Back this Reit’s record of making mergers work

Jones now wants to acquire LXi Reit (LXI), and we are hopeful that he can make a success of this too. The revelation that the two trusts were in deal talks came as a surprise to some analysts, although it wasn't necessarily an unpleasant one: with much to admire in a hypothetical combination, the prospect of LondonMetric emerging stronger means it could be a prime opportunity to buy in.

In the Reit direction

LondonMetric’s £3bn portfolio mostly consists of warehouses. Its merger with LXi Reit would alter its make-up, exposing it to a mix of assets let on long leases, including Travelodge hotels, care homes, supermarkets, and the Alton Towers theme park. However, it would not be the first time it has shaken up its portfolio. As Jones said himself when speaking to Investors’ Chronicle last month: “In a previous life, I assembled the biggest portfolio of retail parks in the UK – probably around £4.5bn. It’s a market I know well, and [LondonMetric] has some. And there are opportunities.”

Sensing he could get better returns elsewhere, Jones eventually sold many of the retail parks. “You’re not going to get a 20 per cent return on rental reviews on retail parks, whereas you can in warehouses,” said Jones.

This willingness to change has yielded good results. LondonMetric has increased its net rental income – rental revenue less the costs of running the portfolio but before factoring in valuation changes – for nine consecutive years. 

Despite this, the company currently trades at a discount to net asset value (NAV) after years of trading at a premium. The market is pricing in the possibility of LondonMetric’s asset values falling further after the Reit took a hefty hit in 2022. This was true of virtually all UK Reits, as rising interest rates reduced buyers’ budgets and thereby drove down property values. However, warehouse Reits like LondonMetric were hit particularly hard because market excitement about their role in online shopping had created a valuation bubble in the decade leading up to 2022. This bubble also drove the average warehouse property yield (annual rental income as a percentage of property value) to its lowest level on record.

As such, when interest rates rose, and government gilt yields rose higher than warehouse yields, warehouses suffered the biggest drop in value, and warehouse Reits suffered the worst share price declines.

This was obviously bad news for LondonMetric, but it could be yesterday’s problem. The discount to NAV assumes further property devaluation, but LondonMetric posted an increase in its portfolio value in its most recent results, suggesting things may have bottomed out. On a macro level, there are signs that the Bank of England’s rate-hiking cycle is over, meaning investment activity and valuations in the commercial real estate sector are likely to pick up this year as the price of debt stabilises or even begins to fall.

'A bucket, not a thimble'

Jones is very aware of this. LondonMetric's own loan-to-value (LTV) ratio fell from 32.8 per cent to 29.5 per cent in the six months to September and Jones said in November that the company is “in a strong position to go fishing as the investing waters begin to settle”. He added that "opportunities come infrequently. When it rains gold, put out the bucket, not the thimble”. The next month, LondonMetric announced it was in merger talks with LXi Reit. There could be more deals to come.

One reason LondonMetric has been able to buy while keeping its LTV at a sensible level is that it is not afraid to sell. Shifting from retail parks to warehouses was part of a continuous ‘recycling capital’ process – selling off stuff with low returns to buy assets with higher returns. Since 2019, LondonMetric has sold just under £1bn of unwanted stock and bought £1.68bn more, largely through the A&J Mucklow and CTPT acquisitions.

Other Reits have also been recycling capital, to weaker effect. Should the LMP/LXi merger complete, the new Reit could have a larger market cap than British Land (BLND). Over the same period, British Land has sold roughly £3bn-worth of assets and bought less than £1.5bn. Where LondonMetric has been a net buyer over the period, British Land has been a net seller. And where LondonMetric’s net rental income has consistently increased over the last nine years, British Land’s has not.

This comparison ignores British Land’s potential for future returns as a developer, of course. Where LondonMetric likes to buy buildings, improve them, and sell them, British Land is keen on developing from scratch. Since 2019, it has spent well over £1bn on capital expenditure and development, while LondonMetric has spent about £330mn. Even accounting for British Land's larger size, that is a big difference.

Indeed, British Land is embarking on a huge development project: Canada Water. The return on investment in this multi-year housing, office, and retail neighbourhood development could be massive, but it will not be immediate. In the meantime, LondonMetric could outgrow British Land next year if it gets its LXi acquisition over the line.

Warehouses and rollercoasters

There are two main bear points when it comes to the LXi deal. First, although it has the approval of the board, it still needs shareholder approval, which means it might not happen at all. In which case, LondonMetric could lose momentum. However, the company's track record, together with Jones' recent comments, suggest it will keep buying elsewhere regardless.

There are also risks if the deal does go through. Earlier this week, LXi sold off £210mn of Travelodge hotels to pay down debt, but its 34 per cent LTV remains higher than LondonMetric’s. And though the deal has reduced its exposure to Travelodge as a tenant, the hotel chain is still a big presence. Together with Merlin Entertainments, the company behind Alton Towers, it accounts for 30 per cent of the rent roll. Both are tenants with ‘junk’ credit ratings from ratings agency Moody’s. During the pandemic, Travelodge and its landlords, including LXi and Secure Income Reit (before it merged with LXi), were at loggerheads over the hotel chain’s non-payment of rent, highlighting the risks involved with having such a tenant in its portfolio.

These considerations matter, but Travelodge and Merlin will represent a much smaller proportion of the overall rent roll in a combined LXi and LondonMetric group. And as LondonMetric has shown, it will not be afraid to sell off any assets if it is worried about income risk. 

In short, whether or not the deal goes through, LondonMetric still looks like a highly investable company with a strong track record that trades at a discount, pays out dividends, and is headed by a well-respected chief executive. Jones said the company joined a “rarefied club” by paying its ninth consecutive dividend. Investors could do worse than join that club too.