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Custodian Reit (LON:CREI) ) has performed strongly in recent years, delivering a total shareholder return of 10% a year over the last three years, and with lower volatility than the REIT sector or the stock market. In this report, we look at the fundamentals that drive this performance.
Custodian Reit (LON:CREI) manages a portfolio of commercial properties across four sectors – Industrial, Retail, Office, and “other” (leisure etc.). The portfolio is broadly spread across UK regions, with a focus on properties offering high rental yields. Custodian differs from many of its peers in that its strategy is to buy lots sizes of below £10mln. We examine the benefits of this strategy in this report.
The company has a disciplined approach to acquiring properties, avoiding purchases that dilute the rental yield of the portfolio or which carry significant risks. Financing of purchases is also conservative, with the company maintaining a low loan-to-value ratio of 21.0%. Equity is issued only when it can be done without diluting returns for existing shareholders. More details of the company’s approach to capital discipline are included on p8.
REIT investors seek not only a high dividend yield but of course a high degree of confidence in future dividends. In this report, we examine some of the factors supporting Custodian REIT’s dividend. The company compares favourably to peers in terms of solid levels of dividend cover, and low balance sheet gearing. We argue that Custodian provides a strong dividend yield combined with a high degree of confidence going forward.
The shares currently offer a forward-looking dividend yield of 5.4%. We argue that Custodian also offers an attractive risk profile underpinned by a well-balanced property portfolio.
Custodian has materially outperformed the UK REIT sector in the last few years. In this report, we look at some of the factors that underpin this performance.
We start with an overview of the outperformance itself. The following chart shows the performance of Custodian against the iShares UK property ETF (IUKP.L).
It’s important not only to note the outperformance but also the low volatility. We particularly draw attention to the period around June 2016, the Brexit vote.
Investors in the REIT sector are of course typically seeking income (dividend yield) more than capital gains. In this respect also, Custodian has performed well, delivering 17.85p of dividends over the last three years, for a total shareholder return of 10% a year over the past three years, versus 3.8% for the sector (again using IUKP.L as a proxy).
At the current share price, Custodian offers a forward-looking yield of 5.4%, among the highest on offer. The following chart shows the dividend yield for Custodian compared with peers. We have selected a peer-group consisting of some of the most comparable REITs. If we were to include some of the larger names in the sector then Custodian compares even more favourably.
In this report, we consider some of the factors behind Custodian’s performance:
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.
We next present some details of the largest sector – Industrial – and an overview of the other segments.
Industrial properties represent 39% of Custodian’s income. These include a large portfolio of warehousing and distribution facilities, as well as manufacturing and other industrial activities.
The image shows a typical representative of Custodian’s Industrial portfolio.
A notable feature of the UK Industrial property market in recent years has been a lack of capacity addition. The following chart shows new industrial space coming on-stream over the last 10 years.
Capacity additions fell sharply after the 2008 financial crisis, and have barely begun to recover.
This has led to upward pressure on rents, with a time lag. The lag exists because rental agreements are often multi-year, and so it takes time for capacity tightness to translate into realised rent increases.
During 2016 and 2017 the expected rental increases in Industrial have begun to come through. The following chart shows rental increases in 2017, for the market as a whole.
In its latest update on April 24, the company indicated that it continues to take a positive view of the Industrials sector, albeit with limited opportunities to make further acquisitions in the space at attractive prices.
In the office space, Custodian is focussed on strong regional markets, with a broad spread across the UK. The image shows a typical example of Custodian’s office portfolio.
In its update of April 24, Custodian indicated that rents are still growing within the company’s office portfolio, which we believe reflects the absence of any Central London exposure (see Ch#6).
Custodian REIT’s retail portfolio includes high street (14% of the portfolio, by income) and retail warehouse stores (20% by income). The images show a typical example of Custodian’s holdings in each segment.
In the update of April 24, Custodian indicated that there is downward pressure on rents in the high street segment, while the retail warehouse segment remains more insulated from these pressures due to supply constraint. At the company-wide level, the relative weakness of the retail segment is offset by stronger conditions in the other segments.
The “other” segment includes properties such as bowling alleys, restaurants, and health centres. These alternative property investments remain a focus for further acquisition
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.
Another benefit of the small lot strategy is low exposure to any one individual tenant. The following table shows Custodian’s position versus some examples of the peer group, in terms of rental yields and in terms of tenant exposure. We’ve included just two peers as examples, but most of the other peers in Ch#2 publish this data in their quarterly fact sheets, so the reader can verify that the trend holds on a wider basis.
A potential concern about the small lot strategy is cost – surely there must be more expense involved in managing a large number of small units? However, Custodian’s financial data shows that this is not the case. In the following chart, we have examined this question by measuring how much of the REIT’s rental income comes through as operating profit.
The measure is not necessarily a measure of “efficiency” per se. Some of the peers have more cost simply because they operate a rental model with a higher service element or with a higher void rate; however, we would argue that the chart supports our main point – Custodian benefits from high yields and a diverse tenant base, without suffering any cost penalty.
We have demonstrated that Custodian offers a higher dividend yield than the peer group, and has been delivering higher total shareholder return.
We next consider the crucial question – how safe is the dividend? After all, it is always possible to deliver higher returns by taking more risk. We focus on two measures of risk: 1) how geared is the balance sheet?, and 2) how well covered is the dividend by rental income?
The following chart shows the dividend yields of our REIT peer group, compared with balance sheet gearing, as measured by the loan-to-value ratio (3-yr average)
We can see that Custodian screens favourably on this measure – high yield, low gearing.
We next look at dividend cover – EPRA EPS (see glossary) divided by dividend per share. The following chart shows this measure on a 3-year average basis for Custodian versus the peer group. Once again, Custodian screens favourably.
Looking at the two charts together, it is notable that the only name that scores better than Custodian in Ch#9 is Picton, which screens less favourably in Ch#8. Conversely, two of the names which appear in the “favourable” segment of Ch#8, FCPT and UKCM, appear on the left-hand side of Ch#9. Taking the two measures together, we argue that Custodian offers an attractive risk/reward profile – high dividend yield with low risk to the dividend.
Finally, we take a look at capital discipline, which is a compelling feature of the Custodian REIT investment proposition.
The left-hand chart shows Custodian’s net operating cash flow, in terms of how much is retained, and how much is paid out as dividends. The right-hand chart shows the financing of Custodian’s property purchases, on a 3-year average basis.
The charts tell a simple story – most of the cash from rental income is paid out to shareholders, with new investments financed by about 20% debt and 80% new equity issuance.
Crucially, when Custodian has issued new equity, it has always been at a premium to net asset value (NAV)/share. The company has a strong culture of prioritising wealth creation to existing shareholders – there is no question of diluting existing shareholders in order to “build the empire”.
The next chart shows the net initial yield (see glossary) for Custodian’s most recently reported acquisitions, compared with the existing portfolio.
With available yields declining in some segments of the commercial property market, the temptation for commercial property funds is to keep buying on higher valuations (lower rental yields). Custodian has a clear policy of avoiding chasing the market – the company is happy to slow down its acquisition activity in order to protect its high yields. This is another example of prioritising wealth creation to existing shareholders.
The following tables include our forecasts for Custodian’s profit & loss (P&L), balance sheet, and cash flow.
EPRA – European Public Real estate Association
EPRA EPS – Earnings per share excluding property revaluations and other non-operating items
Net initial yield – annualised rental income divided by gross market property value, adjusted for estimated purchasers’ costs.
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