Derwent is starting to look like a recovery play

There are many reasons to be wary about the prospects of the London office market, but there has to come a point where the real estate investment trust (Reit) shares in the sector reach fair value. Derwent London (DLN) may have gone past that point.

In its results for the last calendar year, losses before tax ballooned from £280mn to £476mn as high interest rates and the question around the demand for offices post Covid hurt its net asset value (NAV). The shares trade at a hefty discount to that NAV, meaning investors are pricing in another devaluation, but the Reit insists values are close to bottoming out. So who's right?

On the one hand, more leasing activity meant rental revenue rose to £266mn from £249mn while the vacancy rate dropped to 4 per cent from 6.4 per cent, implying tenants want to rent offices if they are the best in class, which Derwent's are. The Reit has a lower debt-to-equity ratio than its peers, giving it headroom to invest in office development, redevelopment, or refurbishment and grow rents further.

However, net rental income (rental revenue minus building running costs before valuation changes) fell to £186mn from £189mn because the company spent more money offering the premium office experience needed to raise headline rent.

The landlord still opted to increase the dividend as it remains 1.28 times covered by EPRA earnings per share, but if net rental income continues to fall, that will stop being the case a few years from now. Analysts are confident this will not happen. The annual dividend has increased consistently since 2007, and consensus forecasts point to it rising to 81.4p in 2024, 84p in 2025 and 98.5p in 2026.

Such forecasts assume Derwent can return to net rental income growth, a position it was in for over a decade before Covid hit, rather than just headline rental growth. There is some merit in this. According to agency Carter Jonas' figures for the final quarter of last year, central London net effective office rent, as in headline rent minus the cost of sweeteners to lease deals, has increased from a pre-Covid baseline for the first time. The figure has been rising slowly since the second quarter of 2021, and the agency noted that the West End is performing best in this respect.

Considering the positive market picture, analyst confidence, low gearing and discount to NAV, we up our rating while noting the risks involved. Buy.

Last IC view: Hold, 2,086p, 11 Aug 2023