Priced for a severe property downturn that’s unlikely to happen

Palace Capital (PCA:205p), a high-yielding regional commercial property Reit, has been forced to pause its asset disposal programme due to the volatility and uncertainty in financial markets and macro-economic environment.

Several properties, including the group’s industrial portfolio, had been prepared and readied for sale whilst other properties are undergoing asset management initiatives to prepare them for sale at a future date. Clearly, it doesn’t make sense to sell the group’s larger assets into the current market, and Palace doesn’t have to either as it has relatively low leverage – a loan-to-value ratio of 32 per cent – so has the flexibility to wait until the market stabilises. In the meantime, the board will continue to sell small, individual assets which lend themselves better to private buyers and special purchasers.

In the latest six-month trading period, the group sold four investment properties for £4.8mn, or 25 per cent above book value at 31 March, and has subsequently sold a further two investment properties for £4.1mn, or 22 per cent above book value at 31 March 2022. At its Hudson Quarter residential development in York, Palace has completed on a further 13 units since the end of March to realise £5.7mn of sales. Only 24 units remain to be sold, of which 10 apartments are under offer to the value of £4.4mn. Despite the disposals, group net debt increased slightly to £75.8mn as the board spent £6mn on a NAV per share accretive share buy-back programme, but the net loan-to-value ratio of 32 per cent on the portfolio’s interim valuation of £235mn remains comfortable. Factoring in disposals since the end of September 2022, proforma net debt is currently around £71.7mn.

The shares have come under pressure though and this reflects a repricing of commercial property by investors. Chartered surveyors at CBRE down valued the portfolio by 6.5 per cent on a like-for-like basis, based on net initial yields (NIY) of 6.6 per cent (office), 5.7 per cent (industrial) and 8.7 per cent (leisure). The revaluation loss of £15.6mn included a £5mn hit from an 89,000 square feet Grade II listed fully let building in Leeds which almost halved in value to £5.3mn after the board concluded that a three-storey extension was no longer financially viable and to reflect the costs of remediation works to the exterior cladding. Excluding the Leeds property, the like-for-like valuation decline was 4.6 per cent across the rest of the group’s portfolio.

Commercial property is still being repriced by investors, so expect further declines in Palace’s NAV. However, with the shares priced 42.4 per cent below NAV of 356p, effectively a 30 per cent decline in property valuations in the future is already being factored into the company's current market valuation. Indeed, for the share price discount to NAV to be wiped out completely, the current portfolio valuation of £231.5mn (factoring in the £4.1mn post period end disposals) would have to decline by £70.5mn to £161mn in order to reduce NAV to £90mn (205p). The implication is that NIYs used to value the portfolio will spike by more than 25 per cent, a highly unlikely scenario in my view given that they already offer a highly attractive premium to risk free government bond yields.

Importantly, Palace has strong rent collection rates (99 per cent), high occupancy levels (89 per cent) and is generating decent rental income growth (£0.9mn of additional annualised rental income in the latest six-month period) from a portfolio that has affordable passing rents of £17.10 per sq ft (offices), £7.10 per sq ft (industrial) and £17.90 per sq ft (leisure). It looks well placed to weather a more challenging market environment.

An average debt maturity of 2.8 years on credit lines at an average cost of debt of 3.9 per cent means that there are no immediate debt maturities, and the directors can recycle cash proceeds from disposals to pay down borrowings. Overheads are being cut, too, with costs reduced by £1.2mn including an office move.

Palace Capital's high yielding shares have delivered a modest total return of only two per cent since I initiated coverage (Alpha Research: ‘A Reit royal value play’, 11 March 2021), well ahead of the 28 per cent loss on the FTSE Aim All-share Total Return index, albeit the shares have given back a chunk of their gains since my last buy call over the summer (‘Hot property’, 22 August 2022). Trading 42.4 per cent below book value, and offering a prospective dividend yield of 7.3 per cent, the shares are still worth holding onto for their income and should offer capital upside when the market stabilises. Hold.

Finally, I will now be on annual leave until the New Year.

■ Simon Thompson's latest book Successful Stock Picking Strategies and his previous book Stock Picking for Profit can be purchased online at www.ypdbooks.com at £16.95 each plus £3.95 postage and packaging. Details of the content can be viewed on www.ypdbooks.com.

Promotion: Subject to stock availability, both books can be purchased for £25 plus £5.75 postage and packaging.