Join our community of smart investors

Reliable income from Picton

FUND TIP: Picton Property Income (PCTN)
July 21, 2011

BULL POINTS:

■ High dividend yield

■ Dividends covered by earnings

■ Chunky discount to net asset value

BEAR POINTS:

■ Refinancing risk

■ Weakness in the secondary property market

IC TIP: Buy at 49p

It's all about the yield. The Picton Property Income investment trust is expected to pay out 4p in dividends this year. With the shares currently on offer for 49p, investors can therefore buy a property-backed income return of 8.2 per cent. That's a very healthy premium over the bank rate.

Of course, high yields can be a double signal - a buy indicator on the one hand and a warning that investors don't believe in the company's promises on the other. In this case, we think the (implicit) promises will be honoured. To understand why, we need to examine the business behind that income stream.

IC TIP RATING
Tip styleValue
Risk ratingMedium
TimescaleLong term
What do these mean? Find out in our

Picton Property Income is a portfolio of 70 commercial properties, split equally between the three main sectors: retail outlets, offices and industrial estates or warehouses. Overall, the assets command a rental yield of 6.9 per cent, which is high by industry standards. That's because, with a few exceptions like Stanford House in Covent Garden, the properties tend to be 'secondary' - that is, in second-tier locations with second-tier tenants. Some 80 per cent of Picton's portfolio is outside of London.

The dividend yield is even higher than the rental yield for two reasons. First, the portfolio is geared with £172m of debt (net of cash); at 4.7 per cent, the average cost of that debt is lower than the rental yield, allowing for a profitable arbitrage. Second, the investment trust is trading on a 20 per cent discount to the value of its net assets on 31 Mar, so investors can pick the income stream up cheaply by owning the shares, rather than the properties.

What Picton Property Income is not doing is paying out more than it earns in recurring income. This is unusual - most of the Guernsey-registered property investment trusts pay uncovered dividends. They were set up in 2003-2005 explicitly as income vehicles, so managers were loathe to cut dividends when the market turned in 2007, instead topping up the yield with cash reserves from sales. Picton (then called ING UK Real Estate Income) bucked the trend by cutting its payout drastically in 2008, provoking grumbles at the time, but rebasing expectations at a level that now looks both attractive and affordable.

PRICE49NAV PER SHARE61
NET ASSETS£209mPRICE DISCOUNT TO NAV19.7%
No OF HOLDINGS:701-YEAR PRICE PERFORMANCE12.0%
SET UP DATE25 October 20053-YEAR  PRICE PERFORMANCE42.0%
VOLATILITY17.55-YEAR PRICE PERFORMANCE-35.0%
TRACKING ERRORnaTOTAL EXPENSE RATIO1.2%
SHARPE RATIO0.72YIELD8.0%
GEARING46.6%*MORE DETAILSwww.pictonproperty.co.uk

*Net debt as a share of gross assets

Source: Bloomberg, Morningstar, Picton, Winterfloods

Geographic BreakdownPercentage
Central London13.60%
Greater London7.20%
South East31.00%
South West4.70%
East Midlands12.20%
West Midlands4.60%
Yorkshire & the Humber4.70%
North West11.00%
North East2.40%
Scotland2.50%
Wales5.50%
Northern Ireland0.60%

Sector BreakdownPercentage
Retail19.7%
Offices34.9%
Industrial33.7%
Leisure4.5%
Retail Warehouse7.2%

Fund manager Michael Morris warns that dividend cover will not be as strong this year because of the refurbishment of a property at 50 Farringdon Road, London, which pushed the vacancy rate up from 7 per cent to 10 per cent at the end of last year and opened a hole in the income statement. But that should reverse when the building is re-let in the booming London office market. The Farringdon Road project aside, Alison Watson at Matrix stockbrokers sees the relatively high void rate as an opportunity to increase the income over the next few years, even if the rental market remains moribund (as it has been since the crash for most secondary properties).

The big risk associated with Picton is its debt profile: all its debt expires by 2013 and will need refinancing. That accounts for the trading discount - some investors are nervous about buying an investment trust with such a large question mark hanging over its balance sheet.

But we think it will pay to be sanguine. Management should be able to negotiate a new facility on competitive terms, and when it does, the discount will snap back. The uncertainty is necessarily short-term as it must be resolved within the next year. That's an opportunity for long-term investors - particularly those that need income. Buy.