AEW UK REIT

AEW UK REIT (AEWU) offers one of the highest yields in the AIC UK Commercial Property sector (10.8%), having so far managed to maintain its dividend in 2020 despite the impact of the coronavirus. The 2p-a-quarter payout is achieved by exploiting inefficiencies in smaller assets, regional locations and shorter lease lengths which are often overlooked by peers. This allows the managers to buy assets at high yields and generate capital growth by taking advantage of optionality, such as asset management or change of use.

AEWU is managed by Alex Short and Laura Elkin at AEW UK, the UK arm of one of the largest real-estate managers in the world. The AEW UK team have over 20 years’ experience investing in property for institutional clients in private funds, and launched AEWU in 2015 as a diversified commercial-property strategy. They are backed by a large team of investment professionals, asset-management specialists and support staff.

This year has seen huge disruption to the commercial-property sector from the lockdown. However, as discussed in the Dividend section, AEWU’s rent collection has held up reasonably well so far, and the board has paid the 2p dividend for the first two quarters of 2020. Clearly there will be more challenges to come, but dividend cover was at 90.5% for Q2 with cash on hand to reinvest.

Nevertheless, the discount remains very wide, at c. 20% versus a sector average of c. 12.5%. This is despite strong NAV total-return performance since launch and the dividend having so far been maintained. The trust faces a continuation vote at the AGM in September.

Markets always overshoot. In the first few weeks of the UK lockdown it was possible to believe that high-street retailing and office working would not come back at all. Now that restrictions are being lifted and transactions are being recorded again, we think the market is starting to reassess its fears, and AEWU’s share price has been ticking up. However, a wide discount still remains.

We think the fact the NAV showed no decline in the quarter to June– and the portfolio a modest 1.6% decline – is a positive indication, although we accept the full impact of the recession is still to be felt. Nonetheless, the c. 20% haircut to portfolio valuation implied by AEWU’s discount seems excessive to our minds, particularly given that half the portfolio is in the top-performing industrials sector.

As we discuss in the Dividend section, there is some work to be done in the short term to reinvest recent sale proceeds to achieve dividend cover, and the board has not ruled out a cut. However, the high levels of cash on the balance sheet following the sale of a significant asset at 25% above carrying value give flexibility, and given the opportunistic approach of the managers there are surely likely to be attractive, discounted assets thrown up by the disruption. The continuation vote in September should also give investors comfort on the downside, as we discuss under Discount.

AEW UK REIT offers investors a way to benefit from the mispricing of smaller commercial property assets with shorter lease lengths, taking advantage of inefficiencies in the market and the opportunities for asset management with a nimble, specialist approach.

The trust is managed by Alex Short and Laura Elkin at AEW UK, the UK arm of one of the largest real-estate managers in the world (see the Management section). They look to buy assets on attractive valuations, with a net initial yield of 7% to 9%. They then aim to generate a capital uplift using the opportunities created by short lease lengths (of three to six years) to negotiate directly with tenants and then, after creating value, either sell on or continue to hold.

The weighted average unexpired lease term (WAULT) is 4.9 years, with an average lot size of just £5m. Alex and Laura believe that the market is currently too quick to apply a premium to long-dated income. Long-dated income is widely considered more secure (and therefore more valuable) but they believe this depends on the asset and the lease, and investors have to be wary of the particulars. Properties are often overvalued because of the length of the leases signed, they believe. By contrast, the value of the smaller and discounted assets AEWU focusses on is much more in the fundamentals such as location and optionality. There is therefore scope for shareholders to benefit from active management, as assets on shorter leases are upgraded or transformed and longer leases signed. In our view, this focus on fundamentals rather than the cashflow value in the lease could well be important in the aftermath of the pandemic as there will be huge pressure for lease renegotiations of longer leases, particularly in the retail and office sectors. Of course this focus also brings different risks such as the need for greater investment of time and resources in active management and more frequent transactions, although there is a high occupancy rate of 96% (as at 30/06/2020) which suggests the managers have had success in completing this higher number of transactions.

AEWU’s portfolio is tilted to the strongly performing industrials sector, which is one of the key factors in the NAV holding up so far during the crisis, as we discus in the Performance section. This sector has been a key area of interest for many managers in recent years, with industrial assets boosted by the trend to online shopping. However, unlike many of its peers, AEWU focusses on the smaller assets which have not, so far, been repriced so aggressively. Yields remain higher than those of the big-box sites which house tenants such as Amazon or large retailers moving into the online space.

Alex and Laura seek out assets in the same type of location as the big boxes, leased to the same types of tenants but which just happen to be smaller. This tends to lend itself to greater optionality, either through asset management, change of use or reletting at the expiry of shorter leases. It also offers greater diversification of tenants at the portfolio level. The managers report on occasion achieving 20% to 30% rental uplifts on industrial assets. AEWU receives rent from 90 tenants across 34 properties. As the below chart shows, industrials make up around half the portfolio, at 52%, and account for 20 of the 34 properties.

The nimble approach can be seen in the management of the trust’s industrial asset in Droitwich. In March this year the lease was renewed and extended, but with landlord-only break clauses included every 18 months which allow AEWU to explore developing the site for residential use at a potentially higher valuation.

The focus on identifying sites with multiple uses could well be key to navigating the period of disruption in commercial property following the pandemic while maintaining capital values. For example, one of the most impacted areas is the leisure sector. AEWU has limited exposure here at 7.7% of the portfolio, but it is clearly amongst the most likely to be impacted over the short term thanks to social-distancing restrictions, even as more leisure industries are allowed to open up. The largest asset AEWU owns in this sector is a site in Dagenham let to Mecca Bingo, McDonald’s and a bowling operator. This site offers potential for industrial or residential use, which the managers believe should underpin values going forward.

One key factor behind values is location, which is often key for change of use. Industrial sites in the portfolio are often situated near major motorways, useful for fitting into logistic chains. The office exposure is concentrated in the regional cities, with Alex and Laura finding valuations in London too rich in recent years. While they acknowledge the challenges for this sector as companies plan their return to the office, they believe the focus on city-centre locations in areas with low levels of supply should protect values. While they do expect a reduction in office space required in the short term, they believe companies are likely to retain city-centre locations for networking at least, and to supplement increased working from home. On the other hand, AEWU has limited exposure to the out-of-town business parks which have seen weak demand in recent years and often have poorer amenities.

The portfolio is widely spread over the three nations of Great Britain, in contrast to some of the larger generalists which tend to focus on London and the South East. The considerable allocation to the north could even see shareholders benefit from the investment aimed at that area under the government’s ‘levelling up’ agenda.

One recent asset-management success in the office sector is the reletting of the Queen Square site in Bristol. This was bought in 2015 with just 54% occupancy. In February 2020, at 100% occupancy, a new letting was achieved which was 55% above the previous passing rent. As a result, AEWU has enjoyed a 60% uplift to the value of the asset since it bought it.

Retail has been the underperforming sector for AEWU in recent years, as it has been across the generalist trusts. The regional focus hasn’t helped either, with London generally being stronger in the sector. However, Alex believes that the focus on strong locations means that the high-street retail owned by AEWU should be more likely to be transitioned to other uses. It should be noted that standard retail (i.e. excluding the stronger retail-warehouse subsector) accounts for just 9.9% of the portfolio and 13.6% of passing rent (as of 31/03/2020).

The alternative sector had been a relatively strong performer until the lockdown caused many of the establishments to close. However, AEWU has sold a large part of its exposure here. This was a site in Corby used as a car park which was sold in May 2020 at an uplift of 25% to its end-of-March valuation. The site was sold to the owner of a neighbouring property wishing to expand and change use. Originally bought for £12.4m, it was sold for £18.8m.

This is an example of how AEWU has continued to prosper during the pandemic thanks to the focus on asset management and flexible assets. Another example is the letting in June of an office in Solihull to the Secretary of State for Housing, Communities and Local Government at an extended 15-year lease length, providing substantial uplift to the value. These manoeuvres are responsible for the very modest fall in the portfolio valuation in Q2 despite the pandemic. While there are clearly more challenges to come as the recession begins to bite, we think the asset-management expertise and the focus on identifying sites in good locations with change-of-use potential could help support the value of the portfolio through the crisis.

To give the trust more flexibility in the light of the pandemic, AEWU amended its loan facility in June to make it in effect a revolving credit facility, allowing the board to repay it at will. On a gross basis, gearing is 23% LTV (29.9% NAV), following the repayment in July of £12m of the £51.5m borrowings previously drawn down. This compares to an average of 24.9% LTV for the generalist peers in the AIC UK Commercial Property sector (as per our calculation at the end of May). However, following the sale of the Corby asset for c. £18.8m (see the Portfolio section), net debt fell to 13.65% on an LTV basis (15.8% on an NAV basis), reducing the net gearing even further. The board has a gross LTV target of 25% over the long term (33.33% on an NAV basis), so there is some small headroom for further drawings.

AEWU has a £60m facility which prior to the amendment could be drawn down in stages but not repaid. It matures in 2023. The covenants require AEWU’s borrowings to remain below 55% on an NAV basis. Net assets could therefore fall by c. 30% before the covenant was tested. There were previously interest-cover requirements too, stipulating interest should be covered five times by income. However, the lender, RBSI, has agreed to waive these requirements throughout this crisis period, with the next proposed test date being January 2021. As of April, interest cover was 7:1 and so significantly above the covenant – albeit prior to the disposal of the Corby asset (7.6% of rental income) and with the full impact of the pandemic on rent collection yet to be felt.

AEWU has outperformed the average AIC UK Commercial Property trust over five years, generating returns of 35.6% to the last month end compared to 33.7%, according to Morningstar data. As the below graph shows, the share price has taken a precipitous fall since the outbreak of the pandemic. We think this represents deep scepticism about the capital values in the portfolio. However, for us the recent announcement of a 0.25% rise in net asset value during the height of the crisis and a modest fall of 1.6% to the portfolio valuation is reassuring and a possible indication that the market has overreacted. The rise is chiefly due to the asset-management success at Solihull and sale of the Corby asset as discussed in the Portfolio section, with modest falls on the rest of the portfolio except for the more troubled leisure assets (which are down 11%). To us this indicates the benefits of focussing on smaller, idiosyncratic assets with optionality, and of having a strong asset-management operation which can generate strong returns from individual assets which are not reliant on the situation in the wider markets.

The below graph shows performance over one year, with the share-price performance relative to that of the sector in orange, showing that the share price of AEWU has been harder hit in the crisis.

It should be noted that the sector is not a perfect benchmark as it contains some sector-specialist funds. However, AEWU’s strong absolute returns in 2017 and 2018 saw it outperform in relative terms, with a mixture of higher income and capital uplifts. The following year, 2019, was an outstanding one in relative terms thanks to a higher income return offsetting capital losses, primarily in the retail sector. Commercial property was weak this year due to concerns about a possible ‘hard Brexit’.

Overall, total returns to shareholders and at a portfolio level since launch have benefitted from the high income return generated. Alex and Laura argue that the long-term record of property returns suggests that during past recessions income returns have been much more stable than capital values, suggesting that those who are able to look through mark-to-market losses in the shorter term have still generated attractive income returns.

In a period in which many of its peers have been forced to cut or delay their dividends, we think the fact that AEWU’s board has been able to maintain its 2p quarterly dividend so far is notable. Given the share-price discount, this means the historical yield is c. 10.8%, the highest in the peer group. This 8p annualised dividend has been paid consistently since AEWU was fully invested in mid-2016, and has been covered fully in the past two years by EPRA earnings (excluding capital gains from income). (In 2018 the reporting dates changed and 1.3p was paid for the first, shorter quarter, which means 8p was paid on an annualised basis.) As for the most recent full year, the dividend was 108% covered by EPRA earnings (excluding fair-value movements in valuations) in the year to 31 March 2020, with 11.7p per share of income offset by 3.02p of expenses and financing costs.

Clearly, the question for buyers at this stage is whether the payout is sustainable. This depends in part on rent collection, which was reasonably strong in the first two quarters (all considering). In Q1, 85% was collected with 10% of rent on payment plans. The benefit of the latter is that the leases have been extended as a part of the payment plan, giving an uptick to capital values. Only 5% is truly outstanding, and we understand from the managers that the tenants who aren’t paying are not those in the most financial trouble. They are confident the rent will be collected, even if legal action has to be taken in due course. The Q2 dividend will be paid from this income, and is 90.5% covered, with income from the payment plans yet to come in.

In Q2, 75% of rent has so far been collected, compared to 92% at the same date in the corresponding quarter last year. A further 10% is under negotiation, pending the agreement of asset-management transactions. Only 15% is therefore truly outstanding at present, compared to 8% at the same stage for this quarter last year. We note that the trust’s weighting to retail is very low relative to that of the generalist peers, at 11.3% compared to a 22.9% average for the generalist trusts in the AIC UK Commercial Property sector. The office exposure is largely to the regional market, with nothing in central London. In our view this could be positive in terms of an earlier return to occupancy, as regional offices are generally more accessible by car than by public transport (of which employers, workers and the government remain wary).

The board has two aims to balance. It has historically placed great emphasis on maintaining the 2p-a-quarter dividend. However, in the short term it has said it is keen to reduce gearing and to proceed with caution. We think the high levels of cash (£15m after the repayment of £12m of debt) mean the board has some flexibility in meeting both these aims, although time will tell which it will prioritise. The board has said that it intends to continue to pay the 2p dividend, but notes the outlook is unclear given the current situation, and so a dividend cut has not been ruled out.

One task will be to replace the £1.32m rental income lost after the sale of Corby, 7.6% of the rent roll. With the sale having gone through in May, Q2 rental income will include the final payments from that property for part of the quarter, but the task for the manager will be to replace that income in order for the 2p-a-quarter dividend to be sustainable. With £15m of cash, were it all to be reinvested the manager would need to generate a yield of 8.8% to replace the £1.32m in income, which is at the top end of the typical 7–9% net initial yield AEWU buys assets at.

AEWU is managed by Alex Short and Laura Elkin. Alex and Laura work for AEW UK, a subsidiary of the AEW group of companies, one of the world’s largest real-estate management groups, which is ultimately owned by Natixis. Alex has 23 years’ experience in property investment, joining AEW in 2014 from UBS, where she managed property funds. Laura has 14 years’ experience, having worked as a surveyor and in property investment before joining AEW in 2013. She is chiefly responsible for sourcing investments. Both are chartered surveyors.

AEW UK is a joint venture between the AEW UK management team (led by Richard Tanner, Rachel McIsaac and Nick Winsley) and AEW SA, the French parent company. AEW UK has two decades’ worth of pedigree investing for institutional clients, and launched AEWU in 2015 to serve the wealth-management and retail markets. Alongside the REIT, it runs core and specialist property funds in open-ended and limited-partnership structures. AEW UK has 13 investment and asset-management professionals, as well as an extensive operations and support team. With the core of AEW UK’s management team owning 50% of the equity of the trust, there is strong alignment of interests between investors and management. Various team members are also personally invested in AEWU.

AEW SA has c. €71bn in AUM, employing over 700 people in Europe, Asia and North America. It runs property funds in a variety of structures and for a wide range of clients and is the real-estate platform of French bank and asset manager Natixis.

AEWU has fallen onto a discount of 20% compared to an AIC UK Commercial Property sector average of 12.5%. As the graph below shows, the trust has tended to trade on a higher rating than the sector (five-year average +0.3%). However, following the coronavirus crisis, not only is the trust trading on its widest ever share-price discount, but it is also trading wider than ever before relative to the sector average.

This discount has emerged despite the fact that the trust faces a continuation vote in September. Ordinarily, we would expect the share price to trade closer to NAV prior to a continuation vote, given that this represents a possible exit at close to NAV, although winding up a property portfolio is not straightforward and so might merit a modest discount. However, this closure has not yet happened. In our view the discount likely reflects scepticism about the value of the portfolio, in that a wind-up could lead to realisable values significantly lower than reported NAVs.

We think these concerns are overdone. As the latest NAV shows, valuers have notably not yet seen fit to write down commercial property as a whole. Clearly there are still challenges to come for the sector, although with offices and retailers opening up there should be more transactions done, which should hopefully reduce uncertainty.

The board has the ability to use buybacks to control the discount but has not done so. Rather it has aimed to grow the trust by issuing shares, most recently raising £7m in February at a premium to NAV.

AEWU has ongoing charges of 1.34%. This compares favourably to the AIC Direct Property – UK Commercial sector average of 1.54%, despite AEWU’s net assets of £148m being considerably below the sector median of £284m. One of the board’s key performance indicators for the trust is that this figure should remain below 1.5%. The management fee is 0.9% of NAV, but this is charged only on invested funds rather than any cash on the balance sheet. There is no performance fee.

AEW UK believes that incorporating ESG considerations into investment is essential to protecting and enhancing the value of assets it purchases. The company expects both occupiers and investors will increasingly focus on ESG issues. In the property market, it expects this to impact building obsolescence, lettability, rates of lease renewals and ultimately the rental and capital values for individual assets, which will impact the potential for resale and for asset management.

AEWU is a member of the Global Real Estate Sustainability Benchmark (GRESB), which commits it to reporting its performance on ESG metrics so it can be compared to peers and to its past record. It currently has two out of three green stars awarded for its performance, having improved its score in 2019 from that of 2018, when it was awarded only one star. GRESB membership is intended to provide transparency to the end investors.