Custodian REIT - income focus, actively managed
Custodian REIT is a UK commercial Real Estate Investment Trust focused on smaller lot-sizes, managing a portfolio of 163 properties diversified across UK regions and property sectors. The company has delivered a positive return on its portfolio throughout the pandemic, as measured by NAV return (details page 3). In this report we examine some of the factors which underpin Custodian's robust performance, and which support increased levels of potential returns to shareholders in the coming years.
On 4 November, the company announced the closing of the acquisition of a UK listed REIT called Drum. This gives Custodian an additional 10 properties, primarily in the regional offices and retail warehouse segments. The acquisition boosts Custodian’s distributable earnings per share for FY 2022 and 2023, and still maintains balance sheet gearing within the 25% target maximum. We outline the financial impacts and the strategic logic of the deal on pages 6-7.
In addition to this acquisition, during the financial year to date the company has undertaken a number of portfolio optimisation activities. During FY Mar 2021, the company generated an additional £9.4mln of portfolio value through asset management activities, and we believe that the current year is on track to exceed this total.
Custodian has been steadily rebuilding its dividend after rebasing at the beginning of the COVID crisis, and has paid a dividend every quarter throughout the pandemic. The company announced a 10% increase in its quarterly dividend alongside the completion of the Drum deal, taking the dividend to 1.375p per quarter from the quarter ended Dec 2021. The shares currently offer a dividend yield of 5.4%.
Drum acquisition, dividend increase
Custodian's strategy is based around generating a strong level of sustainable rental income from its property portfolio. Some of the factors which support Custodian’s rental yields include:
- A ‘smaller-lot’ strategy focussed on assets below £10mln
- Low exposure to historically overbought segments such as city centre offices and prime London property
- Exposure to historically higher-yielding property segments – regional offices, industrial units, in-demand retail warehouse locations
We examine some of these factors in this report and we conclude that Custodian REIT is well positioned to deliver dividend income growth to shareholders in the coming years.
Rental yields support ongoing dividend growth
Year end Mar 31 · 2020 · 2021 · 2022 · 2023
Value of investment properties £-mln · 559.8 · 552.0 · 614.9 · 624.9
Gearing (LTV%) · 22.4 · 24.4 · 21.9 · 20.7
Revenue from property £-mln · 40.9 · 39.6 · 40.4 · 42.8
EPRA EPS (GBp) · 7.0 · 5.6 · 6.4 · 6.7
Dividend (GBp) · 6.65 · 5.00 · 5.25 · 5.50
Custodian is a diversified Real Estate Investment Trust, managing a portfolio of smaller-lot-size commercial properties let to institutional-grade tenants throughout the UK. The company has a focus on cash rental income from investment properties supporting dividends to the shareholder.
Since its market listing in 2014 Custodian REIT has delivered total shareholder return (dividends + capital gains) of 5.9% per year, in spite of the impact of COVID during 2020. The share performance reflects the returns which Custodian generates on its portfolio of UK commercial properties. The investment strategy is characterised by:
- A diverse portfolio of high yielding assets
- The “Small lot” strategy, which offers high rental yields and low exposure to individual tenants
- Strong capital discipline
- A focus on delivering income to shareholders
The company follows a core/core-plus property investment strategy. This means investing in modern high spec properties with less follow-on capex requirements and with investment-grade sitting tenants. The portfolio is diversified across UK regions and across the major commercial real estate segments. The makeup of the portfolio is illustrated by the following charts:
Overview
A diverse portfolio across UK regions and property sectors
Sector and region split of portfolio, by income
Source: Custodian REIT
Custodian has generated positive returns on its portfolio every year since inception in 2014, including the COVID impacted years 2020 and 2021.
Our preferred measure of portfolio performance is NAV total return. This is the percentage annual increase in net asset value (NAV) per share together with the dividends paid as a percentage of NAV. If the share price were always valued at 1x the NAV per share, then NAV return would be the same as total shareholder return (capital + dividends), meaning that NAV return represents a very direct correlation between returns on the investment portfolio and shareholders’ overall gains and losses.
The following chart illustrates Custodian’s NAV total return since listing on the stock market.
NAV returns
Source: Proactive Research
Potential for accelerated returns 2022e, 2023e, 2024e
We argue that Custodian is well positioned to deliver accelerated returns to shareholders in the coming years, and also offers a favourable risk profile compared with the wider stock market or the REIT space. We list some of the factors underpinning our conclusion:
- An attractive dividend yield and a realistic pathway to rebuild the dividend towards its previous peak level
- Active portfolio management creating additional value to shareholders
- A low level of balance sheet gearing contributing to a conservative risk profile
Market positioning
Within the UK commercial property space, different segments offer very different levels of rental yield, where yield is defined as rental income as a percentage of property value. At the high-yield end of the spectrum are properties with perceived high risk of discontinuity in tenancies, including sectors such as high street retail. At the other end of the scale, properties in central London have attracted a lot of investment capital over the last decade driving up prices and therefore driving down yields.
Targeting the sweetspot for consistently high rental income returns
Custodian has a focus on the UK regions, and a high weighting towards industrial properties, offices located in busy and well-connected business parks, and warehouse retail stores, typically in well-connected popular edge-of-town locations let off low rents. We argue that Custodian's areas of focus capture the sweet spot of the UK commercial property market; low risk income streams, but still offering attractive returns.
The following chart shows the rental yields available in the market, for various property sectors:
Available rental yields by sector
Source: Knight Frank, October 2021
Industrial and distribution properties becoming a sellers' market in some areas
.We note that there has been a particular shift in dynamic in the industrials and distribution warehouse segment during 2020 and 2021. Historically this sector offered high yields of 6% of more. Demand for these properties has strengthened significantly during the pandemic with industries becoming more focussed on supply chain issues. Investor demand for these properties has made the warehouse space an increasingly ‘hot’ segment within the commercial real-estate space, driving down the available rental yields. In this sense, the industrials segment has become a sellers’ market to an extent. Within this context, Custodian has found selective opportunities to dispose of properties at a profit, and reallocate capital to other sectors.
In addition to sector allocation, another differentiator for Custodian’s strategy versus many other REITs is the focus on lot sizes of less than £10mln.
The smaller lot strategy
A major advantage of the smaller lot strategy is the premium that can be achieved in rental yields – industry data suggest that sub-£10mln commercial properties achieve more than 20% yield premium, i.e. if big units are delivering 5% rental yields then equivalent smaller units can achieve over 6%, for example.
Smaller lots attracting more than 100bps rental yield premium
Yield premium for smaller lots
Source: Lambert Smith Hampton
The yield premium has averaged 135bps. Although we do not have a figure for year-end 2020, we believe that the premium available on smaller lot properties remains intact.
Active portfolio management
Custodian’s active portfolio management in recent years has included a shift of focus away from high street retail. This shift began well before the start of the COVID crisis which has brought additional pressures on the high street retail sector. The following chart documents Custodian’s shift away from the high street:
Strategic shift away from high street retail going back to 2017
Custodian exposure to high street retail
Source: Proactive Research
The company continues to actively manage its portfolio, with 11 property disposals completed during the last six months. Within this more recent phase of portfolio management for Custodian, the largest number of disposals has been within the Industrials segment, in line with our observation that this segment has become more of a sellers’ market. Custodian will dispose of assets when (a) a good bid is available for the property, and (b) when capital can be reallocated to assets which better fit Custodian's criteria, primarily the potential for rental income growth.
The following table shows the disposals during the last six months:
Recent disposals - profit taking on selected industrial assets in 'hot' markets
Disposals during the last 6 months
Source: Proactive Research
Although Custodian does not target disposals based on achieving a premium to book value, we've included this metric in the table above, as this impacts positively on NAV per share, which is a metric often followed by stock market investors.
Custodian looks for opportunities to use active asset management to create shareholder value across the portfolio. Aside from asset disposals, other portfolio actions include:
- Lease renewals
- Lease re-gear
- Acquisitions
- New lettings
- Rent reviews
During FY Mar 2021 the company achieved a total of £9.4mln of valuation uplifts through its asset management activities (excludes market-driven changes of value). We believe that the current year is already on track to exceed this total, driven in part by the disposals.
Acquisition - Drum REIT
Another significant move during the current year has been the acquisition of Drum Income Plus REIT in an all-share offer valued at £21.4mln which was announced on 3 September 2021 and completed on 4 November. Under the acquisition, Custodian acquired property assets totalling £48.9mln and absorbed £22.1mln of additional borrowings.
Drum matches Custodian's strategic footprint - lot size, geographies, high rental income yields
Drum is a good fit for Custodian’s strategy of smaller lots £2mln-£10mln with strong rental income yields – above 7.5% in the case of Drum’s assets. The portfolio also fits well with Custodian's regional geographic footprint.
The following chart summarises Drum’s portfolio:
Drum REIT portfolio - ten properties with values £2.5mln - £10mln · Regions - North East, Scotland, North West, South West
Source: Proactive Research
Segment split - 53% office, 23% retail park properties
The acquired portfolio is made up of 53% office properties (by value) and 23% retail park properties. The portfolio also includes a high street shopping centre in Gosforth, Newcastle. Although this runs against the trend of Custodian’s recent shift away from the high street, we note that in the case of the Gosforth shopping centre the biggest tenant by far is food retailer Sainsbury's, which represents a solid anchor tenant.
In financial terms the deal impacts favourably on Custodian with EPS increasing, and with balance sheet gearing remaining well within the target of 25%.
The following table summarises the financial impacts of the Drum acquisition for FY March 2023 which is the first full year of inclusion of the Drum businesss:
Financial impact of the Drum acquisition - FY March 2023
Source: Proactive Research
Overall, we argue that the combined effects of disposals together with the Drum REIT acquisition impact positively on Custodian both in terms of financial metrics and in terms of portfolio quality and future rental growth.
Dividend rebuild
Custodian REIT rebased its dividend in April 2020 in response to the Covid crisis. Subsequently, the company has increased its quarterly dividend three times, and also paid a special supplementary dividend in the quarter ended March 2021. The company then announced a further dividend increase mid-year for FY 2022e, raising the quarterly dividend by 10% starting from the quarter ended Dec 2021.
The following chart shows the dividend in recent quarters:
Quarterly dividends
Source: Custodian REIT, Proactive Research forecasts
An important measure of 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 which are not fully covered.
Dividends covered by EPRA earnings-per-share
We measure dividend cover using the EPRA EPS metric. This is earnings per share by the definitions of the European Public Real-estate Association, which 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 measures the rental income which pays the dividend. Custodian’s dividend payments are all fully covered by EPRA EPS, as shown by our table on p1.
We argue that the current dividend offers an attractive yield for shareholders, and is also a sustainable payout supported by strong cash income and a healthy balance sheet position.
ESG metrics
Another important consideration for many investors in the current climate is the environmental, social and governance (ESG) profile of the company, particularly with regard to the environmental efficiency of the property portfolio.
Within its 2021 report and accounts, Custodian outlines the following environmental KPIs, among others:
A comprehensive plan for attaining emissions targets
- Reduce total portfolio absolute emissions by 30% by 2025
- All ‘D’ EPC ratings to be removed or improved by 2027, all ‘E’ EPC ratings to be removed or improved by 2025 and all ‘F’ and ‘G’ EPC ratings to be removed or improved by 31 March 2022
- Reduce absolute energy consumption of the property portfolio by 15% against a 2019 baseline by 2025
- Switch all landlord-controlled sites to 100% renewables by 2025
- Install EV charging points across 100% of the company’s retail warehouse assets by 2025 and investigate onsite renewables on one asset by 2025
- Incorporate sustainability clauses into new leases
Comparing Custodian with the wider REIT space
We have noted (p3) that Custodian generated positive NAV returns throughout 2020 in 2021. This is not the case for some of the biggest names in the UK commercial real estate sector, with names like Land Securities and British Land producing double digit negative returns.
There are actually some REITs that have achieved better portfolio returns than Custodian - names like Segro, Big Yellow, and Primary Health Properties. These are generally ‘alternative’ REITs, with a single sector focus and sometimes with a business model that differs from being purely a landlord. We consider these to be a different investment type than general REITs.
Comparing Custodian against some of the biggest diversified REITs, one characteristic that stands out is portfolio rental income yield.
The following chart compares Custodian's portfolio yield against some of the leading UK diversified REITs.
High rental income yield has been a key driver of Custodian's overall returns
Rental yield on Custodian's property portfolio versus the big UK REITs
Source: Proactive Research
Portfolio characteristics which allow Custodian to achieve superior rental yields include:
- low exposure to London
- focus on smaller lot sizes
- exposure to higher yielding property segments
Another characteristic which has been beneficial to Custodian during 2020 and 2021 has been low balance sheet gearing.
The following chart compares Custodian’s balance sheet gearing against some of the biggest UK diversified REITs, as measured by the loan-to-value metric (borrowings versus property value).
Low gearing reduces volatility of returns
Loan-to-value
Source: Proactive Research
We note that Great Portland has lower balance sheet gearing than Custodian. However, given the higher rental income yield that Custodian generates from its properties this still leaves Custodian with a higher level of interest cover.
Low balance sheet gearing has been an important factor in allowing Custodian to continue paying a healthy dividend to shareholders in spite of the challenges of the pandemic.
Conclusion - a dependable income investment enhanced by active portfolio management
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 positioned for resilient performance relative to the wider commercial property sector
- Active management of the property portfolio generating additional value for shareholders
A conservative balance sheet position