LXi REIT — Strong FY21 with increasing momentum

The FY21 results were ahead of the forecasts contained in our April 2021 initiation note, in terms of both recurring earnings and net asset value.

After the initial impacts of the pandemic, rent collection improved strongly in the second half of the year, supporting increasing DPS, and capital values also increased, driving a 4% increase in H221 EPRA net tangible assets (NTA) per share compared with end-H121, reversing the H121 dip, and generating a 1.1% increase on the year. Including DPS paid, the EPRA NTA total return was 5.6% and the average annual increase since IPO in February 2017 is 10.1%, well ahead of the target of at least 8%.

With the proceeds of the March equity raise swiftly deployed within eight weeks and deployment of increased debt facilities well-advanced, we continue to forecast another year of strong progress with returns in line with target. LXi continues to source attractively priced acquisitions at accretive yields, enhancing income and net asset value, and its pipeline of opportunities remains strong. As existing equity and debt capital resources are increasingly deployed, we expect capital recycling to remain an important driver of returns, optimising capital use and providing a means to rebalance exposures. With 95% of rents subject to fixed or inflation-indexed uplifts, income is well-protected against inflation, which is likely to remain a focus for investors in coming months.

Exhibit 1 provides a summary of the FY21 underlying performance. The financial statements are shown in detail in the Financial summary (Exhibit 9).

Key features of the underlying income results were:

In March 2021 LXi raised £125m (gross) in a well-received and upsized equity raise and has received credit approval from a new lender and Lloyds Bank (the existing lender) to increase its revolving credit facility (RCF) by £65m (to £165m), along with an uncommitted £65m accordion, on the same terms as the existing facility (which carries a 1.55% margin over Libor). With acquisitions identified and legal processes advanced ahead of the equity issue, the net equity proceeds were fully deployed within eight weeks. In total, £151.1m (net of costs) has now been deployed, in 11 separate transactions at an accretive 5.3% acquisition net initial yield (portfolio valuation yield 4.9%), with a blended 21 year weighted average unexpired lease term (WAULT), and 100% inflation indexed (predominantly to the retail price index (RPI)). Around 40% of the deployment relates to forward funding transactions with added potential for valuation uplift.

Recent acquisitions have focused on the foodstore and drive-thru coffee sectors, which have increased as a percentage of contracted rents from 20% to 27% and 4% to 5% respectively, but also include industrial/distribution and garden centres. Most other sectors have been diluted, with budget hotels reducing from 21% to 18%. The portfolio continues to be well spread across eight different sectors, with the largest weightings in foodstores/essentials and industrials, which the investment adviser identifies as being structurally supported and relatively secure and offering good levels of growth. From a tenant perspective, Travelodge has reduced from 9.6% to 8.3%, although it remains the largest tenant, while there are now just three tenants that individually account for more than 5%, LXi’s medium-term target upper limit.

Only a small part of the recent capital deployment was reflected in the end-FY21 portfolio value of £938.4m (including £48m of capital commitments in respect of forward funding commitments). Including a little more than £50m of properties that had exchanged at year end but not completed as well as subsequent further commitments, the portfolio value is now more than £1bn, comprising 146 properties, fully let to more than 50 tenants. The current contracted rent roll (as at 19 May) is now £56.1m, including forward funded properties under construction, with 95% of leases fixed or indexed to inflation (see below), and a long 22-year WAULT.

Strong gains in the external valuations of assets in the foodstores/essentials and industrial sectors, and to a lesser extent healthcare, slightly more than offset negative movements in budget hotels and pubs, obviously significantly affected by pandemic restrictions. LXi observes that hotel and pub valuations were significantly affected by sentiment, with relatively little transactions evidence, and sees good potential for a recovery as well as for continuing valuation growth for its foodstores/essentials and industrial assets, supported by low, sustainable and growing rents and further yield contraction. Acquisition completions in the current year should also continue to be a source of capital uplift, particularly forward-funding transactions.

While LXi’s long upwards-only, mostly index-linked leases may be expected to mitigate some of the cyclical volatility in capital values (and to a greater extent income returns) historically exhibited by the commercial property market, its index-linked leases (mostly capped and collared) and fixed uplift leases provide significant inflation protection, an increasing concern for investors. Only if inflation rises above c 4% will rent growth lag in real terms, while fixed rents and rent collars (minimum uplifts to indexed rents) ensure continuing rent growth if inflation falls to low levels.

Of the 95% of rents that were indexed or fixed at end-FY21, 78% were indexed to inflation (57% indexed to RPI and 21% indexed to the consumer price index (CPI)). The 21% of rents that provided fixed uplifts did so at an average of 2.4% pa. Taken together, the fixed and collared income amounts to 67% of the total at an average minimum uplift of c 2.0% pa regardless of how low inflation may fall. Rent reviews concluded in FY21 generated average uplifts of 2.1% pa.

As economies begin to recover from the pandemic there are expectations that inflation will continue to increase. Official expectations are that any increase will be a temporary phenomenon, but this is far from assured. The most recent UK data for April 2021 surprised on the upside, with the trailing 12-month change in CPI increasing to 1.5% from 0.7% in March, while the 12-month change in RPI was 2.9%, up from 1.5% in March. The Treasury comparison of independent forecasters shows a mean expectation that CPI will be increasing at a 2.1% rate by Q4 of 2021 and at a similar rate in Q4 of 2022, but there is a high level of uncertainty reflected in a wide range of expectations (from 1.3% to 3.7% for 2021). A similar trend is apparent for RPI, with a mean expectation of 3.0% in Q4 of 2021 and 2.9% in Q4 of 2022.

The most recent Investment Property Forum (IPF) consensus data published in February 2021 shows an all-property average forecast decline in rents of 2.7% in 2021, followed by growth of 0.4% in 2022 and 1.4% in 2023. Industrial assets are expected to show further rent growth with retail weakness continuing to suppress the average.

FY21 adjusted earnings of £39.2m was £2.9m ahead of our forecast, mainly driven by the £1.9m gain on refinancing. EPRA NTA of 125.7p per share was 2% ahead of our forecast.

We have made no material changes to our key forecasting assumptions set out in detail in our initiation note other than to increase the non-cash contribution to rental income in respect of IFRS smoothing adjustments in line with H221. These mainly relate to the straight-line recognition under IFRS of fixed rent uplifts over the life of the leases as well as lease incentives.

We continue to assume £185m of capital deployment after the April £125m gross capital raise, with c £34m of this deployment remaining.

We also allow for capital recycling, assuming c 10% of the completed asset portfolio is sold each year (at book value and reflecting the existing portfolio yield) with the proceeds redeployed into new opportunities.

For new deployment, including recycled capital, we assume a c 50:50 split between completed assets and forward funding commitments at an average 5.5% yield on invested/committed capital (before acquisition costs). This implies an acquisition net initial yield of between 5.15% and 5.4% depending on whether the assets are completed properties (we assume standard acquisition costs of 6.8%) or forward funded developments (we assume acquisition costs of 2%).

The increase in rental income and adjusted earnings/EPS is substantially driven by the forecast increase in the IFRS smoothing adjustment. This is excluded from the adjusted ‘cash’ earnings measure used as the basis for dividend distributions for which our forecasts remain little changed, fully covering increased DPS in FY22 and FY23.

Our capital value forecasts assume no change in the portfolio average net initial yield during FY22 and FY23; although the company is hopeful that budget hotel and pub valuations may recover in response to lockdown easing, we have not assumed this.

Despite the pandemic, since IPO LXi has achieved its aim of providing shareholders with secure and growing income, fully covered by adjusted earnings along with capital growth over the medium term. The FY21 DPS of 5.55p was slightly down on FY20 (5.75p), but by H221 was slightly above H220, while the targeted level of 6.0p in FY22 represents a new high since IPO. Despite the H121 dip, the FY22 DPS target represents growth of 4.3%, ahead of expected inflation.

EPRA NTA per share has increased from 98p at IPO (adjusted for issue costs) to 125.7p (end-FY21). Including DPS paid the EPRA NTA total return was 5.6% in FY21 taking the total since IPO to 48.0% or an annual average increase of 10.1%, well ahead of the medium-term target of at least 8%.

LXi shares offer a 4.3% FY22e prospective yield and trade at 1.12x FY21 NTA. In Exhibit 8 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 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. LXi shares show a lower trailing yield than the average of the group, although based on the FY22 target DPS the prospective yield is 4.3%, while trading at a similar P/NTA. Across this long-income group, 12-month 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.