Custodian Property Income REIT plc (CREI) Earnings Call Transcript & Summary

Good afternoon, and welcome to the Custodian Property Income REIT plc investor presentation. Throughout this recorded presentation, investors will be in listen-only mode. [Operator Instructions] The company may not be in a position to answer every question it receives during the meeting itself, however, the company will review all questions today and publish responses where it is appropriate to do so. Before we begin, I'd like to make the following poll. And I'd now like to hand it over to Richard Shepherd-Cross, Managing Director. Good afternoon, sir.

Good afternoon, everyone, and welcome to this webinar. We're talking about Custodian Property Income REIT. As the name suggests, income is the key focus for us. And we have set out to be the real estate investment trust of choice for those private and institutional investors looking for high and stable dividends from a well-diversified U.K. portfolio of real estate. As we go through, you'll see a number of pictures. All of those properties are properties in the portfolio and perhaps that's the best way to describe what we mean when we talk about regional, smaller properties. We're not talking about workshops under the arches, corner shops. These are mainstream commercial properties often modern, certainly fit-for-purpose and led to, more often than not, household-name tenants. So these numbers are as at the 30th of September, a portfolio of GBP 610 million. Spread, as you can see in this pie chart between the industrial and logistics sector, that makes up nearly half the portfolio by value; retail warehousing or out-of-town retail, which has been a very robust part of the retail sector; some offices. I can hear over the airwaves people sucking wind through their teeth, but I've got some good news to tell you about offices. And then a spread of the balance of the portfolio through those assets that fit into none of these sectors, making him other, but that might include children's day nurseries, car showrooms, restaurants, hotel and some high street retail properties as well. So it is a proudly diversified portfolio, over 300 tenancies in 159 properties spread across the U.K. And as I said before, a very strong focus on income. So as at the 30th of September, our annualized earnings per share, 5.8p, and that was supporting a dividend of 5.5p. And importantly for us, that dividend is fully covered by earnings. Target gearing, 25%. Loan-to-value, currently 29.6%. So we are a little bit above our target but not so meaningfully that we feel need to panic. We do have some properties under offer to sell with a specific intention of bringing down that -- some of the variable rate debt we have in the portfolio, and we'll look at debt a little bit more as we go through. Just before we get into the detail, I just want to talk about worth versus value. There is an awful lot of analysis carried out by an awful lot, I'm sure, very bright people looking at commercial property values and real estate investment trust that all too often valued by reference to net asset value. So the aggregate value of all the properties in the portfolio. But I don't think that net asset value is a very good measure of worth. And after all, the valuation of our properties is what the properties could have sold for 3 months ago. So it's backwards looking. And what we should be looking at is any forward projection of how much income the portfolio can generate. And that this chart is a good example of what I'm talking about. The blue line in the chart looks at the net asset value of our portfolio going back 2.5 years. And you can see how values grew really quite sharply in 2022, which was a pretty difficult year for real estate because in the final quarter of the year, we saw values fall back, losing all those gains that have been made over the previous 12 to 18 months. So that net asset value, that apparent work turned out to be nothing more than [ Scotch ] myth, here today, gone tomorrow. Happily, the shareholders of Custodian Property Income REIT didn't allow the share price to chase that net asset value figure up to those dizzy heights, but much more kept the share price as a much -- as a more constant metric as a multiple of earnings. And if you look at the red line, that is the annual earnings per share from Custodian Property Income REIT over that same period. And you can see it was doggedly consistent. And as we look forward, we can be reasonably confident of consistency of earnings, if not some earnings growth into the future because we have a portfolio of properties that are less on average for about 5 years, and that's contractual income that we know we are going to receive. So I think if you want to be a happier investor in real estate, focus on earnings as a metric, not net asset value. It's forward-looking, it's more predictable, and it will lead to a less volatile experience of investing in real estate. And it will mean that you have acknowledged that you're investing for income, which is exactly how you should look at real estate. The good news in the market at the moment, and I said that there might be an opportunity for future earnings growth, is that there is rental growth in real estate. And I think there's been a real disconnect between the investment market, which has a very poor sentiment towards real estate investment at the moment, and you can see that writ large across the share prices of not only Custodian Property Income REIT, trading is slight discount to net asset value, but many of our peers and some of whom are trading at much greater discounts to their net asset value. Investors have turned away from real estate. And I'm convinced it's because a lot of them had very bad experience in 2022. And you could see that if you had been following a valuation metric, you would have seen values rise in the early part of the year and then fall back very sharply at the end of the year. And that did an awful lot to discourage people from considering real estate. But on the ground, the occupation market is pretty strong, and we're seeing rental growth, and actually, valuations have been pretty flat through 2023. I think in our portfolio, value is down just over 4% in the year, so not a significant move in what has been a pretty torrid time for macroeconomic markets, interest rates, most particularly. What this chart is showing is the net initial yield of our portfolio sector by sector. So that is the rent divided by the current value, and the equivalent yield, which is effectively a weighted average yield between the initial yield and the reversion yield. So taking account of future rental growth and the timing of that rental growth. And you can see that there is quite a big step up in yield as we pick up the rental growth that's in the market. Across our portfolio, that's about GBP 6.5 million or 15% of the rent roll. And these numbers are important when you consider debt. If we look at debt, and you absolutely should look at the debt of any property investment company at the moment, not least because it is debt and the rising cost of debt that has made a lot of investors turn away from real estate. Custodian has always taken a long-term low-risk attitude to debt. And you can see in this chart, we have 4 tranches of debt. We have a short-term revolving credit facility. Cost of that is about 6.75% today, which is why if we sell properties, and we have a number under offer to sell at the moment, and we pay down that debt, and we are giving up less than 6.75% income, to save paying out 6.75% in debt, then that will be accretive to earnings. But the majority of our debt, nearly 3/4 of our debt, is fixed rate, fixed for an average of 6.5 years at an average cost of 3.4%. And you set that against our initial yield of 5.8% and an equivalent yield picking up that reversion of 7.3%. You can see that debt is still accretive to the earnings of Custodian Property Income REIT. And that's why we are not particularly concerned that our current level of gearing is a little bit over target. One of the reasons it's over the target is because values have fallen. So that is a simple mathematical equation. And the other reason is that we have remained committed to our capital expenditure program to invest in the assets in the portfolio, and we'll talk about that a little bit more as we go through. But I don't consider that discretionary spend. I think it's absolutely essential that you keep your properties up to date. And in so doing, making sure they hit the best possible energy performance criteria, a minimal carbon output because it's those sorts of buildings that are going to attract the best tenants, secure the best rents and protect value over the long term. And we've remained committed to that program, and that has been gearing creep up a little bit through the last 12 months. What has this strategy done in terms of relative performance? Well, it's led to outperformance by Custodian against its peer group of diversified property investment companies. And we think it's largely due to that focus on income and that stable, relatively high level of earnings, which comes from our specific property strategy, which is smaller regional properties. And this is a bit to remember. This is a bit at the center of our strategy and the bit of our strategy I think will lead to long-term outperformance. What that chart is showing is looking at whole market data going back to 2000. It's looking at the net transaction yield, so the net initial yield properties traded in the market with a lot size of less than GBP 10 million. That's represented by the dark blue line. Our properties greater than GBP 10 million represented by the light blue line. So if you look at the first 10 years of the chart, there was a very consistent and quite narrow margin of about 75 basis points. Detractors might say that's the risk premium. That's the additional risk you take for buying smaller properties. And I'm prepared to accept that some of that is risk, but an awful lot of it is just hassle factor. People don't want to manage a large portfolio of small properties if, in fact, they could have a large portfolio of larger properties, so fewer assets to manage. So let's be generous to my detractors and say that there's a 50 basis point risk premium and 25 basis points of the hassle factor. What happened in 2010 and for the subsequent 13 years? We saw not much longer and that [ business gives me ], time has passed. Anyway, we've seen this huge divergence in yield, not because the smaller properties have become higher risk or indeed the larger properties that become lower risk. What we've seen is a change in the supply and demand dynamics in the market. So from 2010, we saw the open-ended funds, the property unit trust actively buying as they recovered post global financial crisis, and they are now in rapid retreat. But at the time, they were actively buying. We saw pension -- U.K. pension funds upweighting to real estate. We saw overseas investors, both sovereign wealth funds and private equity, all buying relatively large, relatively prime assets. And because of the cost of debt at the time, you also had debt-driven investors in that large prime market. Prime yields were still above the cost of debt, so those purchases could be funded with debt, which was unusual. And again, it's unusual today because that situation has reversed. You cannot fund prime assets with debt in the current market. And that is a new normal or either return to normal, but I think we should all learn to live with. So you saw this huge increase in demand for a relatively small supply of large prime assets, and it's demand and supply that's driven that yield divergence. So we have been able to secure a 150 basis point margin through that period for pursuing a smaller lot strategy. But if we were accepting that only 50 basis points of the margin for the first 10 years was risk premium, we're getting 100 basis points of margin for taking no additional risk. And that is why we do what we do, why we go to the effort of managing a portfolio of small properties. One of the benefits of the smaller lot strategy is that in GBP 610 million, you end up with 159 properties. And if you look at the rent roll, you can see in this chart, the amount of rent that is paid by any one tenant in the portfolio. And it is sufficiently diverse that no one property led to any single tenant represents more than 1.5% of the rent roll. So this is a genuine diversification. And if you look at our larger tenants, most of whose names you will recognize, let's take Menzies Distribution, our largest tenant, we've got 8 properties left to Menzies. So there is further diversification within that blue slice of the pie. And the same is true a you go around. We have 3 propers left to Wickes, 3 to B&M Bargains, 2 to B&Q. So the diversification continues. So our top 25 tenants make up only 38% of our income. If you looked at a number of our peers, their top 25 tenants might make up 50% to 70% of their total income. So much more concentration of income, which is the opposite of what we're trying to achieve. One of the challenges that is sometimes laid at our door when we say we are pursuing a smaller lot strategy is that we must have poorer quality tenants. This is something that we look at very closely. We don't believe that's true. And the Experian credit ratings that you can see in front of you, I think bear that out. And here, you can see in this chart that 89% of our tenants are rated lower than average risk by Experian. Those of you who are glass half empty might be looking at the imminently failing tenants that represent 3.2% of the rent roll. When I look at that, I see opportunity because when one of our tenants fail, we get the property back. It's not like an investment in the underlying business when if the business fails, you lose everything. If the tenants -- if our tenants' businesses fail, we get the property back. And I'll show you an example in just the moment of how that can work out quite well for us. So we believe that you don't have to forego the quality of property, location, tenant just because you are pursuing a smaller lot strategy. Indeed, we think that there are positive benefits to shareholders of pursuing this strategy. Spread of risk, stability of cash flow and a slight quirk of smaller properties is that we believe you get a higher percentage of your investment secured in the underlying bricks and mortar and less in the lease contract. And that's a good thing because the lease contract is depreciating every single day. It's getting a day shorter. And why is that? It's because even when some of our smaller properties, and that's not the case across the board, but for a large number of our smaller properties, even vacant, there is demand from owner-occupiers. And that is not the case of larger buildings. It's very rare, unless perhaps you're Goldman Sachs where you might want to own your own office building in the city. It's rare for most businesses to want to own their real estate. They tend to be leases of property. But in the smaller property sector, there are owner occupiers, particularly in the industrial sector, but also in offices, and that does give us a greater residual value in the underlying real estate. The asset management of the portfolio is a 365-day-a-year operation. Maybe time off, good day at Christmas, but we're pretty busy all year round. And this image you can see here is the CGI of what we have, in fact, now refurbished to exactly the standard of an office building we bought in Manchester in lockdown. Brave, you might say, even foolhardy, but we believe that there would still be demand for offices and indeed there is. And we believe there was a real opportunity to provide the scores of offices that the modern occupier requires, particularly in small plate -- small floor plate format. Very often, the smaller occupiers had to put up with secondary buildings, buildings where they needed to put an awful lot of capital expenditure into fit out, while the big corporate occupiers were enjoying brand-new, well-fitted offices in large floor plates. So we acquired this building on Fountain Street in Central Manchester. It's a very core office location. Rents in the building were GBP 20 a square foot at the point of acquisition. We have cleared out all but one of the tenants. The final tenant was happy to remain in while we refurbished the building. We have created fully fitted offices in the style that you can see here. So not your typical grays and whites of most modern offices. But more homely, warmer tones, nice furniture. On the top floor of this build, we have created a business lounge roof terrace, a digital meeting room and breakout space for all the 6 floors of the building that sits below it. And that's for the use of all the tenants. It's additional amenity. In the basement, we've got hotel-quality showers and changing rooms and bike storage and electric charging points for vehicles. And the expectation is that we will, on the fully fitted office space, get rents of not GBP 20 a square foot, but GBP 42 a square foot. And we launched this building 2 weeks ago. We have strong interest in one floor already. I would love to tell you this story again in 6 months' time and tell you that the whole building can be let. And I wouldn't be surprised if that's the case. This is the sort of quality of space that simply hasn't been made available to the market, but it appears to be very much the focus of occupiers' demands at the moment. That doesn't make up a huge part of our portfolio. It's about 10% of the portfolio. But it's not all bad news. And unfortunately, all we hear in the press is bad news about offices, but I think we have reason to be optimistic. When we consider asset management, we also have to consider about energy performance. And probably 6 years ago, if you had asked me about environmental strategies, I would have said that, yes, we had an environmental policy, and it was in a draw in the office, but I can find it if you are particularly interested. And maybe 3 or 4 years ago, probably 4 years ago, we had that environmental policy out on the desk, and we were considering the ramifications for us as property investors and implications for shareholders. Roll forward to today, it's just how you manage real estate. If you don't manage real estate with a keen eye on environmental performance, you are both missing the moral imperative to improve the quality of your buildings. But perhaps more importantly, for shareholders, you're missing out on a huge financial opportunity that is there for providing the highest quality buildings to your tenants. Through the course of the last quarter alone, we improved our weighted average energy performance certificate, EPC, from 58 to 56. And there is an ambition to be compliant with legislation by 2030 and have all of our properties rated B or above. And for the most part, we have asset management plans in place to achieve that. I said the market -- occupation market was strong at the moment. If we look at what happened over the last quarter, 9 new leases agreed. All of those leases agreed, on average, at 24% ahead of the previous rent. So strong rental growth. Of those 9 new leases, GBP 1 million of that new income was thanks to new lettings. That's adding to the rent roll of the portfolio. And another GBP 0.7 million was lease renewals. They all had a positive impact on valuation. And we are also reducing our vacancy rate or indeed occupancy, if you're more optimistic, which was 90% at the start of the year as we were recovering from a sort of post-COVID tenant failures. And happily, there weren't many, but there were 1 or 2. Occupancy has increased to 91%, and we expect it to be 93% by the end of the year. So really strong and positive progress. Rents are growing. Estimated rental value, so rental growth is also growing, and that's grown from GBP 48 million to GBP 49 million in rent terms over the last 6 months as well. So the overall rental potential is growing. So here is an example of an imminently failing tenants that failed. This was a Pizza Hut on the outskirts of Leicester on a retail park. They failed to trade through lockdown and then put the business into company voluntary arrangement immediately post COVID. We don't like tenants that enter into a CVA. We think they clearly don't respect the landlord and tenant relationship, which we believe needs to be a 2-way street. So we exercised our right to repossess the building. We spent GBP 200,000 on it, improving the EPC from D to A. We added a drive-thru lane and let the building to Tim Hortons as a coffee shop or drive-through coffee shop, doubling the value from GBP 1 million to GBP 2 million, and increasing the rent by 35%. So imminently failing tenant that just needed to fail so we could take the building back. It shows one of the great strengths of real estate as an investment is that you always have the underlying property. Another example, slightly larger assets, and this property has been let to H&M. It was a distribution center for them in Winsford in Cheshire. Barely schedule end. We have a dilapidations claim with them. So they paid to put the building back into the condition they took it at the start of the lease. Over and above that dilapidation payment, we have invested GBP 1.9 million into the building, and it is now fully electrified. So we have a gas supply that we've capped it off. The offices are heated with air-source heat pumps. You can see on the roof there are now solar panels. And we have leased this building to the Xavi Group. Rent has gone from GBP 423,000 a year to GBP 740,000. EPC from C to an A. And in addition to the rent, we also have agreed, let's call a power purchase agreement whereby the tenant will buy their -- the electricity that we generate from the solar panels from us, they get a discount on the retail price of electricity, and we get an estimated 7-year payback on our solar power installation and importantly, an additional line of revenue from a property that we already owned. It just shows you how by making these investments, improving the environmental credentials, the buildings, you are ticking a lot of boxes both from an ESG, cash flow perspective and indeed valuation. If we just think forward, what's the outlook? Values have been pretty stable through this year. There's been quite a lot of poor press against real estate. I think some of that is still very backward looking. There are, of course, fears about interest rates. But perhaps the example that we saw last week, 10 days ago maybe, when the interest rates were kept on hold by the Bank of England and inflation numbers came out much better than expected, we saw, across the whole listed real estate sector, share prices jumped by about 5%. I'm happy to say we've hung on to most of those gains that were made. But what is that telling you? It's telling you that there is money waiting in the wings, waiting for that absolute certainty that interest rate cycle has peaked because investors can see the stability of income and the rental growth, importantly, that is coming through as we let up vacant space and settle rent reviews and drive rents at lease renewal. We remain committed, as I said, to our capital expenditure program. We have over an 18-month period, GBP 28 million of investment into 23 separate projects. We expect that to deliver around about GBP 10 million profit over and above the cost of the works. And of course, at the same time, we are creating the buildings that are then set fair for the future. Fundamentally though, our diversified earnings base supporting fully covered dividends. And with an entry point of the share price today with an earnings yield of north of 6%, that feels like a pretty good place to start if you're investing in real estate. So that's all for me. There have been, I hope, some questions which have gone through on the screen, and I will pick out some of those up and do my best to answer them.

So the first question is given the strong leasing activity and rental growth, what specific strategies in sectors that are driving this growth and how sustainable do you view these trends to be? Half of our portfolio is in the industrial and logistics sector, and that is the sector that is seeing the strongest level of growth. If you took a typical regional industrial property in most towns in the country built a few years ago, rents would be GBP 5.50 to GBP 6.50 a square foot. If you were to build a brand-new property in that location, probably rents would be GBP 10 to GBP 12 a square foot. So you can see significant growth if you can provide those brand-new, low-energy rated, highly energy-efficient buildings. And particularly our market, that sub-100,000 square foot industrial and logistics space, has been completely undersupplied with new development -- really very little development since 2006. Most of the development that has been, has been in a big-box format, large-format logistics units. So for the smaller units, there is a distinct lack of supply. And if new buildings are going to command rents of GBP 10 to GBP 12 a square foot, good refurbished buildings, probably GBP 7 to GBP 9 a square foot, passing rent GBP 6.50 -- GBP 5.50 to GBP 6.50. You can see there's an awful lot of latent rental growth. And we're not yet seeing an increase in the development of the sort of space that the market is demanding. So in terms of how sustainable is that trend, I think it's got a good few years to run. And at the same time, with very little development really since 2006, which was 17 years ago, there are quite a few buildings that are falling off the end of their useful life because the buildings that are 40, 50 years old. Supply is actually shrinking, and we're not replacing that built supply. So that's where we see the strongest growth, I think, in retail warehousing. Out-of-town retail, there is room for growth. It proved to be the more resilient side of the retail sector as opposed to shopping centers and high street retail. And rents are at very affordable levels. So I think potential for further growth there as well. Happily, those are the 2 largest components of our portfolio. Next question which is split into 2. How does the asset recycling process fit into the company's overall investment strategy? And how do the current capital expenditures and redevelopment projects enhance the portfolio's value? And what are the expected returns on these investments? I think the second half, I perhaps answered, GBP 28 million being invested. We expect to see about a GBP 10 million profit on that GBP 20 million -- GBP 28 million invested. Plus, we're going to see higher rents, plus we will have more environmentally efficient buildings. The asset recycling process. We are, for the most part, long-term holders, if indeed that's the thrust of the question. We're not really in the business of buying poor assets, improving them and selling them. That's a typical property company trader activity. We're long-term investors. So we recycle assets by improving them. We then created the assets that perhaps we always wanted. So we tend to be holders of those assets once they have been improved. But one of the, I think, quirks of how we all deal with environmental performance at the moment is that the way environmental performance is measured is very static and absolute. So if we were to replace all our current properties with brand-new, newly developed, BREEAM excellent-rated EPC A-grade buildings, we would score very highly from certain E and an S perspective, maybe not so much for a G because in doing that, we have sold all the properties that we can't be bothered to refurbish and sold them to someone who perhaps doesn't have sufficient resources to improve those buildings and bought buildings where the embedded carbon in building those new buildings hasn't been considered because there's an absolute focus on operational carbon, the amount of carbons generated during the running of the buildings. I think that needs to change. And I think we need to give credit to ourselves and indeed our shareholders need to give us credit. And when I say us, I mean, we as an industry and indeed us in particular -- for improving the buildings that we've got. And every time we improve a building, we are making a difference to the overall carbon intensity of the portfolio. So is that sort of recycling that the question was aimed at, I hope I've answered that as well. The next question is how does the company manage the relationships with tenants to ensure steady rental income and minimize vacancies? The first thing to say on that is we manage this portfolio in-house. We collect all our own rents. It's not something we outsource, which means we have a one-to-one relationship with each and every tenant in the portfolio. We will start speaking to tenants comfortably 2 years before the end of their lease about what their future intentions are. We have approached a large number of our tenants in recent months and, indeed, years, offering to improve the environmental performance of their buildings through the adding of solar PV on the roof. And you can see this image in front of us now, the solar PV on the roof of that building. And the offer is that we will suffer the -- we'll make that capital investment to put the solar on the roof, and in return, the tenant will enter into a power purchase agreement and buy the energy from us. They will make a saving on their electricity bills. They will be able to improve their environmental performance and claim that they are a greener business than they were as indeed can we, and we get an additional cash flow. So it's a partnership relationship. I think the days of adversarial landlord and tenant relationships really should be in the past, and it's not the way we approach things. And if we -- I mean if you take a look back 3 years to when we were in the depth of COVID, in the year itself, we collected 91% of the rent that was due without falling out with a single tenant, and while it was not contractually required to pay rent in that year, and that was largely based on those relationships. And in terms of minimizing vacancies, it's about keeping one step ahead, speaking to tenants well in advance. And making sure that when you do get the properties back, you make the investment to make them attractive to current levels of demand, current market. The next question. When some owners are converting offices to residential, what do you believe the future for office ownership is? And will you be buying any more in this sector? This is something that's talked about a lot. And the words that I hear again and again when people talk about office is stranded assets. And trouble is, you can't just dream up a new word for an old problem and claim it's a new problem. All a stranded asset is, is an obsolete asset. And obsolescence in real estate has been a fact of property investment forever. And it's been particularly acute in offices. Buildings wear out. They become unfashionable. The plant and machinery in them wears out. We come up with better ways of heating and cooling. And we need to make sure that we're keeping our buildings up to date. There are parts of the office market that I don't want to own, out of town, offices on business parks, but there are part of the sector that I'm only too happy to own. And as I said, we acquired offices in Central Manchester. We acquired offices in Oxford. But I think it will always be a smaller part of our portfolio. I'd be very surprised if it was ever more than 20% of our portfolio, given our portion for the industrial and logistics sector and for retail warehousing, which I think will always make up the bulk of the portfolio. And I think there is a future for offices. I'm sitting in our office in London today. The train this morning was busy, busy, busy, busy. And I don't think they're all going Christmas shopping. I think people are coming to the office. And when you come to the office 3 days a week or 5 days a week, those businesses still need offices to accommodate their staff on the days that they're in. So there is a future, but it's a market that is changing and perhaps will always change. That's the end of the questions. So thank you very much. I hope that's been interesting. And I hope I'll see you on a webinar again before too long.

Perfect. Richard, thank you very much for updating investors today. Could I please ask investors not to close the session as you'll now be automatically redirected to provide your feedback in order that the management team can better understand your views and expectations. This will only take a few moments to complete which will be greatly valued by the company. On behalf of the management team of Custodian Property Income REIT plc, we'd like to thank you for attending today's presentation, and good afternoon to you all.