Palace Capital Analyst Q&A: Continued outperformance (LON:PCA)

Hardman & Co

Palace Capital plc (LON:PCA) is the topic of conversation when Hardman and Co’s Analyst Mike Foster caught up with DirectorsTalk for an exclusive interview.

Q1: What does Palace Capital invest in as a REIT, Mike?

A1: A real estate investment trust , it has unusually for REIT’s, a reasonable amount in development assets and those developments are partly residential sale and partly offices to be retained by the company so that slightly makes it stand out.

The other key feature is that 43% are in offices, they’re all regional offices so nothing in central London, nothing really high rise so the typical office would be four/five storeys, relatively low occupation density, the centre of cities like Liverpool, Newcastle, Manchester, there’s Milton Keynes, quite a big office investment as well.

So, 43% in regional offices, 18% in development, that is almost exclusively one site in the centre of York and by the centre I mean within the city walls, it’s a mixed development of apartments which was launched a year ago and has been selling well, and offices.

The rest of the assets are split. You’ve got leisure which is a bit under 20% so leisure clearly is an area that has got some tasks and we’ll talk about leisure later on but the key things there is that they’ve got very long lease terms on leisure, 11.3 years to break. They’ve got some industrial assets which has obviously a strong market and they’ve got a little bit under 10% in retail parks typical tenants being Wicks, Pets at Home so that’s a stronger part of retail and they’ve got a bit in all the supermarkets.

They’ve got virtually nothing in high street shops, the only high street shops they’ve got really are part of a very small mixed use developments and they’ve got no shopping malls or anything like that.

Q2: So, can you tell us how the company has performed?

A2: There’s two answers to that, one is looking at the share price and the other one is looking at the total return on the assets i.e., the assets plus the income off them.

The shares are currently trading on about a 43% discount to NAV. Regional REIT’s and indeed REIT’s in general are out of favour and we think that this is an interesting opportunity to look at. If you look at the performance of the assets, this REIT is about six years old, and the performance in the past four years of the assets has outperformed the MSCI benchmark index in each of those years, including, admittedly moderately, an outperformance in the latest six months.

So, it seems to me that this is something where you got very decent yield on assets and something that’s trading at a big discount to NAV where those assets appear to be outperforming, admittedly modestly, but still outperforming the market.

Q3: Can you give us a bigger view on the strategy?

A3: We talked about the development aspect, I don’t want to over egg that, the strategy is, as we see it anyway, very much a regional one but a city centre dominant regional one and the cities that they pick are ones that have been seeing, obviously this past year is a very difficult and unusual year and we’ll see how it comes out of it, an increase in demand because they are city centre locations.

A lot of the tenants would be either large regional tenants or indeed some of them who are moving out of London. You’ve also got the benefits, because of its being offices, of the fact that city centre yet low rise offices are areas that would seem relatively attractive, particularly because the typical rents are about £20 plus or minus per square foot for the city centre offices like in Manchester, that the company has.

If you look at more recently developed modern city centre offices in these cities, the rents go up to about £30 a square foot so they acquire centrally located modern, but not perfect new build, offices which does allow them scope to raise the rental income modestly and steadily by perhaps refurbishment or working through improving the tenant base.

There is also the development angle, now the development is twofold. They’ve got 18% of their assets in development assets in this site in York but they also, for example, bought a relatively low coverage of the site office block in central Manchester, three streets away from Piccadilly Station. That’s quite happily going along with generating an income but because it’s got low site cover, quite a big car park, there is scope later on if appropriate to undertake redevelopment either by small new build or major refurbishment, or by knocking it down and starting again, or even selling it on.

So, the policy is that although there’s focus, 43% offices and all in the regions, there are lots of different ways of trying to add value through asset management on a detailed level. The strategy also is to go for the higher yields and a lot of the income is generated by that high yielding office market.

Q4: If part of the strategy is development, is that not really a risk?

A4: So, we see it as actually reducing risk.

Obviously, development always has a risk and their development which is predominantly residential flats, clearly you are at the mercy of the market in terms of buyers there but sales rates have been at the prices budgeted pre-COVID and sales rates have been at, or slightly faster, than the budgeted rates. Nonetheless, obviously it is a risk.

The cash that comes in from selling these apartments is cash so if one of the risks of a property company is the gearing and if the market turns against it, the gearing works the wrong way. the fact that you have developments which do turn into cash is obviously a positive, the loan to value for the group as a whole is 42% at the moment because they’d been putting money into this development asset but it will come down to just over 30% in later calendar ‘21 when, and we confidently believe, these apartments finalise their sales.

At that point, there’ll be two things that reduce risk.

One is the lower debt and two is that you’ve got scope to reinvest all, or maybe part, of that cash into yielding assets so you’ve got to bear in mind at the moment, you’ve got 18% of assets tied up in developments which we anticipate actually will be very good with a 50% return cash on cash on those developments.

Nonetheless, at the moment, those developments are generating nothing for the P&L so the risk is in fact that you’re going to get a little bit of a step up in returns once that cash comes back onto the balance sheet for redeployment.

In terms of the other development angle, they have on the office side started marketing, it’s a very small block that has found a very good tenant, a quoted legal services company, Knights. The balance of it, they’ve only just started marketing nonetheless, this is very central York and there’s not much competing office space, clearly the market in 2020 is uncertain so there is an uncertainty there. Just to circle back to the fact that it’s not yielding anything at the moment because it’s under development so any yield is really on the upside in terms of returns.

Q5: Finally, what other risks should we be looking at with Palace Capital?

A5: We like this REIT, we think that the development side is going to have a 50% cash on cash returns, the assets have outperformed the benchmark in each of the past four years, the income yields are good.

Clearly, there are risks in any real estate model and particularly 2020 is a difficult time.

I mentioned that leisure is a bit under a fifth of the assets, clearly that’s a difficult market, nonetheless the tenants are all paying, some of them have renegotiated void periods, rent breaks, but the leases have been extended in all those negotiations. So, the leases on leisure, which are already just into double figures are now 11.3 years and all the tenants have been paying as per the contract apart from two small CVAs of restaurants.

So, the leisure aspect, you’ve got core hotels, you’ve Wetherspoons, you’ve got Vue Cinema and these are tenants with obviously difficult businesses in 2020, but good covenants and paying.

There’s two leisure assets so they’re not easy to manage but at least you’ve got two assets that you can work on rather than having a whole range of different assets.

The majority of the portfolio, which is in offices, there you’ve got a lot of different assets and the weight average lease term is much shorter, 2.8 years so that clearly is a risk. Nonetheless, we have got every confidence that the rental values, which decreased 7% in the first half, are around about bottom, the 7% decrease was a couple of sales actually so the like-for-like decrease was much less and there is scope for voids to be filled in offices.

You’ve got £8.5 million contracted income in offices, that would rise to £10.9 if the voids were filled so there are a few voids and the market is not easy, however, as I said earlier, the share price is trading at a 45% discount to NAV and we actually do think that the voids will reduce in offices as 2021 progresses.

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