretive, largely off-market acquisitions, including attractively priced forward funded developments. LXi’s portfolio benefits from defensive and resilient characteristics including diversification across a range of structurally supported sub-sectors, with a focus on non-discretionary uses, let to a broad spread of high-quality and well-capitalised tenants. Following swift deployment of the proceeds of the £250m (gross) of equity raised in early February, we expect an additional £100m of debt-funded acquisitions before September 2022 although we estimate that LXi could invest twice this amount without breaching its 30% loan to value ratio (LTV) target. While the uncertainties of the pandemic have eased and restrictions have been lifted, economic uncertainty remains, more recently accentuated by international tensions. Despite the potential negative impact on economic growth, the continuing increase in commodity and fuel prices seems likely to sustain inflationary pressures. In this environment, LXi is well placed to offer inflation protected returns, with 96% of portfolio rent reviews linked to UK inflation or containing fixed uplifts. Although inflation is currently above the average c 4% caps that apply to index-linked rental uplifts, a substantial spread remains above funding costs. Fully let assets on long leases at affordable rents provide significant income visibility and, provided those tenants selected by LXi perform as it expects,1 protection from the occupancy risk that may face the mainstream commercial property market should the economy weaken.

LXi has a long weighted average unexpired lease term (WAULT) of 22 years, while index-linked leases (mostly capped and collared) and fixed uplift leases provide significant income protection against inflation.2 Conversely, fixed rents and rent collars (minimum uplifts to indexed rents) ensure continuing rent growth if inflation falls to low levels. The 12-month rate of CPI3 increase was 5.5% in February 2022, the highest rate of increase since March 1992, while the 7.1% rate of RPI4 increase was the highest since March 1991. The Bank of England continues to expect a moderation in inflation as commodity prices stabilise, supply shortages ease and global demand rebalances, but this is far from assured. International tensions have seen oil and commodity prices increase further.

Of the 96% of rents that were indexed or fixed at end-FY21, 75% were indexed to inflation (56% indexed to RPI and 19% indexed to the CPI).5 The 21% of rents that provided fixed uplifts did so at an average of 2.3% pa. Rent reviews completed during H122 reflected average growth of 2.9% pa, but with 62% of rents reviewed at five-yearly intervals, higher levels of inflation will increasingly be reflected in passing rents.

Around two-thirds of indexed rents have caps in place, representing the maximum that rents may increase, which provides significant inflation protection while also seeking to ensure that rents remain sustainable for operators. Only if inflation is sustained above c 4% would rent growth lag in real (inflation-adjusted) terms, a scenario with potentially much wider and more challenging implications across the broader commercial property sector. Fixed rents and rent collars (minimum uplifts to indexed rents) ensure continuing rent growth if inflation falls to low levels.

While inflationary expectations may filter through the economy over time, consensus expectations for open market rent growth, common among mainstream UK commercial property sectors, remain relatively subdued. The Investment Property Forum industry consensus data as of August 2021 show open market growth expectations at less than 2% through 2021–25, with the best performing sub-sector, industrials, at 3.5%.

LXi has a strong track record of quickly deploying additional equity resources into predominantly off-market investments that have been identified in advance and this is continuing despite the scale of equity issuance. The proceeds of £250m (gross) upscaled and oversubscribed equity raise that closed on 9 February 2022 were fully deployed within four weeks. This is an even faster pace than for the £125m (gross) March 2021 equity raise (12 weeks) and £100m (gross) June 2021 equity raise (17 weeks).

Recent acquisitions have been broadly spread across existing and new (to LXi) sectors, which demonstrates both the investment adviser’s strong asset sourcing capability and the benefit of investing across a wider pool of opportunities.

Since IPO in February 2017 LXi has generated returns well ahead of its medium-term target of at least 8% pa and has succeeded in its aim of providing shareholders with secure and growing income, fully covered by adjusted earnings along with capital growth. The accounting total return6 up to 31 December 2021 (9M22)7 is an aggregate 66.6% or an average 11.1% pa. Based on DPS paid, the aggregate income return since IPO has been 24.3%.

At IPO LXi set a target DPS of 5.0p for stabilised DPS.8 Assuming, quite reasonably, that LXi meets its targeted 6.0p of DPS declared in respect of the current financial year (FY22), DPS has increased at an average 4.7% pa, well above inflation during the period, despite a slight dip in DPS declared in FY21 due to the pandemic. LXi targets a 5% increase in FY23 to 6.3p.

In January, LXi published its unaudited net asset value per share as at 31 December 2021 (Q322) of 139.5p, an increase of 4.1% compared with end-Q222. It also announced its target for increased FY23 DPS of 6.3p (+5% vs FY22). Although the shares are not materially below the 12-month and post-IPO high of 155.6p the prospective yield has increased to 4.3% and the premium to NAV has narrowed from c 18% in September to c 6%.

The investment objective is to deliver inflation-protected income and capital growth over the medium term through investing in a diversified portfolio of UK property assets, let or pre-let to a broad range of tenants with strong financial covenants on long (typically 20–30 years at inception), index-linked, triple net leases. This aims to provide shareholders with secure and growing income, fully covered by adjusted earnings, along with capital growth over the medium term.

Long leases provide security of contractual income, while the upwards-only, substantially indexed lease terms add predictability and visibility to income growth. As a result, property yields and capital values are less volatile than may be the case for short-lease assets. These factors support the use, and lower the cost, of long-term debt, enabling LXi to lock in positive and increasing (with rent indexation) spreads between yields and funding costs, while avoiding regular refinancing costs.

LXi’s diversified multi-sector approach differentiates it from many specialist long-income real estate investment trusts (REITs) that focus on a particular sector of the market. While specialisation can bring many advantages, it can also be vulnerable to significant changes in market conditions or strong competition for assets. Low-risk forward funding of pre-let development assets enhances returns by enabling LXi to source high-quality assets at lower cost than would be possible purely from targeting completed assets, while regular recycling of capital provides a means of rebalancing exposures to manage risk and optimise capital deployment.

There is much more to LXi’s investment strategy than a simple ‘buy and hold’ policy for long-lease assets. The key elements of this strategy are:

Additionally, LXI targets high-quality assets that appeal to long-term occupation (or alternative occupiers should the need arise), as well as assets that are of long-term strategic importance to the tenant (such as a main distribution or production site) and where the tenant may already be accustomed to long-term occupation through freehold ownership.

At 31 December 2021 LXi’s portfolio was valued at £1,326.7m9, reflecting a NIY of 4.5%. LXi has since completed or exchanged on the acquisition of assets with an aggregate value of £243m at an accretive blended NIY (net of acquisition costs) of c 5.2%. Including the post-December acquisitions, the portfolio currently comprises 191 assets (31 December 177), across 11 sectors10, 100% let or pre-let on long-term, triple-net leases to 70 strong tenants, with a long WAULT to first break of 22 years. We estimate a current annualised contracted rent roll of c £80m (31 December: £67.6m).

The current sub-sector split by rental income is shown in Exhibit 6. Over the past year LXi has added investments in ‘life sciences’11 and ‘education’12 to the identified list of sub-sectors within the portfolio. The 14 acquisitions announced since 31 December have included additions to foodstores and essentials, car parks, and drive-thru coffee outlets as well as office13, leisure14, training facilities15, and car retail investments16.

Tenant and geographic diversification further mitigate income risks, in addition to the multi-sector investment approach. The portfolio is fully let to more than 70 tenants and at H122 largest 20 tenants accounted for c 70% of annual passing rent (the largest of which was Travelodge at c 7%). The remaining tenants each contribute less than 2%.

LXi is a closed-ended investment company, externally managed by LXi REIT Advisors (the investment adviser). Its shares have been traded on the Main Market of London Stock Exchange, with a premium listing since February 2017 and are a constituent of the FTSE 250 Index and the EPRA/NAREIT Index.

The investment objective is to deliver inflation-protected income and capital growth over the medium term through investing in a diversified portfolio of UK property assets, let or pre-let to a broad range of tenants with strong financial covenants on long (typically 20–30 years at inception), index-linked, triple net leases. This aims to provide shareholders with secure and growing income, fully covered by adjusted earnings, along with capital growth over the medium term.

The board of LXi is responsible for setting strategy and for the company’s overall activities, but it has appointed Alvarium Fund Managers (100% owned by Alvarium Investments, ‘Alvarium’) as the alternative investment fund manager (AIFM) and is externally advised by LXi REIT Advisors. The composition of the board has recently changed as part of LXi’s succession planning, which was supported by external consultants. At the FY22 AGM Stephen Hubbard (chairman) and Colin Smith, both of whom had been with the company since its IPO, stepped down. Three new appointments to the board with effect from January 2022 are Cyrus Ardalan (as chairman designate), a highly experienced investment banker with well-established corporate governance expertise; Hugh Seaborn, with over 35 years of real estate experience including senior corporate and governance roles; and Ismet Levin, with almost 30 years’ experience in commercial, international growth, and technology-led legal software industries across Nasdaq-listed and private equity. They will join existing non-executive directors Jan Etherden, with more than 35 years’ experience in the investment industry; John Cartwright, a former chief executive of the Association of Real Estate Funds; and Patricia Dimond, with an international career of more than 30 years in consumer and financial markets. Together, the board brings substantial real estate, financial, commercial and operating experience to the company. Detailed biographies can be found on LXi’s website.

Alvarium was established in 2009 and has grown to become a substantial, international multi-family office and asset manager, supervising more than US$20bn of assets, for families, private individuals and institutions. It has over 220 employees and 14 offices around the world. The investment advisor is owned by the principals, shareholders and directors of Osprey Equity Partners (‘Osprey’), formed in 2011 and 50% owned by Alvarium.

The investment advisor has extensive expertise in the real estate sector, and its core investment team of property, legal and finance professionals has capitalised and transacted over £2bn of commercial property assets with a particular focus on accessing secure, long-let and index-linked UK commercial real estate through forward funding and built-asset structures. The key individuals responsible for executing the company’s investment strategy are John White, Simon Lee and Freddie Brookes, for whom biographies can be found on page 16.

The fees paid to the investment advisor are, somewhat unusually, calculated by reference to average market capitalisation (rather than portfolio value or net asset value as is more common), which fully aligns its interests with those of shareholders. The fee rates are competitive in a sector context (typically around 1% pa) and are tiered, with the marginal rate dropping to 0.65% with the market capitalisation above £500m. There is no performance fee.

The board of LXi reports that all ESG matters remain high on its agenda, although climate-related risk is a key current focus. A climate risk working group was established during 2021, comprising members of the board and representatives from the investment adviser, which has set the longer-term goals of integrating climate-related matters into the investment process, mapping a route to carbon neutrality, and improving investor reporting.17 A detailed climate risk strategy is included in the annual report with medium-term (36 months) targets to provide a benchmark for progress towards the longer-term goals. Within the H122 portfolio, 82% of assets had an EPC rating of A to C18, and 93% of the assets that LXi has forward funded and 100% of the assets that it has forward purchased have an EPC rating of A or B. LXi says that it is on track to meet the requirement that all UK commercial property must be EPC rated B or better by 2030 and that it expects this to be achieved through asset management (including electric vehicle charging points and solar panels). With LXi’s goals very much in alignment with the carbon neutrality ambitions of tenants, the company does not see the potential for material capex having a negative impact on returns.

Interim results for the six months ended 30 September 2021 (H122) were reported in late November 2021 and were dominated by the continuing strong growth in the portfolio. On a fully completed basis the portfolio value increased by 29.6% to £1.22bn in H122 and by a further 9.0% to £1.33bn at end-Q322. The H122 like-for-like valuation gain was 4.9% (4.6% NIY vs 4.9% at end-FY21) followed by 3.3% in Q322 (NIY 4.5%). As discussed above, LXi has made acquisitions amounting to £243m since the end of Q322. Year-to-date valuation gains have been broadly spread across sectors, reflecting rental growth as well as yield tightening, and including uplifts on recently acquired assets.

EPRA NTA per share increased 7.8% to 135.5p during H122 (end-FY21: 125.7p) and to an unaudited 139.5p at end-Q322. Including DPS paid the total accounting return was 9.0% in H122 and 4.0% in Q322, well ahead of the medium-term target of at least 8% pa.

Exhibit 9 summarises the H122 underlying performance (the financial statements are shown in detail in the Financial Summary, Exhibit 15) and we additionally note:

All of LXi’s assets, including forward funded assets, are income generating from day one. Forward funded assets benefit from licence fees19 during the construction phase and post-completion by cash-backed rental top-ups and reimbursement rent-free periods that may be agreed with developers 20. All of these are initially recognised as a discount to the cost of the investment property with the economic benefit to LXi emerging upon revaluation. In the IFRS income statement this appears as a property revaluation movement rather than rental income. As EPRA reporting excludes valuation movements, it does not reflect this economic benefit at all. Because it is clearly an important component of performance, licence fees and rent top-ups are included within adjusted earnings, underpinning the dividend targets and payment. In aggregate, cash rental income, licence fees and rent top-ups of £23.8m increased by 25% compared with £19.0m in H121.

Our updated forecasts allow for the full deployment of the February equity raise proceeds (already achieved) with associated gearing.

As noted above, the economic benefit of acquisition growth appears partly in income and partly through capital growth, which is then included within adjusted earnings. Our revised assumptions for the mix show a reduction in our forecast FY22 rental income, offset at the adjusted ‘cash’ earnings level by higher licence fee income and rent top-up adjustments. The FY22e adjusted ‘cash’ earnings remains slightly below the previous forecast due to higher administrative and interest expenses. For FY23 we forecast stronger growth in adjusted ‘cash’ earnings than previously as capital is deployed, with a further increase in FY24, as acquisitions make a full contribution and rental uplifts continue. FY23e DPS is increased in line with the company target and we expect further growth in FY24. The increase in forecast EPRA NTA is driven by the H122 performance.

In addition to the recent acquisitions detailed earlier in this report, we assume £100m of further deployment during H123. This includes capital recycled from any disposals, split 60:40 between completed assets and forward funding commitments at an average 5.4% yield on invested/committed capital (net of acquisition costs).

To reflect the lease structure and inflation expectations, we assume a blended average uplift in rents of 3.0% pa.

Our capital value forecasts are based on an unchanged valuation yield, with valuation uplifts driven by the capitalisation of rental growth and LXi’s ability to source off-market properties and forward funding opportunities at attractive valuations. LXi sees additional potential for capital growth from those sectors (leisure and hospitality) most affected by pandemic lockdowns and where yields are yet to reflect the improvement in trading that has since occurred.

At IPO in February 2017 Lxi raised £138.2m (gross) at 100p per share. Strong portfolio growth since then has been funded by a mix of equity and debt, consistent with LXi’s medium-term target gearing of a 30% LTV, with a maximum 35%. The most recent equity raise formed part of the placing programme that was in place between March 2021 and February 2022, under which an aggregate c 352m shares of the maximum authorised 400m shares were issued.

Debt facilities currently amount to £400m, comprising £170m of long-term fixed rate borrowing and £230m of revolving credit facilities (RCF).

The three long-term fixed-rate term loan facilities with Scottish Widows have a blended average fixed rate of 2.85%. They provide certainty of funding costs, attractively below the yield on the portfolio. This gap should only increase over the remaining almost 12 years to the maturity as the property rental stream increases through the upwards-only inflation linked/fixed uplifts.

The RCF provides operational flexibility at low cost (a margin of 1.55% above three-month SONIA21, and capped at 2.95%) to match forward funded development drawdowns during the construction phase, which can later be re-financed from equity issuance proceeds, additional long-term funding, or paid down by the disposal of mature assets. LXi has reached a scale where we believe that it may consider access to the sterling bond market and potentially attractively priced, unsecured, long-term debt.

At end-H122 net debt was £229.1m and allowing for existing capital commitments, the ‘pro forma LTV’ was 25% as shown in detail in Exhibit 13.22 Adjusting for the c £320m of committed investment since H122, as well as the c £300m of additional equity (including the vendor placing), we estimate that net debt is currently c £330m, representing a pro forma LTV of c 20%.

Our forecasts assume the arrangement and drawing of an additional £50m of borrowing over and above the current £400m of facilities. Our investment assumptions indicate a pro forma LTV of c 26%, still somewhat below the 30% target. This provides scope for LXi to invest c £100m more than we have assumed before it would need to consider additional equity raising.

LXi shares offer a 4.3% FY23e prospective yield and trade at a c 6% premium to the unaudited 31 December 2021 (Q322) EPRA NTA per share of 139.5p.

In Exhibit 10 we show the key valuation and performance metrics for LXi and a group of other long-income REITs, mostly comprising sub-sector specialist investors but also diversified investment peers (Secure Income REIT and to a lesser extent, LondonMetric). LXi’s long WAULT of 22 years is slightly above the average of the group. For comparative purposes, the DPS and NTA/NAV data are shown on a trailing basis, taking the last 12 months DPS declared and last reported NTA/NAV. Across this long-income group, the 12-month and three-year share price performance and valuation differ considerably, reflecting the varying fortunes of the sub-sectors on which most are focused. This variability underlines the potential attraction of an actively managed vehicle such as LXi to investors who seek but are otherwise unable to achieve an optimal diversification of risks. We also believe that LXi will have benefited from the strong inflation protection that its lease terms provide both in absolute terms and relative to the peer group, within which some companies (eg primary healthcare investors) have a larger proportion of open market rents.

The broad 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. LXi is not a developer and for reasons discussed above, we believe its forward funding of fixed-price, pre-let developments, an investment strategy in which the investment manager has considerable experience, is very low risk and enhances returns. We consider the main sensitivities to include: