CLS looks too cheap

In a post-pandemic commercial property market, some sub-sectors have been easy to categorise as ‘thriving’ or ‘barely surviving’. Yet unlike logistics or retail, the office sector is more difficult to place. Ancillary retail and leisure space has weighed on rental income and a reconsideration of working arrangements by companies means there could be an increase in space being returned to the market. However, rent collection rates from office tenants have so far proved relatively robust for the major UK-listed office landlords, who have also managed to let space at levels above recent estimated rental values (ERV).

Uncertainty is reflected in the discounts baked into the share prices of London’s office landlords versus their net asset values (NAV). Top of that list is CLS (CLI), which owns and manages a portfolio of offices across London, France and Germany. The shares trade not only some way below NAV, but are also valued at a substantial discount to peers. Yet given the group’s superior rent collection rates in the face of the pandemic and more diverse geographic exposure, the valuation deserves attention. 

To some extent the discount versus peers can be attributed to the profile of CLS’s UK assets. They tend to be non-prime and scattered across Greater London and the South East, as opposed to the newly developed, Central London offices within the portfolios of landlords such as Helical (HLCL), Great Portland (GPOR) and Derwent (DLN). While the investment value of City offices have held steady in recent months, according to research by Savills, those within the M25 moved down in October, compared with the same month last year. That has been supported by a still acute shortage of prime London office space. 

International strength

However, there are also benefits in CLS’s difference. Around half of the group’s portfolio by value is located in France and Germany (15 per cent and 35 per cent of the total respectively). It earned 45 per cent of rental income in these markets during the first half of the year. In both France and Germany the group reported a first-half rise in the value of its portfolio; of 0.4 per cent and 2.6 per cent. This offset a 2 per cent decline in UK assets. 

That was partly a reflection of the trend that has emerged within the vacancy rates of the three portfolios, with the UK recording the largest increase during the 18 months to June, to 6 per cent from 4.1 per cent at the end of December. That compared with an increase for France from 3.1 per cent to 4.8 per cent and a reduction in the average German vacancy rate to just 3.4 per cent, partly reflecting the sale of an under-let property in Hamburg.

The German assets, around half of which are located in Hamburg and Munich, are the jewel in the crown for CLS. More than twice the amount of space was let or renewed during the first half, compared with the prior year, at an average 7.3 per cent above December ERV. The shortage of office space across Germany’s seven major cities has continued to drive demand across the broader market, with average valuations rising further even in the face of the pandemic, according to CBRE, and making the asset class the most popular among investors during the first three quarters of 2020. 

Benefit of resilient tenants

Rent collection rates have been higher than peers in the wake of the strain placed upon businesses during the pandemic. By the end of the first week of October, CLS had received 89 per cent of fourth-quarter rents due, or 92 per cent taking into account those tenants that have switched to monthly rents, and 99 per cent of contracted rent for the prior three quarters. That is above the rates reported by Helical, Derwent and Great Portland Estates during the same period. 

The high collection rate can partly be attributed to the make-up of the tenant base. Government bodies account for around a quarter of contracted rent, with commercial and professional services and information technology the second- and third-largest segments, accounting for a further 21 per cent in total. Tenants in the retail, leisure and travel industries, which are under particular distress due to the pandemic, contribute only 4 per cent of contracted rent. It also has negligible exposure to flexible workspace providers, which have come under greater strain due to increased vacancy rates and lower pricing. Flexible office provider IWG (IWG) reported a decline of almost a tenth in open centre revenue during the third quarter. What’s more, the group is not overly reliant on any one tenant, with the top 15 tenants accounting for only 33 per cent of contracted rent.

Unlike other UK-listed office landlords, CLS undertakes very little large-scale development but instead refurbishes existing offices, alongside acquisitions, in the hope of increasing rental values. This is a less risky way to add value. By the end of June it had just three schemes under development, the largest of which was a 141,000 square foot project in Stuttgart at a £35.8m build cost. That means the group has much less capital committed to projects at a time when demand for office space is a lot less certain.

Management is on the lookout for acquisitions in the belief that value is emerging in the face of the pandemic and has spent £170m so far this year. It has more money to draw on, and at the end of September had cash of over £240m, with a further £50m in undrawn debt facilities. Meanwhile, the cost of debt stood at just 2.49 per cent at the end of June. The group also has sizeable headroom beneath its debt covenants, with the ability to withstand falls of between 30 and 45 per cent in rental income, cash flow and the value of the portfolio.

A sturdy financial position and solid rental collection levels meant the group was able to proceed with dividend payments this year, unlike many other commercial landlords. The 2020 dividend per share was maintained at 2.35p a share and is forecast to grow to 7.45p for the full year. 

Lettings progress has continued through the third quarter. Since the start of July, 41 deals were secured at an average 14.8 per cent above ERV. Although vaccine progress is encouraging, there is still a high level of uncertainty over the pace of economic recovery and whether vacancy levels will rise for landlords like CLS. And Brexit also remains a source of angst (at the time of writing, at least). However, the risk seems to be more than adequately accounted for in the deep discount attached to the group’s shares. Arguably, that valuation also does not reflect the benefits of the diversification in CLS’s geographical exposure in comparison to peers. 

Last IC view: Buy, 209p, 12 Aug 2020