Custodian REIT — Strong capital growth with increasing income

The early stages of the pandemic and the first lockdown had a negative impact on the UK commercial property market but the recovery that started during the second half of calendar 2021 (reflected in CREI’s Q221 performance to end-September 2021) has continued to gather pace. Reflecting this market backdrop, CREI’s Q322 NAV total return of 8.5% was the strongest quarter in the year to date and takes the NAV total return in the first nine months of the year to 20.9%. NAV total return has been positive in each year since IPO in March 2014, despite the impact of the pandemic, with an average annual return of 6.4% pa up to 31 December 2021. Reflecting CREI’s strong income focus, dividends have represented the majority of the total. Until end-FY21, dividends had represented all of the total return since IPO but the strong growth in property values and NAV in FY22 year to date (including the acquisition of the DRUM assets at a discount to valuation) has reduced this to 75%.

Exhibit 2 shows a reconciliation of the Q322 movement in NAV. The 7.7p (7.3%) increase in NAV was driven by net revaluation gains of 6.8p (£30.0m, of which £1.1m was realised on disposal) and 0.9p of accretion resulting from the acquisition of DRUM at a discount to NAV. DPS was effectively covered by EPRA.

EPRA earnings of c £5.7m during Q322 were lower than the £7.3m generated in Q222 (H122: £13.2m) due to several factors that we do not expect to repeat. These include the timing of disposals and reinvestment and lower occupancy (90.9% at end-Q322 vs 91.6% at end-Q222, primarily due to the acquisition of DRUM with its lower occupancy rate). The DRUM acquisition (financed by equity issuance) contributed for less than two months, while the cash proceeds of profitable disposal remain available for reinvestment. Net gearing of 19.5% at end-Q322 compares with CREI’s 25% target and our forecasts anticipate future capital deployment of £30m, adding c £1.8m to annualised rents, as discussed below. The Q222 DPS paid of 1.25p was nonetheless fully covered by EPRA earnings and year to date DPS declared of 3.875p is 109% covered by EPRA earnings in the period (H122: 1.2%). As previously indicated by CREI, the Q322 DPS declared increased by 10% to 1.375p and the board targets aggregate DPS declared for FY22 of at least 5.25p and for FY23 at least 5.50p. We forecast aggregate FY22 DPS of 5.50p (implying a further increase in Q422 to 1.625p1) and aggregate FY23 DPS of 6.0p.

During Q322, the value of CREI’s investment portfolio increased c 13% to £637.9m. In addition to net investment activity (including the acquisition of DRUM), the like-for-like unrealised gain was £28.9m or 5.2% This excludes the £1.1m net gain on disposals and £7.3m uplift from acquiring the DRUM assets at a discount to NAV.

Positive momentum in the UK commercial property market continued through the final quarter of 2021. The industrial sector, with limited supply and strong demand, and an accelerated shift to online purchasing and supply chain concerns, continues to lead performance, driven by strong rent growth and valuation increases. The office sector has shown signs of benefiting from the gradual ‘return to the office’ with rents increasing for high-quality, flexible office space, with strong environmental credentials in prime regional city centres. Having been hard hit during the pandemic, there are clear signs of improvement in the retail and leisure sector, although it is highly variable across subsectors and retail warehousing continues to drive performance with good growth in capital values. The retail warehouse subsector is benefiting from restricted supply, generally free parking and the convenience that is complementary to growth in online sales, both for click-and-collect and customer returns.

CREI’s portfolio valuation movements reflect these market trends, with its strong weighting of industrials and retail warehouses being particularly beneficial. Asset management initiatives (such as lettings, lease renewals and regears) added £6.2m.

CREI’s agreed acquisition of DRUM became effective on 3 November 2021 and is covered in detail in our December update note. Consideration for the acquisition was settled by the issue of c 20.2m new CREI shares, calculated on an ‘adjusted NAV-for-NAV basis’ with each company’s 30 June 2021 net asset value (NAV) being adjusted for respective acquisition costs and adjusting DRUM’s portfolio valuation to the agreed purchase price of £43.5m (end-Q322 valuation: £49.0m). CREI and DRUM are a good fit, with both companies focusing on smaller lot size regional commercial property assets, and both aiming to provide shareholders with an attractive level of dividend, fully covered by earnings.

Additionally, during Q322, CREI invested £7.5m in the following assets:

Three assets were sold for an aggregate consideration of £14.8m, generating £1.1m of disposal gains (before costs) on the end-Q222 valuation, comprising:

Since end-Q322, CREI has sold a high street retail unit in Norwich for £1.3m, in line with valuation.

CREI’s focus on properties with smaller individual values (lot sizes of less than £10m at the point of investment) differentiates it from most of its peers. Properties of this size typically provide a yield premium over larger assets, in part the result of a broader range of potential occupiers, while attracting less competition from larger institutional investors. The end-Q322 portfolio, valued at £637.9m, reflected a net initial yield of 6.1% and comprised 160 different properties, at an average lot size of c £4.0m.

Exhibit 4 compares the transaction net initial yields for properties below £10m versus those above, on a two-year rolling average basis. On this basis, over a 20-year period the spread of sub-£10m transactions over those of more than £10m has averaged c 1.1%. The most recent data show a spread of c 1.9% compared with c 1.4% immediately before the pandemic. In part, this widening may reflect investor perceptions of relative risk to the extent that smaller properties may be disproportionately let to smaller tenants, perhaps more exposed to the impacts of the pandemic. However, this is not always the case and CREI’s targeting of ‘institutional-quality’ tenants, portfolio diversification, active asset management and relatively low cost base all mitigate the potential increased risks and management costs associated with smaller lot sizes. In this way, CREI has harnessed the yield premium to deliver attractive total returns since IPO, driven by dividends paid. In addition to the income premium, with capital values across the broad commercial market recently driven by strong institutional investment, primarily into larger assets, there appears to be ‘catch up’ potential in smaller assets, as has occurred historically.

The Q322 revaluation gains were well above the level assumed in our forecasts and we have lifted our NAV per share estimates accordingly. Otherwise, our forecasts, set out in detail in our December update note are unchanged other than our FY24 DPS assumption. Reflecting on our previous assumption of a 6.65p aggregate FY24 DPS, 101% covered, we are more prudently assuming 6.50p, 103% covered. We continue to assume acquisitions of £30m (including costs) by the end of FY22, at a yield of 6%, adding £1.8m to annual contracted rent. On a pro forma basis, this would take Q322 net loan to value (LTV) to c 23% from 19.5%, utilising existing debt and cash resources.

CREI’s target of aggregate DPS of at least 5.25p per share in FY22 represents a prospective yield of 5.25%. As noted above, we forecast higher DPS than the minimum targeted by CREI in both FY22 (5.50p versus a targeted minimum 5.25p) and FY23 (6.00p versus a targeted minimum 5.50p). Our FY22 DPS forecast represents a 5.50% prospective yield. The share price has not kept pace with the growth in NAV and the c 12% discount to Q322 NAV (113.7p) compares with an average c 5% since IPO in March 2014.

In Exhibit 5, we show a summary performance and valuation comparison of Custodian and what we consider to be its closest diversified income-oriented peers. For comparative purposes, the yield and P/NAV data are shown on a trailing basis. CREI’s share price performance is below the peer group average over 12 months, reflecting the fact that it was more stable during the pandemic sell-off in early 2020 and has therefore shown a lesser rebound. CREI trades on a higher P/NAV than the average of the group, as it has done for most of the period since IPO, and its trailing yield is slightly above average. Factors supporting CREI’s valuation include its strong income focus and 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.