Custodian REIT: a premium investment at a discount
Custodian REIT is a real estate investment trust (REIT) focused on UK commercial property, managing a portfolio of 161 properties spread across UK regions and property sectors. The company recently released an update for the quarter ended September 2020. This showed rental collections stabilising at 88%, albeit below the usual higher run rate. The level of rental income provided the company with enough visibility on cash flow to declare a dividend for the quarter above the level of the previous quarter.
Since listing in 2014, the Custodian share price has outperformed the UK REIT sector and the wider UK stock market, driven by strong underlying returns on the investment portfolio. In this report, we examine the fundamental portfolio characteristics that have sustained the long term outperformance and enabled resilient relative performance in 2020. Key differentiators include:
- A diverse portfolio in terms of regions and property sectors, and low exposure to high street retail.
- A focus on properties that offer strong rental yields but with low ongoing investment requirements and a secure income stream.
- The “small lot” strategy, which offers high rental yields and low exposure to individual tenants without affecting asset quality compared to larger lots.
Dividend:
Dividend income has been a big factor in Custodian's impressive total shareholder returns, and the company remains committed to dividend payments in spite of the challenges that the COVID crisis poses for the commercial real estate space. The company re-based its dividend in April 2020 in response to the current challenges. On the re-based dividend the shares yield 4.8%.
In this report we make a detailed examination of the underpinnings of the dividend including earnings cover and headroom to absorb further rent deferrals. We conclude that the current level represents a sustainable payout and indeed we note that the company declared a dividend above its minimum target in the quarter ended June, and raised this in the latest quarter.
Signs of resilience, credible dividend policy
Based on the re-based level of dividend the shares currently offer a yield of 4.8%. Furthermore, the current valuation on a price/book of 0.9x represents a discount to the historic range, which trended around 1.1x. Other UK REITs are also trading on discount valuations, but we argue that there are significant qualitative differences between Custodian and the wider peer group. In this report, we offer a detailed analysis of some key differentiators. We argue that Custodian represents a premium quality investment trading at a discount valuation.
Valuation and conclusion
Year end Mar 31 · 2019 · 2020 · Current · 2022
Value of investment properties (£M) · 572.7 · 559.8 · 526.1 · 535.0
Gearing (LTV%) · 24.1 · 22.4 · 23.1 · 22.0
Revenue from property (£M) · 40.0 · 40.9 · 38.4 · 39.2
Underlying Op. Profit · 32.7 · 33.3 · 29.3 · 31.2
EPRA EPS (GBp) · 7.3 · 7.0 · 5.8 · 6.2
Dividend (GBp) · 6.55 · 6.65 · 4.20 · 5.20
Custodian has outperformed the FTSE 350 and the UK REIT sector
Total shareholder returns, indexed to 100
Source: Proactive Research
Given the strong performance of Custodian’s asset portfolio, the market has tended to value the shares at a premium to its book value; however, during 2020 there has been some compression in the price/book valuation as investors have rotated out of the UK commercial property sector.
The following chart illustrates:
Price/book for Custodian REIT
Source: Proactive Research
A discount valuation, and an attractive dividend yield at a sustainable rebased level
It is important to note that the current price/book valuation of 0.9x is based on a net asset value (NAV) per share that already reflects significant asset price mark-downs courtesy of the COVID crisis. We argue that the current discount on the shares represents a potential opportunity for investors.
Moreover, investors in the REIT sector are typically seeking dividend income. The company rebased its dividend in April 2020, as did the great majority of UK REITs. Based on the new level of dividend at 1.05p per quarter, the shares currently offer an annual dividend yield of 4.7%.
We argue that the rebased dividend represents a solid ‘floor’ for the dividend payment, and we expect the dividend to increase from this level going forward. In this report, we examine the underpinnings of the dividend (see p8 -10)
In conclusion, we argue that Custodian REIT offers an interesting proposition for investors based on:
- An attractive dividend yield based on a revised payout which is realistic and sustainable
- Risk factors becoming quantifiable and under control, notwithstanding the latest lockdown measures in the UK
- Current market valuation discount as an attractive potential entry point for investors
Market positioning - sectors
Custodian manages a portfolio of UK commercial properties that is well diversified both geographically and by usage, with a focus on assets that offer a strong rental yield (rental income divided by purchase price).
The following charts show the breakdown of Custodian’s income by property type and by geography.
Property portfolio by income
Proactive Research
Industrial properties are the largest segment for Custodian - continued high occupancy and sustained rental income
Custodian has a well-balanced geographic portfolio, and a broad sectoral spread, supporting a strong rental income stream with the benefit of strong risk diversification.
Industrial
Industrial properties represent 47% of Custodian’s portfolio by value. These include a large portfolio of warehousing and distribution facilities, as well as manufacturing and other industrial facilities. The property portfolio in the industrial space is focussed on modern fit-for-purpose facilities with good transport links and high quality sitting tenants.
During 2020 the industrials segment has performed robustly for Custodian with strong occupational demand driven by e-commerce and "onshoring" of supply chains. This has led to low vacancy rates and continued growth in rental income.
Retail warehouse positioning provides Custodian with a degree of resilience
Retail – warehouse and high street
The retail segments combined account for 28% of Custodian’s portfolio by value. The focus for Custodian in recent years has been on retail warehouse properties rather than the high street. The warehouse stores in Custodian’s portfolio are modern properties located on busy and well-connected retail parks.
During 2020 the retail segment in the UK has been heavily affected by the effects of the COVID-19 pandemic. This has led to an increase in rent deferrals and CVA (voluntary administration) agreements, and therefore to significant write-downs to the book value of the assets.
The impact has been greatest on the high street retail sector, while out-of-town warehouse stores have shown greater resilience due to exposure to sectors where consumers are less likely to switch to online shopping – DIY, furniture, homeware, and discount stores. Furthermore, when compared with more fashion-led retail parks, the out-of-town retail locations in Custodian's portfolio have rent levels that remain relatively affordable, and in turn, should support occupancy levels.
The retail segment has particular importance in our analysis of rent collection (p8) and peer group comparison (p10 - 12).
Office
Office properties represent 9% of Custodian’s portfolio by value. The portfolio consists of smaller regional office facilities, with a focus on busy well-connected business park locations.
During 2020 the office segment has experienced some challenges due to the COVID-19 crisis; however, Custodian notes that the lettings market has exhibited an increase in enquiries from companies seeking satellite office locations, which could ultimately be a positive for Custodian’s portfolio.
Other
The ‘other’ segment consists of a variety of different types of property including car dealerships, hospitality and gymnasiums. During 2020 there has been some pressure on some of these industry sectors, and this led to some asset price mark-downs in Custodian’s portfolio during the quarters ended March and June.
Drivers of strong rental yields for Custodian
The biggest driver for the high returns that Custodian has achieved on its portfolio has been the high rental yield from its properties. Importantly the portfolio has consistently exhibited high rental income yields, high occupancy levels (currently 92.9%) and long lease expiry times with a current weighted average unexpired lease term (WAULT) of 5.2 years.
It's easy to find high rental income yields at the expense of taking a lower quality tenant base and a higher risk. Custodian is able to achieve yields above the industry average while maintaining strong WAULT and occupancy rates.
We consider some of the portfolio characteristics that have enabled this:
The small lot size premium
A key strategic differentiator for Custodian versus other REITs is the focus on lot sizes of less than £10mln.
A major advantage of this is the premium that can be achieved in rental yields — industry data suggest that sub-£10mln commercial properties achieve a 20% yield premium, i.e. if big units are delivering 5.5% rental yields then equivalent smaller units can achieve 6.6%, for example. The following chart illustrates:
Small lots offer a yield premium
Yield premium for small lot sizes
Source: Proactive Research
Small lots do not carry a penalty in terms of cost ratio
Another benefit of the small lot strategy is low exposure to any one individual tenant and indeed Custodian’s largest tenant accounts for only 4.1% of total rental income, while 80% of the total rent roll comes from tenants each making up less than 2% of the total.
A potential concern about the small lot strategy is cost — surely there must be more expense involved in managing numerous small units? However, Custodian’s financial data shows that this is not the case, with the company’s EPRA cost ratio (industry standard measure of operating cost) at 14.5% being actually below the industry average (Proactive Research sample, 12 companies).
Premium rental yields – selecting sectors and geographies
Sector selection has been an important factor in allowing Custodian to achieve high rental income yields. Available yields vary depending on property type and location across the UK regions. The following charts show available rental yields on property purchases for different categories of property. We include also October 2019 data as an indication of the pre-COVID position.
Industry data - rental yields by sector
Source: Knight Frank
London offers lower rental yields
Secondary high street retail locations offer higher yields, but lack security
We make the following observations about some of the sectors that Custodian has chosen not to target for investment:
- London prime, office and retail: These sectors have offered low rental yields in recent years. We believe this is because these assets attract the most institutional investment capital and overseas investor capital, and this has led to inflated asset prices and small rental yields.
- High street, secondary, ex-London: Properties in non-prime locations in regional towns offer a rental yield premium compared to other segments; however, these are sometimes locations where retail activity is in structural decline, and landlords risk significant vacancy rates (even pre-COVID). Custodian has not been pursuing this category of property.
Custodian has focussed on property segments that offer good rental yields combined with an income stream that is reliable. The strategy has been effective, and we believe that the portfolio leaves Custodian well-positioned to weather the current economic crisis.
Our final observation on industry yield trends is that yields increased across all categories over the last 12 months. This is because commercial property prices have declined. We do not expect Custodian to respond by pushing for new investments within the hardest-hit sectors such high street retail, and indeed we believe the company is likely to seek to further reduce its exposure to this space. We do believe, however, that depressed valuations may allow Custodian to make opportunistic purchases within the more robust property segments at attractive acquisition prices during the next 1-3 years.
Within its own property portfolio Custodian has booked valuation markdowns in line with the industry trend. Looking at which sectors have taken the biggest markdowns gives us an indication of where rental income could be at risk (see next section) and also an indication that the current NAV (Sep 2020) is up to speed with events in the commercial real estate market. The following chart shows the valuation adjustments Custodian has booked during 2020.
Custodian portfolio - write downs YTD
Source: Proactive Research
The biggest pressure has been in the high street retail segment. The most robust segment has been industrial properties, and we note that this is the largest segment for Custodian. High exposure to the industrial segment is proving to be supportive to the portfolio's performance in the current year.
Pandemic measures have had a significant impact, but are now becoming quantifiable
Current economic environment
The economic situation ensuing from the coronavirus pandemic poses material challenges for the commercial real estate space, in terms of the financial stability of some of the tenant base and also the degree of latitude that the UK government has offered to tenants in deferring rental payments. The additional lockdown measures that the UK government announced from November 5 represent a continuation of some of these challenges.
However, the experiences on rental collection over the last two quarters have now given us a reasonable indication of the extent of the impact on Custodian, and we believe the answer is that rent collections are actually less affected than originally feared.
Along with most other UK commercial landlords, Custodian has entered into contractual agreements with some tenants to allow late payments of rent and also has some tenants that are in arrears without agreement but overall in the quarter ended September 2020 the company has collected 88% of all rent due, net of contractual deferments. The following chart illustrates rent collection during the period.
Rental collection at 88% in the latest quarter
Custodian REIT rent collection, quarter ended Sep 2020
Source: Custodian REIT
Sufficient visibility now for a firm dividend policy
During the quarter, some rental payments that had been deferred by agreement from previous quarters became due for collection, and of these 87% were successfully collected. We believe that this indicates that investors should not regard contractually deferred rent as being by any means written-off.
While it's too early to form a definitive view on the full impact of the economic situation, Custodian has determined that it has enough visibility to make decisions on its dividend policy in contrast to some of its commercial real estate peers.
In April 2020 the company announced that it was rebasing its dividend to a minimum of 0.75p per quarter from 1.6625p previously, a reduction of 55%.
For the quarter ended June 2020, the company then announced an actual dividend of 0.95p, well above the minimum that had been set, reflecting confidence in the level of rent collection, albeit below normal.
On October 29 the company announced a dividend of 1.05p for the quarter ended September, another increase compared to the target minimum, and now 37% below the full-year (FY) to March 2020 level of dividend rather than 55%.
The following chart illustrates the dividend progression.
Dividend payout is running well above the targeted minimum
Re-based dividend
Source: Proactive Research
A key measure of the sustainability of dividends is whether the dividend is fully covered by distributable earnings. We argue that investors should be wary of dividends in the REIT sector that are not fully covered.
We measure dividend cover using the EPRA EPS (earnings per share) metric. This is earnings per share by the definitions of the European Public Real-estate Association (EPRA), and is an industry-standard measure. This measures earnings per share from rental income, after all costs, but excluding any capital gains. This is useful because it is the rental income that pays the dividend. On the EPRA EPS measure, dividends for the first half of FY Mar 2021 were 130% covered.
We believe it is also useful to consider dividend cover based on a worst-case earnings measure, which assumes that deferred rent may never be recovered. We don’t believe that this worst case is likely to materialise, but this gives us some measure of the security of the current level of dividend.
The following chart shows our FY Mar 2021 EPRA earnings forecast, together with two further discounted values, compared with our FY Mar 2021 dividend forecast.
We note that Custodian does not provide guidance as to how much rent might be outstanding by March 2021, and these projections are based on estimates generated by Proactive Research by extrapolation from the last two quarters.
Dividend payment is well covered even in the most pessimistic scenario
Dividend cover by cash earnings - FY 2021
Source: Proactive Research
The chart shows that our FY Mar 2021 dividend forecast is still covered even under the most pessimistic view.
Comparing Custodian with the wider REIT space
The Custodian share price currently trades at a discount to its historic valuation range on a price/book of 0.9x and offering a dividend yield of 4.7%. Valuation multiples have compressed across the UK REIT space during 2020, unsurprisingly given the economic challenges facing the sector.
However, we argue that Custodian has a number of significant differentiators compared with the wider peer group, in terms of the structural resilience of its property portfolio and in terms of key financial metrics. The next few charts provide a comparison of Custodian versus the largest names in the UK REIT space to illustrate this point.
The following table compare's custodian with the largest names in the UK REIT sector.
Custodian share price has held up well compared with the bigger UK REITs
Selected peers
Source: Proactive Research
Firstly we consider two metrics that highlight the relative balance sheet and cash flow strength of Custodian. We measure balance sheet gearing using the loan-to-value ratio. Clearly, in difficult economic circumstances, a conservative debt position is advantageous. The portfolio yield measures the level of rental income relative to the asset base. A higher-yielding asset base provides more cash flow to service debt and to deliver dividends to shareholders.
The following charts show yield and gearing.
Comparing metrics with the big UK REITs
Source: Proactive Research
Furthermore, we noted on p6 that sectoral and geographic portfolio selection are major determinants of the rental yield, and in particular that prime London office and retail offer lower yields then other property categories. In this sense, Custodian benefits from low exposure to London.
The following chart illustrates Custodian's exposure to London versus the larger names in the UK REIT space.
Low exposure to London is a positive for Custodian
Geographic split of portfolio, by value
Source: Proactive Research
Custodian has also been achieving a better level of rent collection than the wider REIT space, albeit some peers have yet to provide the level of disclosure that we've seen from Custodian. One of the biggest factors around rent collection in 2020 has been sector exposure. In particular, the retail property sector has been hit by deferred or defaulted rental payments.
The following chart highlights Custodian’s sector diversification compared with the large REITs.
Low exposure to retail is a positive for Custodian
Sectoral split of portfolio, by value
Source: Proactive Research
We could also compare Custodian to a more directly comparable peer group composed of some of the smaller cap stocks in the UK REIT space - names like UK Commercial Property REIT, Picton, or BMO Real Estate Investments. Some of these more regionally focused peers have similar portfolio characteristics to Custodian and have similarly outperformed the large-cap REITs but even compared to these closer peers, Custodian scores highly on metrics like low operating cost, low gearing, and high yields.
A differentiated and well-positioned name in the UK commercial real estate space
Conclusion:
We argue that Custodian REIT represents a compelling proposition for investors based on:
- An attractive dividend yield, based on a revised payout which is realistic and sustainable
- A property portfolio position for resilient performance relative to the wider commercial property sector
- Risk factors becoming quantifiable and under control, notwithstanding the latest lockdown measures in the UK
- Current market valuation discount as an attractive potential entry point for investors