LXi REIT — Stronger, leaner and fitter

LXi listed in February 2017 and is externally managed by LXi Advisers (the investment adviser). From listing it grew strongly, with its portfolio value reaching c £1.6bn ahead of its merger with Secure Income REIT (SIR), which was announced on 11 May 2022 and completed on 6 July 2022. The merger brought together two complementary and well-performing portfolios and strategies, both focused on very long leases, subject mainly to inflation-linked rental uplifts, to good-quality tenants. The enlarged LXi, with a 30 September 2022 (H123) portfolio valuation of c £3.7bn, is the UK’s leading sector-diversified, long-income real estate investment trust (REIT). The company is a constituent of the UK 250 Index, MSCI Index, STOXX Europe 600 Index and leading property indices. The end-H123 portfolio comprised 348 fully occupied properties, producing annual contracted passing rent of £200.7m, with a long weighted average unexpired lease term (WAULT) of c 26 years. An accretive regear of Travelodge Hotels in December 2022 increased the WAULT to more than 27 years.

LXi’s assets are well diversified across a broad range of resilient subsectors, selected with a focus on high barriers to entry, strong underlying property fundamentals and low starting rents. They are let on very long-term, triple net full repairing and insuring leases to tenant counterparties that have demonstrated strong performance throughout previous economic cycles.

We expect no material change in LXi’s strategy post-merger. Its diversified multi-sector approach continues to differentiate it from many specialist long-income REITs that focus on a particular sector of the market. While specialisation can bring many advantages, it can also create vulnerability to significant changes in market conditions or strong competition for assets. Low-risk forward funding of pre-let development assets has enhanced returns by enabling LXi to source high-quality assets at a 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.

Long leases with good-quality tenants provide security of contractual income, while the upward-only, substantially indexed lease terms add predictability and visibility to income growth. As a result, we expect that property yields and capital values will show less volatility than may be the case for short-lease assets as the UK real estate sector continues to adjust to higher bond yields and a weaker economic growth outlook. We also expect this sustainable income profile to continue to have a positive impact on the cost and duration of available debt funding, allowing the company to lock in positive and increasing (with rent indexation) spreads between those costs and asset yields.

We highlight the following key benefits to shareholders that LXi expects from the merger:

Since listing in February 2017, LXi has delivered an annualised total accounting return of 10.1% pa compounded, well ahead of its 8% pa medium-term target. Of the total return over the period, dividends paid have represented c 40% and capital growth c 60%. We forecast further growth in income returns, both in absolute terms and as a share of the total, with negative capital returns in the current year reflecting significant market-wide property yield expansion.

The merger with SIR was structured in a way that provides continuity of management and enhances the resources available to the investment advisor at a lower marginal cost. Additionally, following the merger, the alignment between LXi and its shareholders has strengthened further and it now has the largest board and management team stake of any UK REIT. The value of this stake at 30 September 2022 was c £140m (at a share price of c 124p).

LXi REIT Advisors (the investment advisor)2 continues to manage the combined group but its capabilities have been strengthened by the addition of key members of SIR’s management team, Prestbury Investment Partners, following its acquisition by the investment advisor.3 As it was undertaken by the investment advisor and not LXi, the acquisition had no direct financial impact on the company and avoided the payment of termination fees and any material negative effect on NAV. The key individuals responsible for executing the company’s investment strategy are John White, Simon Lee and Freddie Brooks, for whom biographies can be found on page 17.

Providing additional continuity of management, the highly experienced and successful senior Prestbury team has a continuing role in the management of the company. Nick Leslau (chairman and majority shareholder of Prestbury) and Sandy Gumm (chief operating officer of Prestbury) have joined the board of LXi as non-executive directors, and Mike Brown (chief executive officer of Prestbury) acts as an advisor to LXI REIT Advisors.

The Prestbury management team has been a significant investor in SIR4 and, having ‘top-sliced’ its position through the cash alternative, it retains a significant 5.8% interest (including Nick Leslau and Sandy Gumm) in the combined group. Along with non-compete obligations for at least two years, this provides a strong alignment of interest between the company and shareholders.

Since end H123, share purchases by members of the investment management team amounting to c 632,000 have been reported.

The board comprises six members5 in total and is chaired by Cyrus Ardalan, a highly experienced investment banker with well-established corporate governance expertise. Detailed biographies of the board can be found on LXi’s website.

At the time of the merger, advisory fee savings were estimated by LXi at £7.5m, representing lower LXi average and marginal fee rates compared with SIR, applied to a larger portfolio. Fees continue to be 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 applied to the enlarged group are competitive in a sector context (typically around 1% pa) and are tiered, with a new marginal rate of 0.55% on average market capitalisation above £2.0bn. There is no performance fee. LXi reported a 12.6% EPRA cost ratio for H123, one of the lowest in the UK REIT sector, and we expect this to reduce further in H223 as the merger takes full effect.

Prior to the merger, LXi built its portfolio through sale and leaseback transactions and smaller lot size, forward-funded developments, enhanced by active capital recycling. SIR was focused on larger-scale sale and leaseback transactions but had also shown a willingness to dispose of assets where appropriate.

LXi expects that the increased scale of the combined group will enable it to pursue larger sale and leaseback transactions in future, leveraging the expertise of the Prestbury management. With larger scale, it should be better placed to compete with the larger US REITs that are active in this space and access opportunities with corporates and financial sponsors. In September 2022, LXi came close to completing a significant sale and leaseback transaction with Sainsbury's, comprising a portfolio of 18 prime grocery store assets, combining defensive assets with indexed rents and a strong tenant. Contracts were exchanged at an agreed purchase price of £500m, reflecting a net initial acquisition yield of 5.0%, above the 4.7% portfolio average yield at the time as well as the end-H123 yield of 4.9%, with the prospect of five-yearly Consumer Price Index (CPI) rent uplifts. LXi intended to part-fund the acquisition with new equity alongside a new debt facility, the balance of which we expect would have supported LXi’s plans to move towards its 30% loan to value (LTV) target. Unfortunately, the transaction was unable to complete because of the significant market volatility that followed the government’s fiscal statement later in September.

The 82 forward-funded developments undertaken by LXi since IPO have increased its access to attractive assets with enhanced returns. While it does not engage directly in development activity, the forward funding (and acquisition at completion) of development assets on a pre-let, fixed-price basis, has been a key element of its growth and has enabled the company to source high-quality assets at lower cost than would be possible purely from targeting completed assets. Acquisition costs for forward funding are lower and benefit from brand-new leases, generally over 20 years in duration. They have also allowed LXi to target more off-market opportunities, as well as developing brand-new assets to tenant specification, in some cases increasing the strategic importance of the asset to the tenant and, in turn, improving the quality of income. The outstanding capital commitment to forward-funded assets currently under construction was £42m at end-H123, with all the assets expected to complete over the following 12 months. The EPRA yield data include expected passing rents on these assets at completion of £3.5m (included within total contracted rents). Forward-funded assets generate immediate income, with ‘licence fees’ paid by the development contractor, on funding advanced, during the construction phase. Where appropriate, developers also compensate LXi for rent-free periods or periods to the next rent review.

The combined group will continue actively to recycle capital as a way of rebalancing portfolio exposures and optimising capital deployment towards the most promising areas. In the almost six years since LXi listed, it has sold c £200m of assets, mostly initiated by unsolicited approaches from interested buyers. Its willingness to sell assets, and its ability to do so ahead of book value, has provided support for the robustness of its external valuations and is further evidence of its ability to ‘buy well’ and enhance value. The company says these disposals crystalised a geared internal rate of return of 24% pa. The 2019 sale of eight hospitals for £347m to a specialist US healthcare REIT was SIR’s most significant disposal during the same period, crystalising an attractive gain of 19% above the December 2018 valuation.

In the current challenging market conditions, LXi has indicated a very near-term focus on refinancing shorter-term debt, accretive lease regears (lease extension) and capital recycling, each of which is well-advanced or provides identified opportunities.

Discussed in detail below, LXi plans to refinance c £800m of borrowings that will mature over the next couple of years. The current level of interest rates indicates an increase in borrowing costs, but we do not expect this to be material.

Since reporting H123 results, LXi has already exchanged contracts with Travelodge on a material and accretive lease regear on all 122 Travelodge hotels that formed part of the SIR portfolio. Of the 12 Travelodge hotels which formed part of the pre-merger LXI portfolio, those that were not forward fundings (with recently agreed contractual rents) had already been regeared. In return for introducing caps and collars (4% pa and 1% pa, respectively) into the lease terms and converting the review basis from Retail Price Index (RPI, due to be phased out by 2030) to CPI +0.5% pa, the unexpired lease term will be extended by a weighted average of nine years to 28.5 years. Following discussions with the external valuer, LXi expects the lease extensions to have a material positive impact on the value of these assets and further enhance their investment attraction. The change in rent review profile will help to ensure that the rents remain affordable over time and avoid becoming potentially over-rented6 versus market rents, while providing a floor to uplifts should the economy later move to a low inflation environment.

As noted above, asset sales, providing opportunities for capital recycling, have mostly been initiated by unsolicited approaches from interested buyers. LXi says that, despite market conditions, it continues to receive unsolicited interest in high-quality assets within its portfolio and that it expects to continue to sell assets selectively where capital could be better allocated to enhance shareholder returns. We expect a blend of reinvestment in assets with a stronger return profile as well as debt reduction.

In September, LXi agreed an innovative ‘income strip’, completing in early October. The effect was to materially reduce debt, and the pro forma LTV ratio, on LXi’s conservative ‘look-through’ basis of calculation, from 37% to 33%7, while generating significant and immediate earnings accretion. Put simply, future rental income in respect of a portion of the company’s leisure assets was sold to an institutional investor at an effective 2.96% net initial yield, allowing the repayment of more expensive bank debt, priced at a fixed 4.95% pa, from the proceeds.

The income sold, for £257m, represents 30% of the rental income received from the Thorpe Park and Alton Towers theme parks operated by the LXi tenant, Merlin. The transaction was structured as a sale by LXi of the freehold of the respective assets and then taking a 999-year leaseback, with the freehold reverting back to it after 65 years for a nominal £1. The sale proceeds were used to fully repay the £232m that had been secured against Thorpe Park and Alton Towers, as well as Warwick Castle (also operated by Merlin). Break costs of £20.6m are fully provided for in the H123 results and the subsequent receipt of £23.1m relating to the closing out of the related interest rate swap has been used to pay down the revolving credit facility.

Lease payments by LXi to the institutional buyer are an initial £8.2m, increasing in line with the annual CPI indexed rent reviews (collared at 1% and capped at 4%) on the properties. Immediate income accretion reflects the positive spread between the lease costs and interest savings on the debt repaid. LXi retains 70% of the rental income received from Merlin for the properties, along with the freehold and all reversionary value after 65 years.

The partial cash alternative offered to SIR shareholders in the merger (25% or £390m) has initially increased the LTV but LXi remains committed to a conservative medium-term LTV target of 30%. In the near-term, we expect the positive impact on LTV of the of the Merlin income strip transaction to be reversed due to the current weakness in property values across all sectors of the UK market. On the LXi basis of calculation, defined in footnote 7, we forecast an end-FY23 LTV of 38.1%, although the Edison basis is significantly lower at 31.4%. The balance sheet nonetheless benefits from substantial headroom against covenants and significant unencumbered assets (£492m post completion of the income strip, including assets under construction at H123).

H123 borrowing was all fixed/hedged at an average cost of c 4.2%,8 removing any near-term exposure to further interest rate fluctuations. However, to protect its longer-term progressive dividend policy, LXi is in the process of refinancing its shorter-term borrowings, those expiring predominantly through 2023–24.

It is currently in advanced discussions on a range of alternatives, facilitated by the relatively low LTVs across each of the debt facilities, and expects to have completed the process by the end of FY23. LXi says that as well as targeting gearing reduction the refinancing will be consistent with its existing low-risk debt strategy, which over the medium-term seeks to maintain strong headroom to borrowing convents, and discrete security pools with no cross-default provisions. A core of long-term, fixed-rate debt locks in income accretion as indexed/fixed rents increase and the spread over funding costs widens. Revolving credit facilities (RCFs) borrowing facilities provide flexibility for asset recycling timing differences and for forward-funded development drawdowns during the construction phase.

At end-H123 (adjusted for the income strip repayment), the debt maturing in 2023 and 2024, as well as a further small facility in 2025, amounted to just under £800m or 60% of all debt outstanding at the time. The weighted average cost of this shorter maturity debt was 4.0%. Since then, LXi has agreed an extension of an existing £60m facility and has completed a new £150m 16-year term loan.

The £60m HSBC facility has been extended by one year, to 2024, with a further one-month extension option, providing it with flexibility with respect to nearer-term asset management and debt capital initiatives. With a revised interest margin of 2.05%, an existing interest rate cap at 1.84% fixes the cost at 3.89% until July 2023, by which time the company expects to buy an additional cap to hedge the cost until expiry. This will be funded by using a small part of the £24m cash realised from the sale of an interest rate cap used to hedge the Merlin facility prior to early redemption.

The £150m facility, provided by a new lender, a leading European insurance company, carries a 1.75% margin over the 2038 UK gilt yield (currently c 3.6%), to be fixed when the facility is drawn, conditional among other things on the redemption of existing borrowings.

Together, the extension and new facility are the first stage of the planned refinancing. Further refinancing of the near-term debt maturities is at an advanced stage of negotiations with agreed heads of terms, with a lender club comprising a number of the company's existing lenders. In our forecasts we assume this to be finalised at year-end FY23 but in reality, it may fall into FY24.

As indicated by the new 15-year term loan, the blended cost of refinanced debt will increase and this is reflected in our forecasts. We have assumed an additional £565m of new debt facilities to be arranged, taking account of the £60m HSBC extension, the already agreed £150m term facility, and other forecast cash flow movements. Based on money market rates, we assume that most of this will be term debt and that c £100m will be RCF. In line with H123 guidance, we also expect the company to cap the SONIA exposure on the RCF at 2.5%, with an all-in running cost including margin of 5.0%. The aggregate estimated cost of the £715m of new borrowing is 5.6%, taking the total weighted average cost of total debt facilities to 5.0%.

Despite the addition of SIR’s more concentrated portfolio sector split, LXi retains the high degree of sector diversification, by income and by value, which it has pursued since IPO in February 2017.

Exhibit 7 shows the pre-merger standalone portfolios as at 31 March 2022 and the pro forma position at that time. Compared with LXi, the SIR portfolio was more concentrated by sector and tenant, but in each case in sectors in which LXi had relatively lower or no exposure (leisure, healthcare and budget hotels). On a combined basis, the resultant portfolio shows an increased balance across sectors. SIR tenants, Merlin Entertainments and Ramsay Healthcare became large tenants of the enlarged LXi (c 19% and 18% of total passing rent respectively) and the share of Travelodge budget hotels increased (from 6% to c 18%).

The Merlin assets include two of the UK’s top three resort theme parks by visitor numbers, Alton Towers and Thorpe Park, as well as Warwick Castle and all the on-site guest accommodation at the three attractions. It also operates two assets in Germany, the Heide Park resort theme park and hotel in Soltau, Saxony, the largest in Northern Germany. Merlin reported strong trading by the UK theme parks (around 80% of the Merlin rent roll is from the UK assets) in its half-year review, with robust consumer demand and elevated revenues per visitor, benefiting from the removal of COVID-19 restrictions. The leases with LXi are guaranteed by Merlin Entertainments, which owns all of Merlin’s operating businesses worldwide.

The Ramsay assets comprise11 freehold private acute hospitals across England. The acute care market has seen a good operating performance post pandemic, particularly in the private pay markets, with key operators reporting strong results. With its greater focus on NHS contracting, Ramsay’s performance has trailed that of peers coming out of the pandemic, but it should benefit significantly as the NHS seeks to address the waiting lists that built up.

The budget hotels subsector has continued to perform well, with both Travelodge and Premier Inn (together 21% of portfolio rents) reporting operating key performance indicators well ahead of pre-pandemic levels for the current year. Positive trading has resulted in strong investor sentiment in the sector, with the value of LXi’s assets up by 4.6% in H123. It is perhaps worth noting that budget hotels have historically outperformed the broad sector during recessions, benefiting from a ‘trading down’ effect. The trading challenges that Travelodge and Merlin Entertainments experienced during the pandemic were driven by lockdown restrictions more than typical, cyclical economic weakness.

As at end H123, the portfolio comprised 348 properties across 13 property subsectors with multiple underlying uses, let on very long leases to more than 80 leading tenant operators. The portfolio is fully let and all leases require full repairing and insuring by the tenant, providing protection from property cost leakage and capital expenditure requirements. The total rent shown in the table includes £0.6m in respect of properties where contracts have been exchanged but have not completed.

The portfolio value is calculated on a ‘completed’ basis and includes the contracted rents on pre-let properties under construction.

Combined with the long WAULT, index-linked leases (mostly capped and collared) and fixed-uplift leases provide significant income protection against inflation. Conversely, fixed rents and rent collars (minimum uplifts to indexed rents) ensure continuing rent growth if inflation falls to low levels.

At end H123, 64% of contracted rent was inflation indexed (41% RPI and 23% CPI), while a further 34% was subject to fixed uplifts. Most indexed rents are capped at around 4% pa and collared at c 2% pa, meaning that, irrespective of the level of inflation, annual rent increases cannot rise above or fall below this band. Indexed rents provide visibility of rent growth but, where capped, will lag in real terms while inflation remains above c 4%. This is common in the long-income property sector, and it represents a fine balance between maximising short-term income against properties becoming over-rented9 or, in some cases, putting stress on tenants.

Across the portfolio, annual rent reviews apply to 57% of contracted rental income, enabling inflationary uplifts to quickly feed through to passing rents and cash flow. For the balance, mostly five-yearly review, the positive impact of current inflation will gradually feed through to passing rent over a longer period. At end H123, the annual rate of CPI was 10.1% and the annualised rate had averaged 9.6% over the preceding six months. The annual rate of RPI was 12.6%, having averaged 12.0% over the preceding six months. The 97 contracted rental uplifts in the period were broadly capped or fixed and delivered average growth of 3.7% pa, resulting in like-for-like rental growth of 2.5%.

We expect blended average like-for-like rent growth in H223 to accelerate to c 4% pa as five-year rent reviews capture more of recent inflation. For FY24 we expect full-year growth to moderate to c 3.0% as uncapped annual uplifts reflect the assumed slowdown in inflation and fewer five-year reviews fall due, partly offset by five-year reviews continuing to capture more of the recent inflation.

While inflation has a positive impact on rental income, it has also driven up bond yields leading to a downward repricing of property values across all main UK commercial property sectors. During H123, the portfolio valuation yield widened by 40bp to 4.9%, although the impact on like-for-like valuation (-1.4%) was significantly offset by like-for-like rental growth of 2.5%. Across sectors, the valuation movements varied considerably, with a tendency for lower-yielding sectors to adjust more significantly. This was particularly the case for industrial assets, which showed the greatest reduction in value, while budget hotels and theme parks showed healthy gains driven by rental growth.

The 10-year UK gilt yield has increased from below 1% at the beginning of 2022 to c 3.3%, having been as high as 4.5% in autumn 2022. Adding to asset pricing uncertainty across the market, institutional investment demand for commercial real estate has fallen sharply, creating a dearth of transaction-based market price evidence for valuers. The open-ended property retail funds sector is again under pressure to raise liquidity and even the pension fund sector has been forced to reappraise sector weightings. Indications from leading UK property consultants are that average UK commercial property valuations declined by c 15% in the final quarter of 2022 but that the decline has slowed significantly thus far in 2023.

While market valuation yields are widening, income growth has a positive impact. As of end H123, LXi calculates that the implicit growth in income over the five years from 1 October 2022, based on the RPI and CPI forward curves at the time of reporting the H123 results, and based on the prevailing portfolio value, would reflect a blended net initial yield (NIY) in September 2027 of 5.6% (versus 4.9% at end H123), or that the blended NIY could expand by a further 70bp, from 4.9% to 5.6%, (all other things being equal) before having any impact on the value. However, in the near term, market-wide NIYs are rising faster than the rental growth that we expect from LXi, indicating that LXi’s property valuations will fall further.

Our forecasts assume – and we stress assume given the uncertainties – that LXi’s property valuation yield will expand by a further c 0.5% in H223 (from 4.9% to 5.4%), equivalent to an almost 10% decline in property values. The outperformance versus the broad market implied by our forecast recognises the positive effect of indexed rental growth, significant exposures to relatively defensive sectors, and the Travelodge regear. We have assumed a flat like-for-like valuation in FY24, despite continued rent growth, increasing the average yield by around another c 0.2% to a portfolio blended net initial yield of c 5.6%. As market yields begin to stabilise, we would expect a recovery in property values, driven by rental growth.

Each additional 1% change in our 10% assumption is equivalent to EPRA NTA of c 2p per share.

The H123 results demonstrate LXi’s underlying growth but, while the SIR merger is fully reflected in the balance sheet, it contributed for less than three months to the income statement.

In Exhibit 11, our presentation of the income statement is structured to first show the breakdown of LXI’s adjusted cash earnings, the basis for dividend distributions, following through to statutory IFRS earnings.

Key income statement developments are as follows:

Key balance sheet developments included:

The key assumptions in our forecasts include:

LXi shares offer a 6.2% FY23e prospective yield and trade at a c 25% discount to the H123 EPRA NTA per share of 141p, and a 14% discount to our forecast end-FY23 EPRA NTA per share of 121p. Since listing, LXi has on average traded at 1.0x NAV and the average, which is broadly in line with the average premium since listing of 1%. The valuation is at a similar level to what it was at the height of pandemic uncertainty, which quickly unwound. In the current environment, the portfolio lease structure provides growth in contractual income in both a high and low interest rate environment, while market expectations are that inflation will begin to subside and with it, the peak in interest rates will be reached.

In Exhibit 15 we show the key valuation and performance metrics for LXi and a group of other long-income REITs, mostly comprising subsector specialist investors. LXi’s long WAULT of 27 years is well 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-month 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 subsectors on which most are focused. This variability underlines the potential attraction of an actively managed vehicle such as LXi, which has outperformed the peer group average over the same one-year and three-year period, 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. Some of this inherent cyclicality may be mitigated by portfolio diversification and LXi’s multi-sector approach enables it to adjust to changes in risk-reward across sectors. Its long, upward-only indexed leases provide security and predictability to contractual income, which may mitigate cyclical shifts in property yields/capital values and supports the use of long-term debt.

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 the 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: