Custodian Reit (LON:CREI) continued to produce positive returns through Q419 despite continuing weakness in high street retail capital values outweighing gains elsewhere, including from accretive asset management. Reflecting positive income growth, the company’s current year DPS target has been increased and, barring unforeseen circumstances, CREI intends to pay fully covered aggregate DPS of 6.65p for the year.
5.9% EPRA NAV total return in FY19
Positive EPRA NAV total returns continued in Q419, with a gain of 0.6% taking the annual return to 5.9%. For the quarter, and for the year, gains were entirely income driven, with end-Q419 EPRA NAV per share reducing slightly to 107.1p (Q319: 108.1p and end-FY18: 107.3p). With occupancy maintained at a good level (95.9%), income continued to grow, with EPRA EPS for the FY19 year increasing to 7.3p (FY18: 6.9p). FY19 dividend cover was 1.11x and CREI targets a 1.5% increase in FY20 aggregate DPS, again fully covered. The portfolio value was £573m at end-Q419, with an unchanged net initial yield of 6.6%. Although asset management continued to add value in the quarter, other revaluation movements, focused on high street retail assets, and reflecting weaker expected rental values offset this and gains from industrial/logistics assets. LTV ended the period at 24.1%. DPS guidance is ahead of our previous forecast, our EPS forecast is unchanged, and we have slightly trimmed capital growth and NAV per share.
Diversified income-focused strategy
CREI is highly income focused, seeking to grow dividends sustainably, supported by a diversified portfolio. Fully covered dividends represent 77% of the NAV total return, a compound 6.8% pa generated since the IPO in 2014. Portfolio diversification, by sector, location, tenant and lease term, is an important element of the strategy for delivering on this goal. Robust occupational demand continues to support high levels of occupancy and rental growth across most of the portfolio, which has low exposure to offices and a relatively high exposure to industrial, retail warehouse and alternative sectors. Retail stress and Brexit uncertainty have the potential to further affect near-term capital values, but may equally throw up investment opportunities.
Valuation: Yield premium supports P/NAV
CREI shares combine an attractive yield, a good level of dividend cover and conservative gearing. Investor demand for the shares, trading at a premium to NAV (unlike peers), provides funding support for accretive acquisitions which, combined with rental growth and asset management, is a positive indicator for future returns.
Business description
Custodian REIT (CREI) is a London Main Market-listed REIT focused on commercial property in the UK outside London. It is income-focused, with a commitment to pay a high but sustainable and covered dividend. It targets a balanced portfolio, with a focus on lot sizes of under £10m.
Positive income-driven returns continuing
The quarterly NAV update for the three months ended 31 March 2019 (Q419) shows a growing level of portfolio income, partly offset by negative net revaluation movements, driven by high street retail exposure. Returns were positive overall, with a 0.6% EPRA NAV total return, comprising dividends paid and a reduction in EPRA NAV per share to 107.1p compared with 108.1p in December (Q319) and 107.3p at 31 March 2018 (end-FY18). For the year as a whole (FY19), NAV total return was 5.9%, with dividends paid contributing 6.1%, and a small 0.2% capital decrease. We expect the detailed full year (FY19) results to be published in early June.
Other key points from the release include:
A fourth quarterly dividend in respect of FY19, of 1.6375p per share, has been approved by the board for payment on 31 May 2019 to shareholders on the register on 26 April 2019. The dividend policy set by the board is to grow DPS on a sustainable basis, and at a rate which is fully covered by projected net rental income and does not inhibit the flexibility of the investment strategy. For the current year ending 31 March 2020 (FY20), in the absence of unforeseen circumstances, the board intends to pay aggregate quarterly DPS equivalent to an annualised 6.65p, a 1.5% increase on FY19.
FY19 EPRA EPS was 7.3p, up from 6.9p in FY18, providing 1.11x cover of the aggregate 6.55p DPS declared during the year (FY18: 6.45p).
During Q419, 3.6m new shares were issued under the company’s block listing facility, raising £4.1m in new equity at an average price of 115.0p, an 8% premium to the unaudited 31 December NAV per share, adjusted to exclude the DPS paid on 28 February 2019. For the year as a whole, c 11.4m shares were issued at an average price of 118.2p, raising £13.4m of equity.
Gearing has remained at relatively modest levels, with a net loan to value ratio (LTV) of 24.1% at end-Q419 (end-Q319: 24.7%).
The portfolio value was £572.7m at end-Q419 (Q319: £576.2m), with no completed acquisitions during the period and a net valuation decrease of £5.0m, or c 0.9%, driven by high street retail properties, primarily due to a reduction in estimated rental values (ERV) at a number of properties (see below). The portfolio net initial yield (NIY) remained unchanged at 6.6%.
Occupancy, calculated on an EPRA basis, remained at a good level of 95.9% at end-Q419, although slightly down in the period (Q319: 96.5%).
Although not active in Q419, CREI is considering a pipeline of investment opportunities and believes that there may be potential to make contra-cyclical acquisitions where short-term market weakness may unlock long-term value.
Portfolio update
CREI’s diversified portfolio comprises 155 assets, split between the main commercial property sectors, with a weighted average unexpired lease term to first break (WAULT) of 5.6 years. There were no transactions during Q419 as the company maintained a strict approach to investment.
With investment policy based on maintaining a suitably balanced portfolio rather than targeting specific sector weights, the movements in Q419 sector weightings (Exhibit 5) reflect variations in market pricing, including the effects of asset management.
Within the quarterly net negative revaluation movement of £5.0m, asset management initiatives added £1.4m to the portfolio value and other quarterly valuation movements were a negative £6.4m, driven by high street assets, where 17 of the 33 properties saw a reduction in ERV in the period. CREI’s high street retail exposure is targeted, with no shopping centre exposure. It expects prime and good secondary locations to remain in demand by both retailers and investors, although with potential further downwards pressure on rents, whereas alternative uses may be needed for poor secondary retail locations
Although portfolio retail warehouse asset values also reduced, by £1.4m during the quarter, CREI believes that valuations and rents are likely to prove more robust than for high street retail assets, supported by relatively low rent levels, free parking and a complementary relationship with online through continued growth in click and collect.
CREI expects the industrial/logistics subsector assets to benefit from demand for smaller urban logistics assets, to meet the challenge of on-line sales fulfilment, and where the letting market is yet to fully mature in contrast to the very large ‘big box’ logistics market. This continues to be an area of selective acquisition for CREI.
The regional office market also continues to perform well, generating rental growth against the background of continuing occupier demand and a relative shortage of availability.
The asset management contribution includes lease renewals and extensions, positively affecting rental income and capital values, partly offset by the company voluntary arrangement (CVA) of Paperchase, reducing rent on a property in Shrewsbury by 45% (£150k to £83k) and the valuation of £0.4m. Further asset management initiatives are under review and are expected to be completed in the current quarter.
Financials
The Q419 NAV update provides an unaudited indication of the end-FY19 EPRA EPS and NAV as well as the LTV ratio, and the full audited results are expected to be released in June. We have made slight adjustments to our FY19 expectations, bringing them in line with the quarterly guidance, making very small changes to EPRA EPS (up) and EPRA NAV (down). LTV is also slightly lower than we previously forecast, reflecting subsequent equity issuance under the company’s block listing facility. The changes to our FY20 forecasts are similarly very modest, although we are a little more cautious about the prospects for NAV growth in the current year.
Our main forecasting assumptions for FY20 are shown below. We will review these with the detailed FY19 results and extend our forecasting period.
We have assumed no changes in the portfolio, although CREI continues to seek opportunities that fit with its investment strategy and the company expects selective acquisition growth to continue. Similarly, we assume no equity issuance.
For achieved rental growth across the whole portfolio, we have assumed a blended rate of 0.5% pa (was 0.6%) comprising growth of 2.0% pa for industrial, a decline of 2.5% pa for high street retail, and flat rents for offices, ‘other’ and retail warehouses.
We assume a small positive net revaluation movement equivalent to 0.3% of the opening portfolio value, following the assumed rental growth but at a lower level, implying some modest yield tightening. From a sector viewpoint, this implies positive revaluation for the industrial assets and further negative revaluation for the high street retail assets. We estimate that a 0.25% increase/decrease in the net initial yield would reduce/increase FY20 EPRA NAV per share by 5.6p/6.0p or c 5%.
Valuation
As an income-oriented REIT, CREI’s focus is on generating a secure and growing income stream that can support its progressive and sustainable dividend objectives, while delivering capital value growth over the long term. As a result, the shares combine an attractive dividend yield, with a good level of dividend cover, and conservative gearing.
Since listing in March 2014, CREI has generated an EPRA NAV total return of 39.0%, or a compound annual average return of 6.8% pa. of the total return, 77% has been generated by dividend payments and the balance by growth in EPRA NAV per share.
Exhibit 8 shows a valuation and share price performance comparison of CREI with a group of close peers with a similar income focus and diversified investment strategy.
The share price premium to EPRA NAV has reduced slightly in recent months, but has been relatively robust and the gap versus the peer group average has widened somewhat. CREI shares continue to trade at an above average trailing P/NAV of 1.05x, which is supported by an attractive, above average dividend yield, with DPS well covered by earnings.
