So, with income hungry investors being deprived of meaningful returns from government and corporate bonds, finance rates ultra attractive on commercial and residential property lending, and likely to stay that way for some time yet, then the wide share price discounts to net asset value on some property companies look ripe for narrowing.
I made this point when I covered the pre-close trading update from property investment company Alpha Real Trust (ARTL:96p) in quite some depth (‘Alpha seeks alpha’, 23 August 2016); noted a short-term trading play on East London housebuilder Telford Homes (TEF:314p) the previous day (‘London trading play’, 22 August 2016); and highlighted the obvious value in the shares of Conygar (CIC:159p), a property fund (‘Insiders buying on solid foundations’, 11 August 2016). I also spotted another undervalued special situation in the shares of First Property Group (FPO:47p), a property fund manager (‘Exploiting sterling weakness’, 18 August 2016).
A retail property play
For good measure, I have identified another sector play well worth considering, Local Shopping REIT (LSR:26.5p), a small cap retail sector focused property investment company with a market capitalisation of just £21.8m and one that’s in the process of selling down its portfolio with a view to returning the cash proceeds to shareholders. The change in investment policy was approved by shareholders in July 2013 and the completion date for the disposal programme is end 2017. The board have been successful to date, having sold off in excess of £94m worth of assets in the past three years.
The remaining portfolio now comprises 336 individual retail properties which have over 900 units and generate an annual rent of £7.1m net of head leases, offer a market rent of £7.67m, and were valued at £76.7m at the end of March 2016. Chartered surveyors Allsops LLP used an equivalent yield of 9.5 per cent to value these assets which seems reasonable to me given that 70 per cent of LSR’s properties are let to individuals or local companies, and over 60 per cent of the leases are less than six years to expiry, so investors will demand a high yield. The units are generally located in local shopping parades and neighbourhood venues for top-up convenience shopping with around 59 per cent of the portfolio classified as A1 shops, 9 per cent cafes, and 6 per cent takeaways. Almost 15 per cent of the portfolio is residential and encompasses 219 units worth £11.39m, or £52,000 each.
In terms of the portfolio valuation, two thirds of the properties were valued at less than £200,000 and accounted for £21.6m of the total portfolio; 81 units were worth between £200,000 and £500,000 to account for £24.5m of the portfolio; a further 21 units were valued at between £500,000 to £1m and had a combined valuation of £15m; and the remaining 8 units had a valuation of £15.6m.
Orderly wind down of portfolio
The key here is that the company has gross borrowings of £53.4m with HSBC secured against the £76.7m portfolio to give a loan-to-value ratio of 72.4 per cent, well within the 82.5 per cent covenant. In addition, LSR holds £12.3m of cash on its balance sheet which, if applied to the HSBC credit line, reduces debt to £41.2m and lowers the loan-to-value ratio to 53.7 per cent. In other words, there is no financial distress here at all and, with 20 months remaining until the HSBC facility expires in April 2018, LSR’s board are not under pressure to make fire sales to meet the end 2017 target of winding down the portfolio.
I would also flag up that having cancelled interest rate hedging facilities in January this year, and previously renegotiated the terms of the HSBC facility, bank debt is floating at a margin of 2 per cent above three-month LIBOR, implying a current interest rate of 2.39 per cent and an annual service cost of £1.3m on the credit facility. This means that once you factor in annual property expenses of around £2m, administrative expenses of £1.7m, interest costs of £1.3m, then LSR’s £7.1m of rental income produces net profits of £2.1m. Based on 82.5m shares in issue after deducting 9.16m shares held in treasury, this translates into recurring EPS of 2.6p and means the shares are being rated on 10 times earnings. Or put it another way, the net profits accrued from the portfolio between now and the targeted wind up date of end 2017 should be accretive to net asset value per share.
That’s worth considering because LSR’s net asset value was £35.3m at the end of March 2016, or 43p a share, so with a market cap of only £21.8m its shares are being priced almost 40 per cent below book value. That’s a huge discount given the board are actively divesting the portfolio, and the company’s net asset value actually increased by £500,000 in the latest six month trading period.
Assessing risks in divestment process
Of course, one of the reasons why LSR’s shares are trading so far below book value is due to the risk that its properties fail to achieve their valuations on disposal. In the six months to end March 2016, the portfolio fell by 0.14 per cent on a like-for-like basis due to a 10 basis point widening of the equivalent yield used by Allsop LLP. This reflected a more cautious investment backdrop and the dampening effect on valuations in the run-up to the EU Referendum, a factor which may impact valuations at the end September 2016 review.
And this is feeding into sale prices as the 18 freehold properties sold in that six-month period generated aggregate proceeds of £4.12m, or 1.72 per cent below their preceding valuation. That said, this is hardly a major problem given there is a £13.5m difference between the company’s market value and its net asset value, offering a hefty safety margin on the final sale prices to be achieved on the remaining £76.7m of properties yet to be sold.
It’s worth pointing out too that the board has not set a prescriptive timetable for the sale of the properties, but has instructed and incentivised its managers to dispose of properties as expeditiously as is consistent with the protection of value in order to maximise the monies paid to the shareholders. They are also instructed to ensure an orderly phasing of property sales to protect value and not over-supply this specialist property market at any one time. A corporate transaction, such as a sale of the company, will be considered, where this offers the opportunity to accelerate the realisation of optimal value for shareholders. Still, there is no guarantee that the company will be able to achieve the full £76.7m market value of the portfolio when the remaining properties are sold, nor is there a guarantee that the end 2017 deadline will be hit.
High property yields warranted
Another reason for the high property yields on offer is because investment returns from retail property have lagged the other main property investment sectors, with rental and yield performance weaker than office and industrial markets. Investors are still exercising a degree of caution towards a sector which has experienced a structural adjustment arising from the impact of online shopping, which has led to a rebasing of rents to more affordable levels. Well publicised concerns regarding excess space capacity amongst supermarket operators may have tainted investor attitudes too.
That’s not to say the company hasn’t been successful in its lettings. By adopting a flexible approach to lease renewals and a sensible active asset management approach, LSR has managed to reduce voids in the portfolio from 13.18 per cent to 10.78 per cent in the 12 months to end March 2016. LSR’s advisors have also adopted a flexible approach when signing new leases by offering stepped rent increases whereby the initial rent is below the market rent for the first few years, but above it for the remainder of the lease term. This secures a tenant, brings in income and reduces voids on the portfolio.
Tenant default is another issue worth considering for any property company. In the case of LSR, it holds deposits equating to 24.2 per cent of its quarterly rent roll, and further deposits, typically one month’s rent, are held by its managing agent and regulated tenant deposits schemes in respect of residential tenancies. This provides some protection in the event of a tenant defaulting on its rent, but it still has an impact on rental income, levels of voids and the ability of LSR to sell a property. Still, this doesn’t appear to be a problem as LSR’s bad debt charge was around £250,000 in its last financial year.
Costs of investment manager
When LSR adopted the new investment mandate three years ago, the board appointed INTERNOS Global Investors to manage the disposal programme and Steve Faber, an employee of INTERNOS, was appointed as designated investment manager and a main board director too. Mr Faber has extensive experience of UK property including at Tesco Stores, Land Securities Trillium and at RREEF where he was head of UK Asset Management and responsible for £2bn of property.
Under the management agreement, LSR agreed to grant INTERNOS the following fees: an annual asset management fee of 0.70 per cent of the company’s gross asset value; an annual performance fee comprising 20 per cent of recurring operating profits each financial year above an annually agreed hurdle, rebased quarterly downwards on a pro rata basis to reflect sales; a sales fee payable on the disposal of assets, subject to a ratcheted scale being nil for less than £50m, 0.5 per cent for £50-150m and one per cent for £150m or greater of aggregate sales; and a terminal fee, calculated as 5.7 per cent of any cash returned to the company's shareholders above the "Terminal Fee Hurdle". The Terminal Fee Hurdle is calculated at the first 36.1p per share in cash returned to shareholders from the start of the scheme and this sum rises by 8 per cent annually after the first year.
The fee structure was designed to reduce the basic administration cost of the company by £600,000 per annum, while at the same time incentivising INTERNOS to sell assets whilst maximising returns to shareholders. INTERNOS earned around £500,000 in fees in the six months to end March 2016, which seems a fair arrangement to me, but it’s worth flagging up the disposal costs nonetheless.
Valuation
LSR is a small cap property company so one would expect some liquidity discount to be applied to the valuation, but a 40 per cent share price discount to end March 2016 net asset value seems excessive considering its investment advisers are still working towards a realisation of the portfolio by the end of next year with a view to returning cash to shareholders as soon as possible thereafter.
Even taking a bear case scenario whereby 10 per cent of the current portfolio value is accounted for in costs and discounts to sell the properties, and that really would be a bearish outcome, I still arrive at a realistic liquidation value of £30m, or 36p a share, after deducting the HSBC borrowings and after factoring in retained net profits earned by LSR between March 2016 and end 2017. To put my liquidation value into some perspective, it’s a hefty 35 per cent above the current share price. And given this could be earned in the next 18 months, it’s a favourable return too.
For good measure, LSR’s share price appears to have successfully retested the July price lows around 24p, suggesting that the sell-off from the March highs around 31p is complete and a recovery could be on the cards. I am willing to bet on that possibility and with the shares trading on a bid-offer spread of 26p to 26.5p, I rate them a value buy and have an end 2017 target price of 36p. Buy.
