Custodian REIT PLC (LSE:CREI): The 6% yield and NAV discount is an opportunity
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 group's key focus is on income growth while managing risk through diversification. Revaluations remain difficult to forecast in the current uncertain commercial property environment. But, given that dividends generate the bulk of long-run returns, we believe the prospective dividend yield of 5.9% looks very attractive.
Economic backdrop
Following a turbulent summer period which saw UK government bond yields reach 4.5% in late September, the markets have stabilised somewhat. This follows the formation of the new government and the Autumn Statement has provided more clarity on the government finances going forward. However, gilt yields remain elevated in relation to the last decade, and inflation, at 11.1%, is at a forty-year high. Further, the economic growth outlook remains subdued with a prolonged recession a possibility.
Second quarter results
Custodian REIT recorded a mixed first half, with a 3.2% total net asset value return over the first quarter (Q1) followed by a 5.8% decline in Q2, which reflected the deteriorating economic conditions. The quarterly dividend per share has been maintained at 1.375p and management is maintaining its target dividend of no less than 5.5p in the current year. EPRA earnings per share (EPS) for both quarters were 1.4p, or 2.8p for the first half, which covers the dividends. The group has conservative borrowings with loan-to-value (LTV) ratio of 25.4%, which has eased post period end to 24.5% following disposals.
Attractive investment case
The key to the investment case is that the group invests in sub £15mln properties which represents a significant yield pick-up on larger properties. Custodian REIT has 163 assets providing a net initial yield (NIY) of around 5.7%. Consequently, the group generates attractive rental income, and grows this income, while reducing the risk through broad regional and sectoral diversification. No single property generates more than 2% of group rental income. Also key to the investment story is the stock offers a strong hedge against the recent jump in inflation, as property values have typically grown in line with inflation.
Focus on driving attractive returns through earnings growth
The stock trades at a chunky 18% discount to the latest NAV of 113.7p per share, which is attractive, compared with a typical 10% premium prior to the pandemic. In addition, the stock offers a 5.9% dividend yield in the current year, based on our forecast, which compares with the 3.1% yield on UK 10-year gilts
Valuation
Year end Mar 31 · 2021 · 2022 · 2023 · 2024
Value of investment properties £-mln · 551.9 · 665.2 · 607.4 · 624.1
Gearing (LTV%) · 24.4 · 19.1 · 25.4 · 24.4
Revenue from property £-mln · 38.7 · 39.0 · 41.8 · 43.5
EPRA EPS (GBp) · 5.6 · 5.9 · 6.1 · 6.2
Dividend (GBp) · 5.00 · 5.25 · 5.50 · 5.63
NAV/Share (GBp) · 97.60 · 119.70 · 100.80 · 104.90
Custodian REIT's goal is to be the REIT of choice for private and institutional investors seeking high and stable dividends from well-diversified UK real estate. Following its market listing in 2014 Custodian REIT has delivered a total shareholder return (dividends plus capital gains) of approximately 5.5% per year. This performance is in spite of the share price weakness during the 2020 COVID-19 crisis and the 2022 financial market turbulence.
The group's 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
Prior to the pandemic, the shares typically traded at a premium to the net asset value, which reflected investor optimism in the strategy. We believe this strategy of buying a diversified portfolio of higher yielding smaller properties remains as compelling as ever, and the recent dip provides investors with an opportunity to buy the shares at a sizeable discount.
Attractive investment case
Net asset value development
The stock trades at an 18% discount to the latest NAV of 113.7p per share and an 8% discount to our year-end forecast NAV of 100.8p. While these discounts are smaller than the peer average, they are attractive compared with a typical 10% premium prior to the pandemic. In addition, the stock offers a 5.9% dividend yield in the current year, based on our forecast, rising to 6.1% next year. These yields compare with the 3.1% yield on UK 10-year gilts
Valuation
Company overview
Custodian REIT is a specialist in smaller regional property. The chart below shows that prior to the global financial crash in 2008/2009 the “risk premium” between smaller properties and their larger brethren was around 75bp. This widened significantly in subsequent years, providing a great opportunity for Custodian REIT to exploit. Management argues that the true risk premium has not changed, and largely reflects a “hassle factor” in dealing with smaller properties rather than actual risk.
Two-year rolling average transaction yield (%)
Source: Custodian REIT annual report
Investment performance
The company has generated an average total NAV return of 9.2% over the first full eight years of listing. This included the particularly strong performance in FY22. The total NAV performance includes NAV returns combined with dividends.
Total NAV returns
Source: Company accounts
Dividend returns
Custodian REIT has been steadily rebuilding its dividend after rebasing at the beginning of the Covid crisis, and paid a dividend every quarter throughout the pandemic.
Dividend development
Source: Company accounts and Proactive Research
Property strategy
Custodian REIT's goal is to be the REIT of choice for both private and institutional investors who are seeking high and stable dividends from well diversified UK commercial real estate. The company’s portfolio is focused on smaller lots, principally targeting properties of less than £10m at the point of acquisition, though recent acquisitions indicate that management has lifted this target to £15mln. The group's average lot size is £4.4mln.
This focus on smaller lots offers:
• An enhanced yield on acquisition – with no need to sacrifice quality of property/location/tenant for income and with a greater share of value in ‘bricks and mortar’;
• Greater diversification – spreading risk across more assets, locations and tenants and offering more stable cash flows; and
• A higher income component of total return – driving out-performance with forecastable and predictable returns.
Inflation
The group's strategy is to provide inflation protection from bricks and mortar, rather than through lease contracts, as management backs open market rent reviews to deliver rental growth. While the inflation theme puts a focus on RPI (retail price index) and CPI linked rent reviews, management argues that an over reliance on index-linked rent reviews can lead to a disparity between investment values and underlying property values and at some point in a property’s life cycle rents will be re-based to open market values. Historically, inflation-linked contracts have typical had caps and hence do not necessarily offer a hedge against inflation. We note that 86% of Custodian REIT's FY22 rent reviews were on an open market basis, while 9% were fixed and 5% inflation-linked.
Diversification
Diversification covers tenant, property, sector and location. The group's 163 properties involve more than 300 leases are ares diversified both geographically and across sectors. The sectoral split is shown below.
Sectoral split
Source: Custodian REIT
Top ten tenants
The top ten tenants, shown below, cover 28 properties and reflect 22% of the rent roll. No single tenant in any one property represents more than 1.5% of the total rent roll.
Top ten tenants % of income
Source: Custodian REIT presentation
The immediate opportunity for growth
The company's passing rent is £41.8mln while the estimated rental value is £49.4mln. Hence, reversion upside potential is £7.6mln or 18% of the current passing rent roll, which is mainly from vacant properties. The greatest potential is in the industrial space, which represents 48% of the group's portfolio by value and office and retail warehouse also offer potential. While the high street retail sector is negative, it only represents 7% of the portfolio.
Reversion potential
Source: Custodian REIT presentation
Q2 NAV update
Custodian REIT recorded a mixed first half, with a 3.2% total net asset value return over the first quarter (Q1) followed by a 5.8% decline in Q2, which reflected the turbulent economic conditions.
Despite the challenging backdrop, the company is experiencing continued momentum in the leasing market, with 23 new leases signed in the first seven months of the year. This included:
- Ten in Q1, securing £1.8mln of rent for 6.8 years
- Five in Q2, securing £0.4mln of rent for 6.2 years
- Five post period end in Q3, securing £0.6mln of rent for 7.0 years
Further, two rent reviews settled at an aggregate 22% increase and added £0.1mln of rent and accretive asset management added £1.2mln to valuation.
In addition, £26.5mln invested during Q2 at an average net initial yield of 6.8% with net deployment during the quarter increasing annual rent roll by 4.5% to £43.0mln (30 June 2022: £41.1mln)
There has been an increase in the ongoing charges ratio, which is mainly due to ESG (environmental, social and corporate governance) regulation. EPRA earnings per share (EPS) for both quarters were 1.4p, or 2.8p for the first half, which covers the first half dividends. The quarterly dividend per share has been maintained at 1.375p and management is maintaining its target dividend of no less than 5.5p in the current year.
The group has conservative borrowings with loan-to-value (LTV) ratio of 25.4%, which has eased post period end to 24.5% following disposals. The group's target LTV level is 25%.
The weighted average cost of drawn debt of 3.5%. However, we note that 84% of the company’s £167mln of drawn facilities (of the £190mln total facilities) is at a fixed rate of interest and the weighted average term is 6 years.
Movement in net asset value
Source: Regulatory news
Recent acquisitions
The company made four acquisitions in the third quarter, but the rate is slowing and, going forward, management expects a quiet period for acquisitions over the next six months until there is greater clarity on the outlook. The immediate focus will be investing in the existing portfolio.
Acquisitions in the current fiscal year
Source: Regulatory news
*Passing rent divided by purchase price plus assumed purchasers’ costs.**Reversionary rent divided by purchase price plus assumed purchasers' costs.
Recent disposals
The group made two disposals following the second quarter, both at a premium to book value. This has reduced the groups LTV to 24.5% from 25.4% as at the end of September. We estimate the total disposal profit in the year to date is approximately £1.7mln.
Disposals in the current fiscal year
Source: Regulatory news
Economic backdrop
Following a turbulent summer period which saw UK government bond yields reach 4.5% in late September, the markets have stabilised somewhat. This follows the formation of the new British government and the autumn statement has provided more clarity on the governments fiscal plans and strategic direction. However, gilt yields remain elevated in relation to the last decade, and inflation, at 11.1%, is at forty year highs. Further, the economic growth outlook remains subdued with a prolonged recession a possibility. A reduction in employment numbers will put pressure on rentals levels while a severe recession could lead to increased bankruptcies.
Ten year gilt yield
UK government bond (gilt) yields
Source: Market sources
Forecasts
We have reduced our forecasts to reflect the tougher economic conditions and higher interest rate environment. We have also introduced FY24 forecasts.
We reduce our FY23 EPS forecast from 6.5p to 6.1p. We forecast this will rise to 6.2p in FY24 as rental gains are largely negated by higher interest rates on borrowings. We have cut our dividend forecast from 5.75p to 5.50p in the current year and forecast the dividend to rise to 5.625p next year.
We assume no further acquisitions going forward, as the company is trading at around its target LTV ratio and is focusing on driving its existing asset portfolio.
While it remains very difficult to forecast valuations in the current environment, we have conservatively assumed that the bulk of last year's revaluations are reversed in the current fiscal year, but with gains starting to flow through thereafter.
Income statement
Source: Company accounts and Proactive Research
Financial position
Source: Company accounts and Proactive Research
Cash flow
Source: Company accounts and Proactive Research