CLS's discount is too steep

CLS has a relatively simple model. It buys properties on which it feels it can increase rents and then sells them once it sees little further valuation upside. This model gives its operations a focus on asset management and development. This increases risk for would-be investors, which is reflected in the sizeable discount. However, its international diversity and track record is a source of reassurance.

Last year, despite a relatively sluggish domestic performance, falling vacancy rates across the portfolio drove up like-for-like rents and NAV. The portfolio's vacancy rate fell to just 3.8 per cent, from 5.8 per cent in the prior year. The strong performance was driven by properties in Germany, where CLS targets assets in improving cities with a lack of commercial space. Vacancy rates in the country dropped from 7.1 per cent to 4.2 per cent. This focus is proving profitable in other ways too. This month, it disposed of a 17,124 sq metre office space in Greater Munich for €45.3m, which was 16 per cent above its December 2018 estimated value and represented a net initial yield of 4.3 per cent.

Money from disposals has helped fund acquisitions and development spending. CLS spent £70m on purchasing properties last year, with activity particularly focused on the UK. The deals helped the group achieve overall rental income growth of nearly 10 per cent. Meanwhile, since the start of the new financial year further space has been added in central London, Lille and Cologne. It also invested £18m in refurbishing and developing properties in 2018, including major investments made in properties in New Malden and Brentford, which should unlock further rental growth. 

It is not only CLS's focus on lifting rents and property values that is driving shareholder returns. Management is focused on expanding the gap between the property portfolio's net initial yield and the cost of debt. Last year the net initial yield stood at 5.5 per cent and management continued to reduce its cost of debt. In fact, the latter fell to its lowest ever year-end level of 2.43 per cent in December, mainly due to the early redemption of £65m 5.5 per cent unsecured bonds due in 2019.  

The group’s European exposure also offers safeguards against any further depreciation of sterling against the euro. Analysts at Berenberg estimate that every 1 per cent fall in the value of sterling versus the euro would add £4.5m to NAV and £0.8m to pre-tax profit. 

The group has a solid track record of outperforming the wider sector – over the past 12 years Berenberg estimates it has made an average annual total return of 15.3 per cent, compared with an average of 2.3 per cent from peers within the UK-listed office sector. Admittedly, the rate of growth is expected to slow to 7.7 per cent this year, according to the broker's forecasts, from 10.9 per cent in 2018 and 18.9 per cent the year before. That reflects the potential for some outward movement in UK yields and rental decline. There was some indication of that last year as the net initial yield based on contracted rents was flat at 5.6 per cent, while the revaluation uplift from UK assets was just 0.5 per cent, compared with the 9.3 per cent and 3.8 per cent rise in valuations across Germany and France, respectively.