GCP Student Living — Strong H119 progress and positive outlook

GCP Student Living (DIGS) is a specialist UK real estate investment trust (REIT), investing in student residential assets, and differentiated by a focus on assets in and around London. The shares have been listed since May 2013 and the company has a premium listing on the FCA’s Official List, trading on the Premium segment of the Main Market of the London Stock Exchange. The investment objective is to provide shareholders with attractive total returns in the longer term through the potential for modest capital appreciation and regular sustainable dividends with RPI inflation-linked characteristics.

The student housing sector continues to attract investor interest for its favourable risk-adjusted yields, good levels of rental growth and less exposure to the economic-led cycles that affect traditional commercial property sectors such as offices, industrial and retail property. DIGS is focused on assets in or around London in order to benefit from a structurally positive demand-supply balance, which is no longer the case in all regions of the UK. The London market continues to see increasing numbers of international and post-graduate students, driving demand for purpose-built student accommodation (PBSA), while planning restrictions and competing demands limit supply. Geographically, DIGS will also invest in other markets that offer similar market dynamics (eg Brighton). Within these markets, the investment manager targets high-specification, modern, purpose-built accommodation with proximity to a suitable higher education institution and/or a major transport hub. Such properties, in the chosen locations, may be more likely to both appeal to students today and offer longevity of income potential to support long-term value creation, even if the current yields may be lower.

At 31 December 2018, the portfolio comprised the 11 assets shown at the bottom of Exhibit 1, providing c 4,100 beds, of which c 3,100 are operational and fully let for the 2018/19 academic year. The portfolio value was £841.5m, reflecting a net initial yield (NIY) of 4.74%.

Gravis, the external investment manager, was established in 2008 and is privately owned by its directors and founding members. It currently manages £2.6bn in assets, including two other listed closed-end vehicles. Nick Barker from Gravis is the fund manager with day-to-day responsibility for the provision of investment advice to DIGS. The primary asset manager is Scape Student Living, which is closely aligned with Gravis, the directors of which own 50% of Scape.

Interim results for the six months ended 31 December 2018 (H119) show the current portfolio performing well and continuing to grow. Rental income grew strongly, benefiting from development/refurbishment completions, above inflation rental growth and continued full occupancy. Profitability is additionally showing the benefit of scale economies. Dividends have been set, and investment decisions made, based on the investment manager’s expectation that they will be covered by earnings on a fully developed and let basis. With dividend cover increasing to 81%, the H119 results provide evidence that the company is well on track to achieve this. EPRA (and IFRS) NAV per share increased by 5.9% during H119 to 157.93p. Including dividends paid during the period, the six-month NAV total return was 7.9%.

In July 2018 DIGS entered into a conditional contract to acquire and forward-fund Scape Brighton, its second asset in the city, situated on the University of Brighton’s main campus. Scape Brighton is expected to provide 555 beds and extensive communal areas, with c 1,500 sq ft of retail space, on the primary campus of Brighton University. Construction work began in November 2018 and the asset is expected to be operational in September 2020, in time for the 2020/21 academic year. DIGS provided approximately £24m of forward funding in H119, which is initially accounted for as a loan receivable asset on the balance sheet.

Under the contractual arrangement with Scape Student Living that has allowed DIGS to acquire several attractive, newly developed assets since IPO, the company has an option to acquire Scape Canalside, a 412-bed, new-build asset located adjacent to Queen Mary University of London, in the same locality as the group’s existing c 590-bed Scape East asset. Scape Canalside is expected to reach practical completion by July 2019 and DIGS must soon decide whether to exercise its option or not. The asset is highly attractive to DIGS and the decision substantially rests on it having access to suitable funding. The design of Scape Canalside and its market positioning are complementary to the existing Scape East asset and similarly it benefits from close proximity to Queen Mary University, a strong Russell Group higher education institution. The increasingly stringent planning environment in London also increases the attractiveness of the option, providing access to a further significant, high-quality, purpose-built asset. Recent transaction activity (see below) suggests an increasing scarcity value for schemes that have already received planning approval.

At the end of H119, DIGS had a cash balance of £19.8m with drawn debt of £235m, at a blended fixed rate of 2.96%, and a remaining term of seven years. The loan to value ratio was 25.7%. DIGS’s outstanding commitments include the remaining construction work at Circus Street, Brighton, the forward-funding commitment to Scape Brighton, and the forward purchase agreement for Scape Canalside. To provide the funding for this additional portfolio growth, DIGS has in recent months increased its equity and debt capital resources:

In aggregate, the new debt facilities with Wells Fargo provide DIGS with £100m of flexible floating rate debt. This will avoid the need for DIGS to hold excess cash ahead of development funding, and extends the positive spread between the licence fees on development forward-funding and the cost of the debt, which should further support increasing dividend cover.

In terms of income returns, DIGS targets regular sustainable dividends with RPI inflation-linked characteristics. A relatively small proportion of rental income is contractually directly linked to RPI (Circus Street at completion will be an exception), and so the inflation-linked characteristic relies on the selection of suitable assets and locations with favourable demand-supply dynamics that have the potential to deliver continuing rental growth. Exhibit 5 shows that DIGS has been able to sustain rental growth in excess of both RPI and the market over several years.

From a student demand-supply perspective, the differentiating features of the London market can be summarised as:

Two significant trends that favour DIGS’s London area focus are for the strongest universities to attract an increasing share of applicants, and the continuing strength of international student applications.

Since the UK government raised tuition fees to a maximum of £9,000 pa in 2012 (and subsequently increased to £9,250), which was followed by a removal of the cap on undergraduate student numbers in 2015, there is clear evidence that many students are influenced in their choice of university by its cost and the expected future benefit. This has enabled the top universities to grow in size while maintaining their academic requirements. Given its concentration of top universities (home to six of the top 40), London has benefited.

Data from the Universities and Colleges Admissions Service (UCAS) show that, at the important 15 January 2019 application deadline (for the 2019/20 academic year), international (excluding EU) student applications were ahead by 9.0% compared with 2018/19 applications at the same time last year, with Chinese applications particularly strong. EU applications were also up, but by a smaller 0.9%. Helping to counter Brexit uncertainties, EU students that entered in the previous 2018/19 academic year were guaranteed the same fee rates as UK students, as well as access to student finance for the duration of the course. Including UK applications (down 0.7%), total applications were up by 0.4%. International (ex-EU) students currently account for 63% of the DIGS total, with EU students a further 14% and UK students the balance (23%). International students are often less price-sensitive than domestic students when it comes to choosing suitable accommodation.

The decline in UK-domiciled applicants seems largely driven by demographics, although the long-term decline in the number of UK 18- to 20-year-olds should begin to reverse from 2020, while the desire to go to university, measured by participation rates, has continued to increase.

The UK government has recently published a new Education Strategy in which it outlines plans to increase international student numbers by more than 30% and their income contribution to the economy from an estimated c £20m currently to £35bn by 2030. There is no limit on the number of international students that can study in the UK, and among the measures that are being suggested to achieve the new targets are proposals to extend the post-study period during which students may remain in the UK and potential measures to support them into UK employment.

The blended net initial yield (NIY) on the DIGS portfolio continued to tighten during H119, from 5.04% at end-FY18 to 4.74%, broadly spread across the portfolio.

The continuing attraction to investors in purpose-built student accommodation assets (PBSA), particularly London-based assets, is evident from several recent market transactions, and may indicate scope for further portfolio yield tightening. We have previously commented on the August 2018 acquisition of a £350m stake in the £1.1bn, 5,100-bed Chapter portfolio, alongside existing investor Greystar Real Estate Partners, by Allianz and PSP Investments. Gravis estimates the transaction to have been at an NIY of c 4.0%. In March 2019, the same group of investors, through the Chapter portfolio, agreed to acquire an additional prime London student housing asset from Apache Capital. The transaction values the 458-bed Paul St East, EC2, purpose-built student accommodation block in Shoreditch at more than £160m, which Gravis estimates reflects an NIY of 3.75%, which compares with the current Scape Shoreditch NIY of 4.15%. Also in March, Watkin Jones completed the £90m forward funding and sale of Kelaty House, a 599-bed student development in Wembley, to the real estate investment business of DWS, the investment management arm of Deutsche Bank of Germany, and a new entrant into the UK student accommodation market. Gravis estimates that the 4.90% agreed forward funding yield on the asset is consistent with a stabilised investment yield of c 4.5%. Although Kelaty House and Scape Wembley are comparable in terms of size, the stabilised yield for Scape Wembley is 4.90% despite it benefiting from closer proximity to underground transport links.

Should DIGS proceed with the acquisition of Scape Canalside, the price will be based on the estimated fair value. We do, however, expect some immediate capital value uplift as the agreement provides for DIGS to receive some discount on the difference between market value and the previously agreed minimum price.

Although a direct read-across from market transactions to the DIGS asset would not be appropriate, the positive implications of this continuing investor interest are clear. We estimate that a 50bp tightening in the blended DIGS portfolio yield would increase NAV per share by c 25p, or more than 15%.

The 8–10% long-term return target that DIGS has set reflects the anticipation of continued rental growth to drive income earnings and dividends, with a corresponding positive impact on capital values, assuming broadly stable yields and a positive impact from modest gearing. Returns since IPO have been well ahead of this target, and the H119 EPRA NAV total return of 7.9% represents an annualised rate of more than 16%.

In the period from IPO (20 May 2013) to the last published quarterly NAV at 31 December 2018 (end-H119), DIGS has generated an EPRA NAV total return (dividends reinvested) of 106.3% on the opening NAV per share (after issue costs) of 97p, or an annualised compound return of 13.8% pa. Over the same period, the share price total return (dividends reinvested) was an aggregate 88.2% on the IPO price of 100p, or an annualised compound return of 11.9% pa. The closing share price at 31 December 2018 was 148.4p and it has since risen to 155p.

The DIGS NAV total return to 31 December 2018 is ahead of the broad UK commercial property sector, the FTSE All-Share Index and UK gilt returns over one, three and five years, and since inception.

For much of the period since IPO, DIGS has traded at a premium to NAV (including income), of up to a peak of 12% (Exhibit 8). Since the mid-2016 EU referendum result, the continuing strong growth in NAV has outpaced the share price. Given that student accommodation as an asset class benefits from a more stable yield, with lower volatility than mainstream commercial property, the small discount to NAV appears attractive. Positive fundamentals in DIGS’s target markets point to further rental growth. Combined with the completion and letting of assets currently under development, this should support future income growth and capital values, particularly given the continuing strong investor-led interest in PBSA assets, especially in London.

In Exhibit 9, we focus on the three UK-listed student accommodation companies, DIGS, Unite and Empiric, showing summary valuation and share price performance data. Reflecting positive sector fundamentals, all three stocks are trading very close to 12-month share price highs. DIGS offers a higher dividend yield compared with Unite and trades at a lower P/NAV. Empiric has a higher yield but as it continues to reposition itself from internally driven trading problems in 2017, the prospects for dividend growth are modest.

In the near term, the continuing strong fundamentals in DIGS’s target areas of the market, and the further benefit to earnings, cash flow and dividend cover from the completion of assets currently under development, are positive indicators for DIGS’s performance. Perhaps even more important is the DIGS focus on larger and more efficient, well-designed and purpose-built assets, in good locations in supply-constrained markets, factors which provide comfort that the portfolio will be capable of sustaining performance over the long term.