Regional REIT — Underlying progress but leasing remains subdued

Real Estate

Regional REIT

Underlying progress but leasing remains subdued

Q323 update

Real estate

13 November 2023

Price	31.2p
Market cap	£161m

Net debt (£m) at 30 September 2023		395.9
Net LTV at 30 September 2023		52.6%

Shares in issue	515.7m
Free float	88%
Code	RGL

Primary exchange	LSE
Secondary exchange	N/A

Share price performance

%	1m	3m	12m
Abs	14.5	(32.0)	(51.3)
Rel (local)	18.1	(29.3)	(50.6)

52-week high/low

64.9p

26.4p

Business description

Regional REIT is focused on office assets in the regional centres of the UK, outside the M25, highly diversified by property, tenants and the underlying industry exposure of those tenants. It is actively managed and targets a total shareholder return of at least 10% with a strong focus on income.

Next events

Q4 DPS and valuation update

Expected February 2024

Analyst

Martyn King

+44 (0)20 3077 5700

financials@edisongroup.com

Edison profile page

Regional REIT is a research client of Edison Investment Research Limited

Regional REIT’s (RGL’s) Q323 trading update includes details of further leasing events, at rents ahead of market levels, and continuing asset sales, at or above book value. However, with the balance of occupiers remaining cautious, as economic prospects are assessed, rent roll and occupancy weakened. Supported by the strong ‘return to the office’, RGL continues to expect an acceleration in leasing, to provide the underpinning for its efforts to reduce gearing while maintaining income and dividends.

Year end	Net rental income (£m)	EPRA earnings* (£m)	EPRA EPS* (p)	NAV**/ share (p)	DPS (p)	P/NAV (x)	Yield (%)
12/21	55.8	30.4	6.6	97.2	6.50	0.28	20.8
12/22	62.6	34.1	6.6	73.5	6.60	0.37	21.2
12/23e	54.2	27.2	5.3	61.4	5.25	0.51	16.8
12/24e	53.8	25.0	4.8	65.3	4.80	0.48	15.4

Note: *EPRA earnings exclude revaluation movements, gains/losses on disposal and other non-recurring items. EPRA EPS is fully diluted. **NAV is EPRA net tangible assets per share.

Capturing rental upside but leasing slow

The Q323 lease retention was high (73.2%), renewals were at an average 6.2% premium to passing rent, and new lettings added £0.4m to rent roll, at a premium to estimated rental values (ERV). However, this did not offset lease maturities, and annualised rent roll was £1.8m lower versus H123, at £68.0m, and EPRA occupancy was 80.7% (H123: 82.5%). Further leasing progress since Q3 includes the recently reported £0.5m letting at Norfolk House. ERV was stable at £88.7m, 30% ahead of rent roll, representing a significant income opportunity as conditions improve. Based on H123 valuations, loan to value ratio (LTV) was 52.6%, but with disposals continuing, RGL continues to target a medium term 40%. H2 to date disposals of more than £8.1m have been at an average premium to book value of more than 20%. Reflecting a slower pick-up in leasing, we have reduced FY24e EPRA earnings by 4% but we still expect full cover of DPS, at a quarterly rate of 1.2p in both FY23 and FY24.

De-gearing and sustained DPS can be achieved

The share price rating reflects little confidence that RGL can achieve asset sales on terms that both sustain income and dividends as well as de-gearing, most immediately ahead of expiry of the £50m retail bond in August 2024. While the investment market remains subdued, the asset manager notes an active market for the sort of low income/occupancy, small lot size assets it targets for sale, typically for alternative use. Recent sales, at or above, valuation are encouraging. With a strong return to the office, and signs that interest rates may be peaking, RGL expects occupier uptake will increase, supporting the leasing of vacant space, while sales of lower income/vacant properties further reduce void costs.

Valuation: Highly exposed to good news

If RGL can demonstrate progress towards its targets, and our forecasts, the current valuation of its shares (FY24e dividend yield of c 15% and c 50% discount to H123 NAV) indicates significant upside potential.

Leasing activity is yet to gain momentum

While occupier demand remains generally robust, the impact of the sharp rise in interest rates on economic activity remains uncertain, and occupiers have adopted a cautious ‘wait and see’ approach when it comes to new lease commitments. The retention rate has remained strong and while new letting has continued it is not currently at the pace required to maintain occupancy, given that some level of tenant attrition is inevitable. The continuation of lease renewals at levels that are on average above passing rents, and new lettings at above ERV, is encouraging evidence of affordability and underlying tenant demand. Following a decline in H123 ERV, the stability in Q3 is also welcome, with very small movement (to £88.7m vs £88.9m at H123) reflecting property disposals. Rent collection also remains strong, and the collection rate is slightly ahead of the same period last year. For the whole of FY22, RGL collected more than 99% of rents.

The 13 new leases exchanged in Q3, providing £0.4m pa of additional rental income, brought the nine-month total to 56 new leases with a rental value of £1.6m, at an average 11% above ERV.

Around half of the £1.8m decline in Q3 rent roll, despite the 73.2% retention rate,1 related to just one lease, which we understand to have been related to corporate activity involving the tenant.

1 The retention rate measures how much of the rent that comes up for renewal in the period for lease expiries (excluding breaks) is retained, including the impact of lease renewals/re-gears, tenants that are holding over and units where the tenant has vacated but a new tenant is already in place. RGL typically achieves a retention rate of around 70% or above, and in H123 it was as high as 76.3%.

Since the end of Q3, RGL has leased previously vacant Grade A office space to an existing tenant in the same property, Global Banking School (GBS), at Norfolk House in Birmingham, adding more than £0.5m pa to rent roll. The new lease is to December 2037, with a break option in 2032 to be coterminous with the existing GBS lease. In aggregate, GBS now accounts for £1.4m pa of rental income. In addition to this, at 133 Finnieston Street in Glasgow, Anderson Anderson & Brown LLP, one of Scotland’s largest accountancy and professional services firms, has taken c 20,000 sq ft of office space, to September 2033, with an option to break in 2028, at a rental income of c £0.4m pa.

Exhibit 1: Lease maturity profile at 30 June 2023 (H123)

Source: Regional REIT

Although not published on a quarterly basis, at H123 the weighted average unexpired lease term (WAULT) was 4.8 years, or 3.0 years to first break.2 Coming into H223, leases representing c £7m of rental income were due to expire before the end of the year, and c £10m over FY24. We estimate that including post Q3 events, most of the H223 lease maturities have been settled. Turning to FY24, at a typical c 75% retention rate, it will require c £2.5m of gross new letting to maintain the level expiring income. Additional new lettings are required to replace any exercise of lease break options or other terminations of tenancies. On top of the lease maturities, tenants have the option to exercise lease break clauses covering a further c £10m pa of rental income during FY24, although historically only around 15% of these are exercised in a typical year.

2 A break clause gives the tenant and landlord an option to end the tenancy before the expiry.

While the government appears to be relaxing its targets on energy efficiency improvements, this is not the case for many occupiers, who continue to be attracted to properties that will assist them in meeting their own carbon emission targets, as well as providing a working environment that will attract their workforce back to the office. During Q3, portfolio EPC ratings3 continued to improve as RGL progresses towards meeting the government’s minimum energy efficiency targets. With some exceptions, the expectation is that all newly rented commercial property will require a minimum EPC rating of at least C by 1 April 2027, and to B by April 2030. By end-Q323, the percentage of the portfolio EPC rate A or B had increased to 65.2% from 59.6% at H123. RGL plans further progress through a combination of investment, within its rolling capex programme, and sales of lower rated assets that cannot be enhanced on an economic basis, within its disposal efforts.

3 Energy performance certificate.

Progress with disposals

Assuming no benefit from property values, reducing LTV to 40% through asset sales alone implies the sale of c £150m worth of properties. However, we expect a controlled programme of sales, spread over the spread over the next couple of years. We have assumed £15m of disposals in H223 (of which more than £8m has been announced) and £75m in aggregate by end-FY24, on average at around book value. As with H123, we assume the sales will include a significant share of vacant properties. This mix was reflected in a 2.4% net initial yield on the H123 sales compared with 9.4% on the occupied properties alone.

Total disposals in Q3 amounted to £2.1m (before costs), reflecting a net initial yield of 7.2% and in line with the 30 June 2023 valuation. Since Q3, the company has completed on the sale of its Venlaw and Elmbank Gardens offices at Charing Cross, Glasgow, for £6.25m, 26.3% ahead of the end-H123 valuation. The purchaser intends to redevelop the office space for student and residential use.

Although UK commercial property market investment transactions remain subdued, RGL says that there is an active market in smaller lot size assets (of £5m to £10m). Smaller lot sizes are typically substantially equity funded and less influenced by the cost and availability of debt. Low capital values (an average £14.6 per sqm for RGL’s office properties) support the change to a broad range of alternative uses, dependent on location among other factors, such as student accommodation, hotels, residential, nursing homes, nurseries and industrial. The average lot size of the RGL portfolio is £5.0m but, excluding the top 15 assets (valued at £232m or an average £15m), the remaining assets, valued at £520m, have an average lot size of £3.9m. This indicates a broad pool of assets from which disposals can be selected.

We have trimmed our EPRA earnings forecasts but continue to expect full dividend cover

We have not assumed that the reduction in Q3 rent roll (c £1.7m) net of the post-period lettings in Birmingham and Glasgow (c £0.7m) are made up in future periods, reducing our forecast annualised rental income by £1m and FY24 EPRA EPS by c 4% to a little over 4.8p. Crucially, we still forecast full dividend cover in FY23 and FY24. Most peers that have reported valuation data for the three months to end-September 2023 have shown further weakness in office property values. Based on this, and other market indications, we now assume a like-for-like 4% decline in portfolio value during H223 (previously nil), reducing our forecast NAV per share and slowing the reduction in LTV (from the Q323 level) that we expect from asset sales.

Exhibit 2: Forecast summary

	New forecast		Previous forecast		Forecast change
£m unless stated otherwise	FY23e	FY24e	FY23e	FY24e	FY23e	FY24e	FY23e	FY24e
Rental & other property income	70.5	68.1	70.9	69.0	(0.4)	(1.0)	-0.5%	-1.4%
Non-recoverable property costs	(16.4)	(14.3)	(16.4)	(14.3)	0.0	0.0	0.0%	0.0%
Net rental income	54.2	53.8	54.5	54.8	(0.4)	(1.0)	-0.7%	-1.8%
Administrative expenses	(10.8)	(11.0)	(10.8)	(11.1)	0.0	0.0	-0.1%	-0.4%
Net finance expense	(16.1)	(17.8)	(16.1)	(17.8)	0.0	0.0	0.0%	0.0%
EPRA earnings	27.2	25.0	27.6	25.9	(0.4)	(0.9)	-1.3%	-3.8%
EPRA cost ratio (excl direct property costs)	16.8%	17.7%	16.7%	17.5%
EPRA EPS (p)	5.3	4.8	5.3	5.0	(0.1)	(0.2)	-1.3%	-3.8%
DPS (p)	5.25	4.80	5.25	4.80	0.00	0.00	0.0%	0.0%
Dividend cover (x)	1.01	1.01	1.02	1.05
EPRA NTA per share (p)	61.4	65.3	67.3	71.0	(5.9)	(5.7)	-9.6%	-8.7%
EPRA NTA total return	-8.7%	14.1%	-0.6%	12.6%
Gross borrowing	(406.7)	(356.7)	(406.7)	(356.7)
Net LTV	51.8%	46.9%	49.6%	44.8%

Source: Edison Investment Research

The key forecasting variable for EPRA earnings is net rental income, and our assumptions include:

■

Disposals of £75m, £15m in H223 (a total £30m for the year) and £60m in FY24. The £15m assumed for H123 includes the £6.25m Glasgow disposal.

■

A net initial yield on disposals of 4%, allowing for a blend of vacant and income generating assets.

■

Disposals are achieved at book value.

■

No net impact from leasing activity (changes in occupancy or rents at review), other than that reported for Q323 and the subsequent lets in Birmingham and Glasgow discussed above. The assumed disposals to end-FY24 reduce annualised gross rent roll by £3m, although the full impact will not be felt until FY25.

■

Non-interest income of £2m in H223 and £3m in FY24.

■

A reduction in nonrecoverable property costs of c £1.5m pa by end FY24.

■

Overall, we forecast net rental income to increase from the H123 level despite significant property sales, with the loss of gross rental income substantially offset by an associated reduction in property costs, and a normalisation of non-rental income. It is important to note that while the latter has been a regular contributor to income, visibility is low.

■

The c £75m disposal proceeds are used to repay secured debt while the maturing retail bond is refinanced with unsecured debt at 10%. The interest saved on the repayment of secured debt only partly offset higher unsecured borrowing costs in FY24.

Exhibit 3: Edison net rental income estimates

£m	H123 reported*	H223e	H124e	H224e
Opening gross contracted	71.7	69.8	68.2	67.0
Net leasing	(1.4)	(1.0)	0.0	0.0
Disposals	(0.5)	(0.6)	(1.2)	(1.2)
Closing gross contracted rent	69.8	68.2	67.0	65.8
Income statement
Gross rental income	34.3	34.2	33.4	32.8
Non-rental income	0.0	2.0	1.5	1.5
Total rent & related income	34.3	36.2	34.2	33.9
Non-recoverable property costs	(8.3)	(8.0)	(7.4)	(6.8)
Net rental income	26.0	28.2	26.7	27.1

Source: Regional REIT data, Edison Investment Research. Note: *The H123 split between gross rental income and non-rental income is an Edison estimate. Total rent and related income, and net rental income are as reported.

Other forecasting assumptions include:

■

A 4% like-for-like reduction in H223 property valuations, with a constant valuation yield through FY24.

■

Net LTV declines of 51.8% at end-FY23 and 46.9% at end-FY24, or c 40% excluding the unsecured borrowing. The FY23e LTV is below the 52.6% that was reported for Q323 and based on H123 valuations adjusted for capex and disposals, with the impact of disposals slightly offsetting the impact of the H223 valuation movement. Disposals have a more significant impact on FY24e LTV.

Key sensitivities in our forecasts are:

■

A 10bp (0.1%) increase in the property valuation yield reduced FY24e EPRA NTA per share by 1.5p. A 10bp reduction in the yield would increase EPRA NTA per share by a similar amount.

■

A 10% reduction in the proceeds on asset sales (ie a sale at a 10% discount to book value) would reduce FY24e EPRA NTA per share by 1.5p. A 10% increase in proceeds would increase EPRA NTA per share by a similar amount.

■

A 10% reduction in the proceeds on asset sales (ie a sale at a 10% discount to book value) would increase FY24e LTV by 110bp (or 1.1%). A 10% increase in proceeds would reduce LTV by a similar amount.

Exhibit 4: Financial summary

Year end 31 December (£m)	2020	2021	2022	2023e	2024e
INCOME STATEMENT
Rental & other property income	62.1	65.8	76.3	70.5	68.1
Non-recoverable property costs	(8.8)	(9.9)	(13.7)	(16.4)	(14.3)
Net rental & related income	53.3	55.8	62.6	54.2	53.8
Administrative expenses	(11.3)	(10.6)	(11.4)	(10.8)	(11.0)
EBITDA	42.0	45.2	51.2	43.3	42.7
EPRA cost ratio, excluding direct vacancy costs	19.6%	16.8%	16.2%	16.8%	17.7%
Gain on disposal of investment properties	(1.1)	0.7	(8.6)	(0.4)	0.0
Change in fair value of investment properties	(54.8)	(8.3)	(113.2)	(59.6)	20.0
Change in fair value of right to use asset	(0.2)	(0.0)	(0.1)	(0.1)	(0.1)
Operating Profit (before amort. and except.)	(14.1)	37.6	(70.8)	(16.8)	62.6
Net finance expense	(14.0)	(14.9)	(17.2)	(16.1)	(17.8)
Fair value movement in interest rate derivatives & goodwill impairment	(3.1)	6.0	22.7	5.1	0.0
Profit Before Tax	(31.2)	28.8	(65.2)	(27.8)	44.8
Tax	0.2	0.0	0.0	0.0	0.0
Profit After Tax (FRS 3)	(31.0)	28.8	(65.2)	(27.8)	44.8
Adjusted for the following:
Net gain/(loss) on revaluation/disposal of investment properties	55.9	7.6	121.9	60.0	(20.0)
Other EPRA adjustments	3.2	(6.0)	(22.6)	(5.0)	0.1
EPRA earnings	28.1	30.4	34.1	27.2	25.0
Period end number of shares (m)	431.5	515.7	515.7	515.7	515.7
Fully diluted average number of shares outstanding (m)	431.5	459.7	515.7	515.7	515.7
IFRS EPS - fully diluted (p)	(7.2)	6.3	(12.6)	(5.4)	8.7
EPRA EPS (p)	6.5	6.6	6.6	5.3	4.8
Dividend per share (p)	6.40	6.50	6.60	5.25	4.80
Dividend cover (x)	1.02	1.02	1.00	1.01	1.01
BALANCE SHEET
Non-current assets	749.5	925.2	825.6	753.8	724.2
Investment properties	732.4	906.1	789.5	712.8	683.4
Other non-current assets	17.2	19.0	36.2	41.0	40.9
Current Assets	101.1	85.5	80.4	66.3	63.6
Other current assets	33.7	29.4	30.3	28.5	27.2
Cash and equivalents	67.4	56.1	50.1	37.8	36.4
Current Liabilities	(49.1)	(58.4)	(56.6)	(61.4)	(58.6)
Borrowings	0.0	0.0	0.0	0.0	0.0
Other current liabilities	(49.1)	(58.4)	(56.6)	(61.4)	(58.6)
Non-current liabilities	(380.9)	(449.9)	(446.5)	(412.9)	(363.4)
Borrowings	(310.7)	(383.5)	(385.3)	(351.7)	(302.5)
Other non-current liabilities	(70.3)	(66.4)	(61.3)	(61.2)	(60.8)
Net Assets	420.6	502.4	402.9	345.8	365.9
Derivative interest rate swaps & deferred tax liability	5.0	(1.0)	(23.8)	(28.9)	(28.9)
Goodwill	0.0	0.0	0.0	0.0	0.0
EPRA net tangible assets	425.6	501.4	379.2	316.9	337.0
IFRS NAV per share (p)	97.5	97.4	78.1	67.0	70.9
EPRA NTA per share (p)	98.6	97.2	73.5	61.4	65.3
EPRA NTA total return	-5.8%	5.0%	-17.5%	-8.7%	14.1%
CASH FLOW
Cash (used in)/generated from operations	48.0	56.9	48.5	50.0	41.3
Net finance expense	(12.5)	(13.1)	(15.2)	(15.0)	(16.7)
Tax paid	0.2	0.0	0.0	0.0	0.0
Net cash flow from operations	35.7	43.8	33.3	35.0	24.6
Net investment in investment properties	(0.3)	(98.3)	(5.2)	16.7	49.4
Acquisition of subsidiaries, net of cash acquired	0.0	0.0	0.0	0.0	0.0
Other investing activity	0.1	0.0	0.1	0.0	0.0
Net cash flow from investing activities	(0.2)	(98.2)	(5.1)	16.7	49.4
Equity dividends paid	(26.7)	(27.8)	(34.0)	(29.4)	(24.8)
Debt drawn/(repaid)	22.2	73.8	14.3	(23.1)	(50.0)
Net equity issuance	0.0	(0.1)	0.0	0.0	0.0
Other financing activity	(0.8)	(2.7)	(14.5)	(11.7)	(0.6)
Net cash flow from financing activity	(5.3)	43.2	(34.2)	(64.1)	(75.4)
Net Cash Flow	30.1	(11.2)	(6.0)	(12.4)	(1.4)
Opening cash	37.2	67.4	56.1	50.1	37.8
Closing cash	67.4	56.1	50.1	37.8	36.4
Balance sheet debt	(360.1)	(433.1)	(435.0)	(401.6)	(352.5)
Unamortised debt costs	(6.0)	(6.9)	(5.8)	(5.1)	(4.2)
Closing net debt	(298.8)	(383.8)	(390.6)	(368.9)	(320.3)
LTV	40.8%	42.4%	49.5%	51.8%	46.9%

Source: Regional REIT historical data, Edison Investment Research forecasts

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Regional REIT (LSE: RGL)

Regional REIT — Underlying progress but leasing remains subdued

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