UK Commercial Property REIT (UKCM) is the largest generalist commercial property trust in its AIC sector with net assets of over £1.1bn. Manager Will Fulton, of Aberdeen Standard Investments, aims to buy assets which are benefitting from structural social and economic themes which should support capital values and income growth. This has led to a progressively high allocation to the industrials sector, helpful during the pandemic, as it benefits from the shift of retailing online. It has also led to an increasing allocation to areas of the alternatives sector which Will thinks are benefitting from secular growth trends, including student accommodation and supermarkets.
As discussed in performance, the portfolio has been relatively resilient during the crisis thanks to the industrials weighting and to prudent levels of gearing when the pandemic broke out. However, the dividend was cut in half in April 2020 as a response to the lockdowns and their unknown impact. In fact, the rent collection has outperformed these feared worst-case scenarios, and so potentially there is scope for a raised final dividend payment this year - which could lift the annualised yield on the current share price to 2.1% or above.
UKCM trades on a discount of c. 17% to NAV. While during the earlier period of the crisis it was narrower than its generalist peers on average, this is now in line with the peer group tracked by JPM Cazenove.
UKCM has the lowest net gearing of the generalist UK commercial property trusts at just 6.4%. Will has a total of £218m of cash and undrawn credit facilities to put to work to boost income, in what he hopes will be a year of recovery.
We think UKCM is an excellent core property portfolio to hold for the long term, although we acknowledge the yield is unexciting in the short term. Will’s approach to identifying secular themes and positioning the portfolio accordingly really paid off in 2020, even if via a black swan event. With capital values in retail and offices likely to be under pressure in a weak economic environment, the focus on alternatives also looks well-timed with attractive yields of over 5%, although the income generated from the student properties will not come online until the 2022/2023 academic year.
In the short term it may take an increase in the dividend to close the discount, or at least the market seeing a clear path to that, given that most property investors are probably seeking a yield rather than share price appreciation. As we discuss in the dividend section, we think the outlook on this front is good. A deployment of the substantial cash and borrowing facilities on hand in the coming months would be one potential source of dividend growth. In the immediate term, with the current quarterly dividend more than covered by the rental income being collected, this means that a top-up payment to the dividend in April is a distinct possibility.
|A portfolio tilted to the top-performing and resilient industrial sector
||Commercial property is sensitive to GDP and the UK is passing through a downturn
|Lots of uninvested cash and borrowing facilities on hand
||Unpredictable outlook for alternatives sub-sectors in the short term
|Scope for dividend reinstatement depending on progress of recovery
||Yield is low relative to peers
UK Commercial Property REIT (UKCM) is the largest generalist trust in the AIC UK Commercial Property sector with net assets of over £1.1bn. It aims to generate attractive income and capital growth from a diversified portfolio of property assets. Since taking over in 2015, manager Will Fulton has steadily focussed the portfolio on the industrials sector which has been benefitting from the secular shift of retailing online, and away from bricks and mortar retail. This positioning has proved helpful as the pandemic has helped this trend accelerate, with consequences for valuations in the respective sectors. Will is now looking outside the mainstream sectors for resilient ‘future fit’ yield, making further recent investments in student accommodation and supermarkets at attractive yields, although the student properties are forward funded and won’t generate an income until the 2022/2023 academic year. The chart below shows the current positioning versus the latest data from the MSCI IPD Balanced Monthly and Quarterly Funds index.
We think it is fair to say that Will takes a conservative approach to management, which has proven helpful given the sudden economic disruption that the coronavirus pandemic has caused since March 2020. Rather than chase yield in areas of secular decline, he looks to identify properties with strong long-term fundamentals. To be more specific, he looks to identify social, demographic and technological structural trends, which should support certain types of property and certain locations. It is this that has led to the increasing focus on the industrial sector rather than high street retail and shopping centres, and it is this that supported the beginning of a shift into alternatives prior to the pandemic. At the time, the trust broadened its investment policy to allow the manager to invest in all alternatives sub-sectors, rather than just the leisure space.
While some of the initial purchases have proven unluckily timed – the lockdowns were particularly destructive for the cinema industry – interest in the alternative sectors is clearly going to be an ongoing theme. In March 2020 UKCM signed a forward funding agreement for the construction of a 221-bed student accommodation complex in Exeter. This should generate a 5.6% income yield net of operational costs once completed for the 2022 academic year. In December 2020 it signed an agreement to forward fund a similar development in Edinburgh on an expected net operating yield of 5.5%. In the same month UKCM bought a supermarket let to ASDA in Torquay on a 15-year lease and a net initial yield of 4.7% rising to 5.25% in July. We expect the trust to continue to explore such opportunities, particularly given that high demand has driven down yields on the industrials sector. Having entered the crisis with low gearing and cash on hand thanks to his conservative approach to valuations, Will is in a good position to acquire such assets in the future and thereby continue to reshape the portfolio.
Will looks for high quality properties in areas with strong economic fundamentals. There is a strong emphasis on the South East, the economic engine of the country. That said, exposure to London has been cut to 19%, with only one office asset in the centre of the city. Will believes that a partial shift to home working will hit demand for office space, with London to be particularly affected. This is another example of Will’s conservative approach working well for shareholders: he reduced his exposure to London offices due to high prices and concerns about the impact of Brexit before the outbreak of the pandemic. The exposure to the city is concentrated more in peripheral industrials. For example, UKCM’s portfolio includes a large Amazon distribution hub in Wembley, which the retailer leased in 2019 for ten years on an inflation-linked contract. In Q1 2020 UKCM sold Eldon House in London, reducing its exposure to the City to zero.
The remaining retail exposure is mostly in retail warehouses and out-of-town retail parks. These account for 67% of the headline retail exposure of 19%, with the remaining third also including the supermarket acquisition. Retail parks can operate as nodes in last mile distribution networks for online sales and click and collect sites, meaning they gel better with the new omnichannel strategies of retailers. The fact they are generally accessible by car and that they occupy more space, allowing for more customers to shop in a ‘socially distanced’ fashion, is also helping during the pandemic. Of this exposure, the majority is represented by three out-of-town retail parks in strong locations: Kew, Tunbridge Wells and at Junction 27 of the M62 near Leeds.
The focus on quality and on social trends has also led to an increasing focus on ESG considerations, as we discuss in the ESG section. This is another area which is likely to see change occur thanks to the pandemic. First, office tenants are likely to demand ‘greener’ properties and have the bargaining power to insist, given the lower overall demand. However, there may well also be a greater emphasis on social responsibility on behalf of business and property owners, which we have seen during the crisis period. To that end Will and the team have been working hard with tenants to help give them a path through their current difficulties. This has resulted in some good financial outcomes for the Trust too, with lease ‘regearing’ – removing break options and extending lease duration. Occasionally it has meant forbearance too rather than pursuing a troubled tenant legally.
It has understandably been a busy period for asset management. Over the course of 2020, the team managed to reduce the voids on the portfolio from 10% of ERV to 6.5%. This was helped by the letting of a major facility at the Lutterworth industrial park to Armstrong Logistics on a 15-year lease. The anticipated sale of the vacant Network House in Hemel Hempstead at valuation (in the office sector) will also reduce voids again when it completes, bringing them down to just 5%. We are likely to see a high level of activity continue, with leases providing 8.4% of the rent by passing value ending in 2021. Only a quarter of this is in retail (2.3% of ERV). The tenants are Boots, TK Maxx and Gap. More than half is in the industrial sector.
UKCM entered the coronavirus crisis with one of the lowest levels of gearing in the peer group, and gearing has reduced since then. UKCM has borrowings worth 15% of NAV but holds enough cash that, on a net basis, gearing falls to 6.4% (as of 31/12/2020). This compares to gross and net figures of 18% and 15% at the end of 2019, respectively. We think the low level of gearing is one reason UKCM was rewarded with a narrower discount than its generalist peers following the initial impact of the crisis, but most importantly it means the manager is well-placed to refashion the portfolio for the post-pandemic economy.
The current debt of £350m has a weighted average period to maturity of 8.2 years and an all-in rate of 2.88%. Will has £150m of undrawn borrowing facilities available and a further £68m in cash for total available capital of £218m, c. 19% of NAV. We think this puts UKCM in a strong position to weather the rest of the pandemic, while also putting it in a great spot to take advantage of any opportunities thrown up by the crisis. Will is able to pursue opportunities in the sectors he thinks offer the best potential for income and growth going forward rather than being tied to past decisions, and the recent commitments to attractively yielding student accommodation assets and supermarkets may indicate how part of the portfolio is going to evolve, while we note Will is positive on the fundamentals for the industrials sector.
UKCM has generated NAV total returns of 22.3%over the past five years (to 15/02/2021) according to Morningstar data. This compares to an average return of 27.8% for the members of the AIC UK Commercial Property sector. However, the sector is flattered by the presence of a number of sector specialists in the outperforming industrials sector. Restricting our analysis to the true generalists, UKCM’s returns are in line with the average returns of the peer group according to JPM Cazenove.
Past performance is not a reliable indicator of future results
Returns on commercial property have drifted down in recent years, with declining interest rates one factor. The Brexit referendum result led to some weakness in the office sector, while the ongoing shift from retail online has led to that sector underperforming. In 2020 the pandemic led to both sectors performing poorly, retail especially, and industrials outperforming. Logistics have benefitted from the shift of retail online and more tenants of industrial properties have been able to keep trading. There is also a Brexit stockpiling affect which has helped warehouses, and Will believes will do so in the near future. Again, the comparison to the sector is slightly misleading. UKCM lost 0.8% in NAV total return terms in 2020 according to JPM Cazenove. The average generalist trust lost 3.3%. The portfolio’s high exposure to industrials was helpful, as were the low levels of gearing entering into the crisis.
Past performance is not a reliable indicator of future results
UKCM’s industrials holdings outperformed those in the benchmark, the MSCI IPD UK Balanced Portfolios benchmark, thanks to superior capital returns and a lower income return. As the largest exposure in the portfolio (ending the year at 58%) this helped drive relative returns. On the other hand, the portfolio suffered due to exposure to alternatives. This included two cinema-anchored properties which were forced to close for most of the year. Overall the portfolio saw greater capital appreciation.
The hit to capital values of UKCM’s portfolio has unsurprisingly been much greater in the retail and alternatives sectors. These were written down by 12.2% in the first half of the year (11.1% in the index) and 13.5% (6.9% in the index) respectively. The alternatives exposure was therefore responsible for the slight underperformance compared to the benchmark in that period. They suffered from being made up mainly of leisure, for example cinemas, which were forced to close for almost the entirety of the year. UKCM’s alternatives exposure saw a decline of 4.5% on a total return basis in the second half compared to a fall of just 0.2% in the index. The retail exposure actually outperformed in a falling market.
With their alternatives exposure, Will and shareholders have been unlucky, as the lockdowns were black swan events. The high weighting to industrials however is testament to his good decision to prioritise this sector over retail in the years before the crisis and has had a positive impact in the crisis. A high exposure to industrials previously helped the portfolio outperform in 2016 and 2017 (see above chart). However, despite the underweight position, the exposure to the retail sector was damaging in 2018, causing the trust to underperform the index. Indeed, had it not been for capital falls of 12% in the trust’s holdings in that sector – versus a 5.4% fall for the sector in the benchmark – the trust would have comfortably outperformed. The high levels of cash and undrawn borrowings Will has available gives him flexibility to refashion the portfolio, and the recent purchase of a supermarket on a long lease and commitments to student halls developments indicates where he thinks some of the best opportunities are.
The board of UKCM cut the dividend in April 2020 like most of its generalist commercial property peers. UKCM’s dividend was halved to 0.46p a quarter. This has proven to be a conservative decision, with the income generation outperforming these commitments and we understand a payment of a minimum of 0.4p a share is expected to be added to the final dividend payment for the year (to maintain the regulatory requirement to distribute 90% of income). Incorporating this, the yield on the current share price rises to 2.1%, although we note there is still scope for a higher final payout than 0.4p. The factors that have made UKCM a more resilient investment in the crisis have also reduced the yield. The low level of gearing and high cash balance reduce income potential and the industrials sector has seen tightening pricing thanks to it being an obvious beneficiary of the lockdowns. However, it is evident that the current income generation of the portfolio is ahead of what was feared, raising hopes of further increases when economic activity is restored to normal levels.
UKCM managed to collect 83% of rents over the COVID-impacted quarters of 2020. This predictably varied across sectors, with 91% of rent in the industrials and offices sector received and only 67% in retail and leisure (much smaller parts of the portfolio). Once the rent recovered later than quarter end and commercial regeared leases are included, the rent collection for the portfolio as a whole rises to 90%. The team continue to work hard to recover rents due, working with tenants sympathetically given the ongoing restrictions. A focus on quality assets and tenants when letting has proven helpful. Odeon Cinemas, forced to close for most of the past year, has extended the lease on its Kingston cinema out to 15 years in return for an element of rent-free during 2020.
Will has a significant amount of capital to invest. UKCM has £68m uncommitted cash and £150m undrawn credit facilities, and he is looking for ‘future fit’ properties which will boost the income. In the final quarter of 2020, UKCM committed a total of £57m to student accommodation projects in Edinburgh and Exeter which are expected to produce net operating yields of 5.5% and 5.6% respectively and are due to open for the 2022/2023 academic years. It also purchased a property let to ASDA in Torquay on a 15-year lease with an NIY of 4.7% rising to 5.25% in July. These were funded in part by disposals. The manager illustrates the rent roll could theoretically increase by around 41% on the current rent bill, assuming uncommitted cash can be invested at 5% and all property is leased at its rental value. While this is theoretical and many elements will change, it does indicate there is potential for the yield to rise in the coming years.
The lead manager is Will Fulton and he draws on the work of a team of four other investment professionals in the UKCM Real Estate Team, as well as two in the Real Estate Finance Management Team. UKCM also benefits from the deep resources at Aberdeen Standard Investments in terms of support functions, such as debt, risk management and insurance.
Throughout Will Fulton’s 30-year career he has held a variety of commercial real estate positions both in the UK and across continental Europe. During this time, he gained multi-disciplinary experience spanning investment, valuation, asset management, debt facility management, development and investor relations. Before focussing exclusively on UK Commercial Property REIT from early 2015, he oversaw a team managing the £2.3bn Standard Life Heritage With-Profits real estate fund. Will is a chartered surveyor and joined Standard Life in 1987 from university.
UKCM trades on a discount of c. 17%. While this is wide in absolute terms, it is in line with the 20.5% average of the generalist UK commercial property trusts tracked by JPM Cazenove, and UKCM is the median trust in that peer group. UKCM’s discount has been narrower than most of its peers through much of the post-pandemic period, with the low level of gearing and high industrials weighting providing resilience which we think was driving a narrower rating. However, it may be the relatively low yield is keeping the discount wide at the current time. We note the yield on the current share price is 2.1%, incorporating the 0.4p extra payment expected in the final quarter of the financial year. This compares to an average of 4.5% on the peer group.
Clearly there is a trade off to be made between yield and security, with the highest yielders more exposed to the troubled sectors. We think further tightening of the discount could come as lockdown easing increases confidence in the sector, but a restoration of the dividend may be necessary for a significant move. The full sector average of the AIC UK Commercial Property sector in the graph below is biased upwards, due to the presence of a number of sector specialists which are in less economically sensitive sub-sectors such as logistics (and are shortly to be moved to their own sector by the AIC).
The board has the authority to buy back up to 14.99% of the share capital, although they have not used that prerogative in recent years. The board intends to use the buy-back authority – which is subject to the income and cash flow requirements of the company – if the level of discount represents an opportunity that will generate risk-adjusted returns in excess of that which could be achieved by investing in real estate opportunities at a particular time.
If the discount remains wider than 5% for 90 consecutive days, the board is obliged to call an EGM to discuss a continuation vote. Since a continuation vote was passed in March 2020, however, a further continuation vote does not need to be held for at least two years in relation to the discount control mechanism. The trust also has a number of periodic continuation votes as dictated by its Articles of Association, the next of which is scheduled for 2027.
The ongoing charges are 1.56%, compared to a weighted average of 1.50% for the AIC Property – UK Commercial sector. However, the last calculation date was December 2019. At that time, excluding direct property costs (putting it on a more level playing field with equity trusts), the ongoing charges fell to 0.8%. The management fee since January 2019 has been 0.6% on the first £1.75bn of gross assets and 0.475% on the remainder. The KID RIY figure is 1.84%.
The efforts by the board and management team of UKCM to emphasise ESG concerns have been recognised by external analysis. UKCM was ranked second in the listed UK Diversified peer group by the Global Real Estate Sustainability Benchmark (GRESB) for 2020. It was awarded two green stars (down from three in 2019). UKCM has also won an EPRA Gold rating for sustainability Best Practice Recommendations.
The board and management team of UKCM believe that ESG matters are increasingly critical to investment returns in commercial real estate. Issues of energy efficiency and climate change, resource usage and the social impact of the urban environment are all critical to occupiers of space who choose more carefully, and investors in real estate who are interested in sustainable cashflows. The team believe this transfers to shareholder returns from property. To that end they have adopted the ESG policy of the investment manager, Aberdeen Standard Investments, which is underpinned by three principles:
- Transparency, Integrity and Reporting: being transparent in the ways in which the company’s strategy, approach and performance are communicated and discussed with its investors and stakeholders.
- Capability and Collaboration: drawing together and harnessing the capabilities of its ESG platform, with the insights and experiences of its property consultants and industry best practice.
- Investment Process and Asset Management: integrating ESG into decision making, governance, underwriting decisions and asset management approach. This includes the identification and management of material ESG risks and opportunities across the portfolio. The approach clearly involves proactive elements, rather than simply responding to industry or societal norms.
In addition, UKCM has published its own bespoke ESG document entitled ‘Dialling up the Integration of ESG’, which the board urges all UKCM stakeholders to read and is available on its website.
The managers have identified four major forces for change which guide the prioritisation and integration of ESG factors in the portfolio. These are: Environment and Climate; Governance and Engagement; Demographics; and Technology and Infrastructure. Together they make up the ‘ESG Impact Dial’, a proprietary research framework which is used to guide investment decisions as well as asset management work. The managers work in partnership with contractors, suppliers, occupiers and consultants in order to seek continuous improvements in ESG performance within the framework provided by those megatrends.
UKCM reports extensively on its progress in ESG matters in its annual and semi-annual reports to shareholders. Clear and detailed numbers on performance are given, allowing investors to track and monitor progress. In our view UKCM has excellent ESG credentials among the diversified commercial property trusts.