Bearing this in mind, shares in regional shopping centre owner London & Associated Properties (LAS: 44.25p) look ideally poised to enjoy a sharp re-rating. I have been keeping a close eye on the company, but was deterred by the fact that net borrowings of £131m dwarfed shareholders funds of £54.7m, and did not feel comfortable with a balance sheet gearing level of 240 per cent. There is also the small matter of a £24m liability on interest rate hedges taken out in 2007 and which have a further 15 years to run. Other investors have been cautious too because London & Associated Properties only has a market value of only £37m, or half its EPRA net asset value of £76m and a third less than its IFRS book value of £54.7m.
However, the sale of a number of property assets has changed the company’s profile dramatically and one that mitigates financial risk substantially. Let me explain.
Asset sales mitigate risk
When London & Associated Properties reported half-year results to the end of June the company owned properties which were valued at £205.4m and headleases were in the book for £28.6m. The main asset held at the time was the King Edward Court Shopping Centre in Windsor. Eleven years ago, the company acquired the property for £45m in a joint venture with Bank of Scotland and subsequently a further £24m was invested developing the properties. At the end of 2007, the company bought out the other 50 per cent from Bank of Scotland in a deal valuing the centre at £97m.
It was therefore with interest that I noted at the end of last year that London & Associated Properties had agreed to sell the centre to the property investment arm of Scottish Widows. The £104.7m sale price equated to a net initial yield of 5.6 per cent which looked a fair price at the time. Moreover, the net proceeds from the sale will make significant headway in degearing London & Associated Properties' overgeared balance sheet which was burdened with £139m of gross debt and had only £8.3m of cash balances. The disposal follows on from the sale in August of two fully let freehold retail properties for a total cash consideration of £9.48m. The properties, a Primark unit in Chesterfield and the Superdry unit in Windsor, generated net income of £700,000. Proceeds from that sale were used to pay down two debentures totalling £6.7m: a £5m debenture accruing interest at 11.3 per cent and maturing 2013 and a £1.7m debenture accruing interest at 8.67 per cent and maturing in 2016. In addition, at the end of last year, the company concluded the sale of a property held with Lloyds Bank in Halifax to raise a further £500,000.
So at a stroke London & Associated Properties has transformed its balance sheet. By my reckoning, proforma net debt is now around £16.5m, down from £131m last June, equating to less than 20 per cent of EPRA net asset value of £90m. It also means that financing risk is no longer an issue and I expect the company to be able to complete in the near future on refinancing its £47m revolving credit facility with The Royal Bank of Scotland. London & Associated Properties also has a £70m term loan due for repayment in November, so the aforementioned sales put the company in a strong negotiating position. The proceeds from the disposals should also wipe out the outstanding and expensive debenture stock held with First Mortgage. Namely, a £5m issue accruing interest at 11.6 per cent per annum and maturing in 2018, and a £10m issue at 8.109 per cent maturing in 2022.
Interest rate hedge liabilities falling
The other issue which bothered me previously was the size of the interest rate swap liabilities in place to hedge off interest rates risks on £117m of floating rate bank debt. The hedge to cover the £47m revolving credit facility consists of a 20-year swap for £10.4m with a seven year call option in favour of the bank, taken out in November 2007, at 4.76 per cent; and a 20-year swap for £40m with a seven year call option in favour of the bank, taken out in December 2007, at 4.685 per cent. The hedge to cover the £70m term-loan consists of a 20-year swap with a seven year call option in favour of the bank, taken out in November 2007, at 4.76 per cent.
The problem with these interest rate swaps is that with the current 15-year fixed interest rate around 3.05 per cent, and London & Associated Properties having entered into swap agreements at fixed rates of 4.76 per cent and 4.68 per cent on its floating rate credit lines, then this creates a liability. To put this into perspective, every 0.1 per cent fall in the 15-year fixed interest rate adds £1.6m to the liability on these hedges when they are marked to market value.
The good news is that with the UK economy bottoming out, and long-term bond yields rising again, the liability on these interest rate hedges is falling fast. In fact, at the end of 2012, when the 15-year fixed interest rate was 2.47 per cent, the directors calculated that the liability was a whopping £34m. However, by the end of June last year, the 15-year fixed interest rate had risen to 3.05 per cent, and the liability had fallen to £24m. Please note that under IAS 39 the hedges are not deemed to be eligible for hedge accounting and any movement in their value is charged directly to the consolidated income statement. This explains why there can be sizeable non-cash charges to the income statement if 15-year government bond yields move even by small amounts.
It’s also worth noting that the banks who are the counter party to these hedging arrangements have an option to cancel them in November 2014 and January 2015, although London & Associated Properties’ board has no intention of exiting these instruments then. It makes sense not to because the UK government gilt with maturity of December 2027 currently has a yield to redemption of 3.16 per cent, so reducing the liability on the hedges by a further £1.6m. It’s only reasonable to expect a further normalisation of long-term bond yields as the Bank of England ease off money printing and start taking steps to tighten monetary policy as and when the economy is strong enough to withstand interest rate rises. In this scenario, we can expect the liability on these hedges to continue to fall as bond yields rise which in turn will have a further positive impact on London & Associated Properties net asset value.
Property portfolio
Of course, the investment case has to stack up even if the shares are trading on half their EPRA net asset value. I believe it does because the voids on the company’s properties was a miniscule 1.6 per cent at the end of June and the weighted average unexpired lease term is around eight years, therefore providing a decent income stream without much occupancy risk. The company’s portfolio includes the Orchard Shopping Centre in Sheffield; Kings Square, West Bromwich; the Langney Shopping Centre, Eastbourne, owned in joint venture with Columbus Capital Management; and Brixton Market, in South London.
Orchard Square remains fully let in spite of the failure of Republic, a tenant of one of the company’s two prime units on Fargate, Sheffield’s principal shopping street, which went into administration. The business was subsequently acquired by Sports Direct and has now been rebranded as USC. Sports Direct has invested in the fabric of the store and rental levels are now based on store turnover, which should be similar to the level previously received by London & Associated Properties.
In West Bromwich, and in spite of the difficulties experienced in the economy, Kings Square has maintained the same high level of occupancy over the past year. It has helped that Sandwell College, which houses some 11,000 students, opened to the rear of the centre which has boosted footfall.
A major success story is Brixton Markets where the company has two indoor markets let on 25 year leases from April 2011 to InShops Limited, a subsidiary of Groupe Geraud, who operate 200 markets across Europe. Brixton Village was established as a quality retail and restaurant location and one that continues to attract interest from retailers. In fact, the market is fully let, and has over 100 retailers on the waiting list for any available space.
Since London & Associated Properties signed the leases to InShops, gross revenue has increased by almost 25 per cent even though the markets were fully let at the time. InShops believe that the outstanding demand will continue to drive rents forward in the market and they expect cash flows to continue to increase. Importantly, London & Associated Properties is sharing the upside as the company receive half of this increased rental income in line with a profit share agreement with InShops.
Asset management side
The recurring income from the property centres aside, the company also generates significant income from asset management through London and Associated Management Services (LAMS). Working closely with insolvency practitioners from Deloitte, the subsidiary has been managing the Agora portfolio on behalf of Lloyds Banking Group (LLOY) and sold the first of the shopping centres for a sum in excess of valuation. And LAMS has just set up a joint venture with a large American private equity fund to acquire three shopping centres which will be managed by LAMS. The identity of the parties and assets involved is confidential at the moment, but expect an announcement shortly which can only be positive.
Attractive valuation
So, with a series of property disposals transforming the London & Associated Properties balance sheet, and occupancy levels robust despite a challenging trading climate, I see little reason why the shares should be valued on half EPRS net asset value. In fact a valuation between 60p to 65p a share seems reasonable to me especially since the company now has the firepower to go out and make value enhancing acquisitions, having completed on the King Edward disposal.
Please note that I have taken into consideration the fact that chairman Sir Michael Heller and his family have an interest in 47.5m shares, representing 56.6 per cent of the issued share capital net of treasury shares; Cavendish Asset Management have an interest in 6.9m shares, representing 8.32 per cent of the share capital; and James Hyslop has an interest in 3.3m shares, or 3.97 per cent of the issued share capital. This clearly reduces the free float and will make the shares more volatile, but they still look a decent investment.
From a technical perspective the risk is to the upside too. A move above December’s highs of 46p would open the door up for an assault on the 2009 highs of 52p, with very little resistance beyond that until a price range between 65p and 75p, dating back to 2008 before the stock market crash that year.
So, priced a third below my fair value target price range of 60p to 65p, I see ample scope for London & Associated Properties shares to be re-rated over the next six months as other investors acknowledge the transformation in the company. Expect positive news flow in the forthcoming full-year results in April. Trading on bid offer spread of 42.5p to 44.25p, the shares rate a value buy.
