Profit from the deal of the year

Last September, First Property acquired control of the companies that own the majority of the buildings in Krakow Business Park, located 15 minutes from the centre of Poland’s second largest city. The four buildings comprise 50,000 sq metres of office space and are half let, bringing in annual net operating income of €2.6m (£2.3m). The tenant mix is impressive with blue chips including investment bank UBS, and logistics group UPN.

However, the €47m debt secured on the buildings was in default last autumn which is why First Property acquired the equity for a bargain basement £900,000. Since then it has restructured the loans which are no longer in default and are now charged at an interest rate of 1.85 per cent above three-month Euribor, the latter being negative so the effective rate is only 1.85 per cent. Even better the debt is interest-only for the next two years, and there are no covenants, thus giving First Property time to invest in the development to increase rental income before debt repayments need to be made.

Bearing this in mind, the company has been working busily in the background, applying for planning approval to expand the facilities on the site to include a new sports ground, parking area, new retail and restaurant facilities, and a refurbished railway station which will have a more frequent service to Krakow. It also plans to refurbish the lobbies of the office buildings and upgrade the underinvested vacant office space. The cost of all this capital expenditure is €16m. Plans to develop additional plots and make acquisitions will cost a similar sum.

Here’s the smart part of the deal. In order to fund the cost of the capital expenditure, First Property has secured commitments from third party investors who will invest €33m in new equity in Krakow Business Park to give them a 76.6 per cent equity interest. First Property will retain an equity stake of 23.4 per cent which is in the books for just £900,000, or a tenth of the read through valuation.

It’s a real coup for the £55m market-cap company as the new investors include some of the wealthiest and most prestigious institutions in the world: Willis Towers Watson Partners Fund; St Catherine’s College, Oxford; Christ’s College, Cambridge; and Christ Church, Oxford which is making its first ever overseas investment in its 500 year history. The reason why these institutions are prepared to invest reflects the financial gains to be made: when the business park is fully let, Mr Habib believes it will produce annual net operating income of €7.5m, or almost three times the current level.

Interestingly, just before the credit crunch the four office buildings alone were “under offer for €120m to €130m” and Mr Habib believes that when fully let they will be worth “north of €100m”. I can only agree that “it’s one hell of a deal”, and one that’s simply not priced into the company’s current valuation.

Record results for the 2018 financial year

Shortly before details of the Krakow deal emerged, First Property announced record pre-tax profits north of £9m for the second year running, buoyed by sharp increase in its funds under management from £477m to £625m in the 12 months to end March 2018. Around £454m of the total is managed on behalf of third parties, representing a 45 per cent increase on the prior year, driven by new mandate wins including Fprop Offices LP, a £181m fund launched last summer to invest in office blocks and business parks across England. That fund is £114m invested, has around £67m of additional client funds available to invest, and has potential to gear up too.

First Property invests in some of the 12 funds it manages, and successfully so as it earned a pre-tax profit of £1m on revenues of £2.9m from these investments in the 12-month trading period. It also holds a 51 per cent majority stake in Fprop Opportunities, a company which holds five properties in Poland worth £74.5m. Fprop delivered a pre-tax contribution of £2.16m, representing a chunky 16 per cent return on the equity held in the five properties, a contribution which offers substance to First Property’s equity stake.

The majority of First Property’s pre-tax profits of £9.2m last year were derived from three high yielding directly owned properties in Poland which are worth £91.7m and produced an annual pre-tax profit before central overheads of £6.9m. Bearing this in mind, US banking group Citi, a tenant at one of the company’s office properties, Oxford Tower in Warsaw, vacated 10,000 sq metres of space in February which had been generating €3m (£2.6m) of income.

First Property is refurbishing the vacant space at a cost of €300 per sq metre and has already let out 26 per cent of it for a rent of €1.21m (effectively 55 per cent higher than previously) with the new tenant moving in September. It has another tenant lined up for 14 per cent of the space too at a similar rent. These lettings are supportive of the €36m book value of the 20,000 sq metres of space First Property owns in Oxford Tower through its 50 per cent share.

Admittedly, the current year shortfall in income from Oxford Tower prompted analyst Tim Dainton at house broker Arden Partner to clip his current year pre-tax profit estimate to £7.5m. However, that was before news of the Krakow deal emerged which will give First Property €360,000 of annual management fees in addition to earnings derived from its 23.4 per cent shareholding in the Krakow Business Park. Moreover, the company had around £15m cash on its balance sheet at the end of March 2018, some of which could be deployed on earnings enhancing debt funded acquisitions of high yielding property in Poland, thus reducing the profit shortfall even further.

It makes sense to do so as the company’s £171m portfolio of 10 high-yielding commercial properties in Poland and Romania (including £74.5m held by Fprop) generate an average yield of 9.6 per cent, well in excess of the 2.34 per cent weighted average cost on non-recourse borrowing (loan-to-value of 68 per cent), so generate healthy profits to support a progressive dividend policy while First Property ramps up its third party fund management business. That’s not the only reason I remain very positive on the investment case.

Supportive share price drivers

Firstly, the company’s adjusted book value of £63m, or 53p a share, only values the interest in Krakow Business Park at cost of £900,000. The read through valuation implies a mark-to-market valuation of the equity stake of £9m. Based on 111.2m shares in issue, the additional upside is 7p a share. It also means that First Property’s fast growing fund management business is effectively in the price for free. That seems anomalous to me.

Secondly, there is a lack of new supply into the Warsaw office market, so this is supportive of demand for the “cost effective and well located locations of First Property’s buildings”, says Mr Habib. He has reason to think this way as vacancy rates in the city have tightened from 15 per cent to 10 per cent in recent months, suggesting the income shortfall from Oxford Tower is only likely to be short-term.

Thirdly, Arden Partners’ current year pre-tax profit and EPS estimates of £7.5m and 4.6p understate the company’s true level of profitability. That’s because it doesn’t take into account the future profit share on the aforementioned £181m Fprop Offices LP fund. First Property has opted for a profit share in lieu of an annual management fee. To put this into perspective, based on an initial yield of 6.2 per cent on purchase, and after taking into account debt funding allowed, when fully invested the new fund should generate a 7.5 per cent return on equity and produce a profit share north of £1m for First Property and an additional return on its £1.96m co-investment. The Fprop Offices LP fund should be fully invested this year, and has the option of gearing up too.

Furthermore, if the new fund generates an annual internal rate of return of between 7.5 per cent to 15 per cent then the financial returns ratchet up for First Property; the company is entitled to 25 per cent of the total profits in this scenario, thus highlighting the potential for additional profit upside if investment returns are boosted by capital gains. It’s only fair to point out that if capital losses exceed income in any one year, there will be a claw back on income paid in prior years, a sensible arrangement in my view.

Fourthly, First Property has built in net asset value (NAV) growth given that virtually all of its current year EPS estimate of 4.6p a share is recurring and exceeds the forecast dividend per share of 1.7p by quite some margin. The difference between net profits and the dividend paid boosts NAV per share.

Fifthly, the board have sensibly used £2.2m of the surplus cash on the balance sheet to buy back 4.8m shares at 46p each after the March 2018 financial year-end to reduce the issued share capital to 111.2m shares, the effect of which is to boost both EPS and NAV per share.

Re-rating beckons

I first recommended buying First Property’s shares at 18.5p in my 2011 Bargain Shares Portfolio, since when the board has paid out total dividends of 8.84p a share excluding the recently declared final of 1.18p (ex-dividend date of 23 August 2018). This means that if you had invested £1,850 to buy 10,000 shares seven years ago, and reinvested your dividends by purchasing more shares in the market, you would now be holding 13,400 shares worth £6,566. That represents a healthy 255 per cent total return, or an annualised return of almost 19 per cent during the holding period. NAV per share has risen from 14p to 53p in the same period, reflecting the shareholder value created from First Property’s shrewd investment activities.

There are not many companies that have been able to report 19 per cent annual NAV growth since 2011 and have paid out dividends equating to more than half their market capitalisation, but First Property is certainly one which is why I have stayed long of the shares and exploited repeat buying opportunities along the way. Indeed, I last rated the shares a buy at 49p ahead of the 2018 full-year results (‘From yachts to clean energy’, 23 Apr 2018) which was the correct call as the share price subsequently hit a record high of 60p before profit taking took hold.

Needless to say, I feel another repeat buying opportunity has presented itself given that investors have yet to cotton on that the Krakow Business Park deal offers masses of investment upside to First Property’s shareholders. I am reassured too that new lettings at Oxford Tower are well above previous rent levels and the income shortfall is only likely to be short-term. When the penny drops, as I am sure it will, expect First Property’s share price to make new highs above the 60p high water mark, and make headway towards my 65p target price. Strong buy.

■ Simon Thompson's new book Successful Stock Picking Strategies was published on 15 March and can be purchased online at www.ypdbooks.com, or by telephoning YPDBooks on 01904 431 213 to place an order. It is being sold through no other source and is priced at £16.95 plus £2.95 postage and packaging. 

Simon's second book Stock Picking for Profit has now been reprinted and is available to purchase online at www.ypdbooks.com for £16.95, plus £2.95 postage and packaging, or by telephoning YPDBooks on 01904 431 213 to place an order.