Schroder European Real Estate Investment Trust Plc (SERE) Earnings Call Transcript & Summary

Well, good morning, ladies and gentlemen, and thank you very much indeed for joining us this morning for the Schroder European Real Estate Investment Trust Annual Results Presentation. My name is James Lowe. I look after sales for the Schroder Investment Trust business. I'm very pleased to be joined in the studio this morning by my 2 colleagues, Jeff O'Dwyer, Portfolio Manager for the European REIT; and Rick Murphy, Finance Manager. Just before you hear from the team on the presentation of the results, a couple of things from me. [Operator Instructions] You can also download a couple of things on your screens. If you'd like to follow along with the presentation, you can download a copy of the presentation. And also, there is a copy now of the annual report available to download, if you'd like to get into some more of the detail. With that short introduction, I'll hand you over to Jeff to start the presentation. Jeff?

Great. Thanks, James, and good morning, everyone, and thanks for dialing in to the results. Just before I go through the results and give an update, I just wanted to sort of touch base and remind investors what we offer. Firstly, the European REIT is a unique and compelling opportunity or proposition that gives investors exposure to a diversified portfolio in growth European cities and those cities include Berlin, Hamburg, Stuttgart, Frankfurt and Paris. It's obviously a very strong diversified to what we have here in the U.K. Secondly, approximately 100% of the leases are subject to indexation, so therefore, offering a good inflation hedge. Thirdly, at the interims, you may remember that we made a decision to really go conservative and move to a covered dividend. We retained quite a bit of capital and strengthened the balance sheet, really to position the company in the strongest position possible. We're now sitting here today with this strength and giving us the opportunity now to invest in or improve the quality of the portfolio, potentially look at a new acquisition as well as a means of trying to drive earnings growth going forward. Obviously, today for a new investor, we think the shares provide a compelling investment case and those that sort of buy the shares today can come in at a 40% discount to NAV, getting a 7.6% dividend yield and obviously some headroom in cover. Later in the presentation, I'll give some flavor on transaction evidence to give a bit more comfort around asset values. I'll talk you through the robustness of the dividend against interest expense and some comfort on how we're managing 2024 refinancings. And then finally, with the Schroder platform, obviously, having teams on the ground is a very key part of our story. And those teams are specialists across a multisector basis. So we have office specialist retail specialists, industrial specialists. On top of that, we've got sustainability specialists, which is becoming increasingly key, particularly in terms of trying to provide a solution to tenants and therefore, retaining tenants to help drive performance going forward. Just moving to the operational side of things in terms of what we've done over the year. Obviously, the portfolio has held up exceptionally well. We've got 97% occupancy. There's pretty well only one asset that has some vacancy and that's the Saint-Cloud office building. That will continue to be a bumpy asset. Through the year, we've obviously increased rents. We've been able to -- on the back of the indexation I touched on earlier, been able to drive rents by about 5.3%. So that's helped with earnings, we've done sort of roughly 15 new leases and regears across about EUR 1.5 million of contracted rents. We did a little transaction early in the year, which helped sort of strengthen our exposure to the growth industrial side, again, a sector that we see stronger rental growth in. This was also an asset that not only enhanced the income profile given it was a 20-year lease, but also the quality of the portfolio, given the nature of an award-winning industrial asset in a very strong location in the Netherlands called Alkmaar. In terms of looking now, I did sort of present in the interims, our decision to retain that capital and we're doing some sustainability audits at the moment. They're in process. We'll have the results of those in sort of January, February. It's 2 parts, really. It's really to understand the whole net zero modeling, but also to benchmark the assets against a scoreboard or a scorecard that we have in here as a means of us being able to then pivot and potentially sort of half -- mid next year sort of pivot to being more sustainable. So that's why we've retained some of that capital that we have. But we're in a very strong position now to be able to invest in the portfolio or potentially do another acquisition, as I touched on. Just on this slide, I just wanted to highlight, and I think in terms of where we're sitting in the discount that I touched on around 40%, we've got one of the lowest LTVs out there in the peer group. I haven't named all the peers here, but you can see there's diversified, sector-specific U.K. listed vehicles. We do look attractive. We've got a dividend cover that's 106% for the last 6 months with an attractive dividend yield. And obviously, that discount, we feel probably over-penalizes the trust relative to the other peer group. So I'll stop there. I'll let you sort of read that on your own. There may be some questions later on, but I'll now hand over to Rick to talk through the financial results.

Thanks, Jeff, and good morning, everybody. So looking at the financial highlights for the September 2023 year-end and beginning first of all, with the balance sheet. We can see on screen that as of the financial year ends, the company had EUR 32 million of cash on its balance sheet, which we really feel moving into 2024 does provide the company with significant flexibility around upcoming loan refinancings and also the opportunity for potential investment opportunities in the new year. With regard to loan refinancings, 2 loans were successfully refinanced in 2023. And Jeff will talk a little bit more around that success later in the presentation in a few slides time. With regard to LTV, modest LTV net of cash of only 24% at the financial year-end. Dividend cover of 106% for the second half of the financial year, and that's posed to re-basing of the dividend for EUR 1.85 per share down to EUR 1.48 per share and an 89% dividend cover for the full financial year. With regards to EPRA earnings, really pleasing to be able to say that these have jumped from EUR 6.1 million in 2022, so EUR 8 million as of September 2023, 31% increase, driven in part by like-for-like rental income growth, indexations and the acquisition in Alkmaar, the Netherlands for circa EUR 11 million back in March '23. With regard to the income base of the company, almost every lease currently is index linked or some sort of form of inflation uplift. And with regards to rent collection, full rent collection across the financial year, bar the shopping center in Metromar, Sevilla, Spain, for which the group wrote down its investment fully back in 2021. And just finally, on the slide from a performance perspective, NAV total return of minus 5% against the 7.3% in the prior year, predominantly driven by valuation declines over the financial year. Moving to the next slide, we see the NAV movement bridge. So an opening NAV of EUR 188.2 million or EUR 1.408 per share and a closing NAV of EUR 171.4 million. So a fall in NAV over the year of EUR 16.8 million. So we can see off that EUR 16.8 million, EUR 15.7 million is in that top line. So that's unrealized valuation losses across the portfolio in the 12 months, predominantly as yields have deteriorated and moved out over the period. With regard to transaction costs, EUR 1.2 million was invested as part of the acquisition of Alkmaar in the Netherlands back in the spring. Capital expenditure of EUR 2.8 million was invested predominantly at the Houten asset in the Netherlands and the office asset in Saint-Cloud, Paris. With regards to Paris Boulogne-Billancourt, development profit, EUR 1.5 million has come through the NAV this financial year. And as we move into financial year '24 and there's a maximum of a further EUR 1 million of potential NAV uplift to now come through that sale and development going into next year. Just positively as well with regard to Paris Boulogne-Billancourt, it's really pleasing to be able to say that as of today's date, that, of course, are in development, EUR 100 million to be received and EUR 98 million has been received by the company at today's date. With regard to the Seville joint venture investments, as mentioned, we fully impaired this back at the interims in 2021 and no reversal of that impairment in the 2023 financial year-end. EPRA earnings of EUR 8 million. Noncash capital items of EUR 0.8 million positive, that's predominantly a reversal of certain deferred taxes of valuation declines over the financial period. And then dividends paid to investors of EUR 7.5 million in the financial year, so bringing our NAV down to EUR 171.4 million or EUR 1.282 per share. On the next slide, we can see a summary of the income statement. So the top line, we can see a 31% increase in EPRA earnings year-on-year, EUR 6.1 million were our EPRA earnings for '22 and just under EUR 8 million for '23. At that top block, we can see that rental income has been a real boost to that. So that's like-for-like rental growth indexations and as mentioned, that acquisition in Alkmaar around the half year. Together with an improvement in the cost base, we work closely with suppliers to try and maximize value for the company. And we can see whilst net finance costs have gone up EUR 574,000, obviously, with increasing Euribor rates over the financial period, we try to actively manage our cash. I said we got EUR 32 million on the balance sheet and choice to maximize interest rates to partly offset some of those interest costs that have increased over the financial year. And then say, together with a fall in taxes, has meant that, that improvement in EPRA earnings of EUR 8 million. And just moving to the dividends. Here, we can see the trajectory of the dividend over recent financial periods and particularly post the sale of Paris Boulogne-Billancourt a couple of years ago. And dividend cover, just as a reminder, for the second half of the '22 financial year was 72%. That increased to 76% for our interims for the first 6 months of '23 and is currently 106% dividend cover for the second 6 months of the financial year. So a fully covered dividend. We can see on the screen, as mentioned, the dividend has fallen and have been re-based, as Jeff mentioned, from EUR 1.85 down to EUR 1.48. And this was deemed to be a strong move by the company for a few different reasons. It really is felt that having a fully covered sustainable dividend moving into next year is important for the balance sheet. It's the acknowledgment of the rising interest cost base we've seen as Euribor rates have increased over this year '23. And also, finally, with regards to capital employment -- capital deployment, it just allows a patient deployment of that capital as investment opportunities potentially rise going into 2024 with a view to hopefully maybe moving on that dividend cover from 106% a little bit further into 2024. And with that, I'll pass back to Jeff.

Just moving through the portfolio and a couple of things here I'll highlight not only in terms of the acquisition that we made in Alkmaar. Obviously, that's enhanced the quality of the portfolio not only from a construction point of view, ESG sustainability but also from an income, particularly around the lease length being 20 years and the covenant strength of that asset. Our allocation, and you can sort of see here, there's a sprinkling of assets across the different sectors, but we've got around 1/3 in offices, around 30% exposure to -- in the industrial sector, about 16% to retail and a small allocation to alternatives, which is the data center and the car showroom and we've about 12% in cash. I want to talk a little bit more around some of the liquidity and some of the pricing that we're seeing. And I know investment volumes have sort of fallen off a cliff, and there's a Slide next that I'll talk through a little bit more detail on that. But I just wanted to share with you some recent evidence that gives you some comfort around values and how this portfolio has been valued. And it's the top left asset in Berlin is probably one of my favorite assets given we're sitting on 4 hectares of land. But actually, there's been a very similar asset, a lease to Hornbach sold that's located in the northern part of Berlin, identical building in terms of size of lettable area, size of sites and same tenant. And that's traded at a value that's about 10% premium to what we're valued at. So again, highlighting the liquidity and the value for this type of retail being sort of stand-alone big box, and there is demand, certainly from private high net-worths. Equally in Frankfurt, we have another retail asset. It's a smaller grocery asset with another Schroder fund, we've been in the market selling 2 grocery assets in Germany. We've had 20 bids come in for those assets at pricing that again is about a 5% to 10% premium to what we're valued at here. So it gives me a lot of comfort around the retail, in particular, that we can sell these and there is demand and liquidity and supporting the net asset value that these particular assets are valued at. On the office side, we're located, particularly in Germany, in 2 submarkets being Hamburg or 2 cities being Hamburg and Stuttgart at a very, very tight supply, so particularly Stuttgart, where we have record low levels of vacancy. It's about 2%. There's just no choice. They're both lot sizes that are in sort of around the EUR 20 million mark. So again, very palatable and where we're seeing demand. And then the rest of the portfolio is primarily industrial and again, a sector that is holding up exceptionally well. I think we've probably seen a bit of a floor in terms of where values are for the industrial side, and I feel very comfortable that if we were to sell these assets that they would be highly demanded and very, very liquid. Just on the investment volume side, the left-hand side chart, you can see here, obviously, volumes in total falling off. But interestingly, the ratio or the focus has been on the smaller lot sizes, so these lot sizes that are sub EUR 30 million, which is where our strategy has been focused on. So you can see there sort of over the last, what, sort of 15, 16 years that the nature of or the percentage of assets or deal size less than EUR 30 million has moved from 40% to 75%. On the right-hand side, I just want to sort of share with you where some of the different sort of sectors across our fund have fallen. So on the industrial side, we've seen a reduction over the year of about 8%. We -- the sub portfolio of industrial represents about a 6.5% net initial yield. So debt is still accretive. And if you then start thinking through and comparing that against where sort of risk-free rates are, there's a really attractive premium that we have there. So on the industrial side, you're getting 380 basis points, through the office is around 250 and then the retail above sort of 300 basis points. Obviously, the 10-year sort of bond has been moving around pretty aggressively. It's fallen again this morning. So that sort of gap has increased. So again, not only is debt accretive, but obviously, that premium that you're getting remains attractive in terms of relative to the risk of government bonds. This slide really just highlights us as investment managers and how we can derisk an office building. So this was a Grade C building where we turned that into a grade A BREEAM rated asset. We provided a solution to the tenant, created value here. Obviously, what went behind the special dividends that we gave back to investors in 2022. So just highlighting really how we can derisk and create value through our asset management expertise. So therefore, looking forward, where can we look to do that in some of the other assets now. At the smaller end, we've got the Frankfurt investment. We'll probably be doing some regearing there and strengthening the profile of that, particularly maybe looking at expanding the Lidl. In Apeldoorn, we're in discussions with KPN about how do we extend or how do we provide a solution to them to stay. At the moment, it's used as a data center and office building. The data center is quite critical for them. It's an asset that also has some benefit in terms of alternate use. There is medium-density residential that surrounds this asset. We've still got 3 years left on the lease, but it's something we're trying to work with the tenant to see how we can derisk that and provide a solution to them. Berlin, I've talked about, again, longer term, try and create value here through planning, getting approval for a mixed-use concept having the 4 hectares there in a growth part of Berlin in a capital city that is naturally undersupplied from a residential point of view. So that's more of a longer-term angle. And then Saint-Cloud, we've got the train station that comes outside the building, not until 2030, but that's certainly an angle where we see potential ERV growth on the back of that infrastructure improvements. And that's generally the nature of how we've looked at investing. We typically look at submarkets where there's supply constraints, where we're buying off rents that are affordable, where we're buying into areas where there is improvements in infrastructure and where there is competing demands for users. And you've seen and I've talked before about how those sort of 4 elements come into the acquisition strategy that we've presented. Obviously, the inflation hedge, I've sort of talked through that before pretty well, all the leases are indexed. In Germany, there's a slight nuance where you have to wait for the hurdle to be hit. Obviously, we've seen inflation starting to come back and really pull back quite aggressively. Forecast now for next year are between sort of 2.5% and 3%. We did see actually some pretty strong double-digit inflation in the Netherlands, and that's what went behind that sort of 5.3% growth that I touched on earlier. On the debt side, and this is one of the reasons why we did retain some capital. We had some 2023 expiries that really positively, we can say that we've derisked. So in particular, the Dutch logistics where we entered into a new refinancing there with ABN, we decided to take a little bit more capital there to give us a bit more protection as well. We've -- we're now in discussions and in advanced discussions about bringing forward the refinancing of the Saint-Cloud loans, that doesn't expire until December next year. And what we're thinking of doing there is actually refinancing now, but keeping the hedge that we have. So we've got a cap that's in the money at 1.25%. We'll keep that in place for another year, and then we'll likely enter into a forward from December next year. We've agreed heads of terms on that with the existing lender, but still need to go through internal approvals and with the Board. But again, positive to sort of say that actually there is debt available for counterparties like us who have the ability to derisk the sustainability side. It's likely we'll probably repay a little bit of that loans and move on the EUR 17 million loan principal down a little bit, but it is positive news that we do have availability of debt there. The other loan that we have and have been working on and have sort of terms or interest agreed is on the Rennes logistics. So that's a loan that expires in March next year. I feel very comfortable about refinancing. That's obviously in a sweet spot where lenders, particularly given it's an industrial asset with decent lease length on that very strong covenant, there's a lot of banks out there wanting to lend on that. So I feel very, very comfortable on that refinancing. So overall, we're in a really strong position. If you then sort of think about -- if you take out Saint-Cloud and that's a loan where we're in discussions with the bank about trying to facilitate a sale here. But if you remove Saint-Cloud from the numbers, our gearing position actually falls by about 3%. So we moved from a 33% LTV or 24% net of cash to 30% and 20% net of cash. So a really healthy position going forward. The point about what happens to your earnings if you've got sort of interest expense increasing. So what we've tried to sort of do with this slide is sort of show, well, okay, if we refinance the Saint-Cloud, if we refinance the Dutch loan that we've done, and we refinanced Rennes, what happens to our interest expense. So by the end of next year, with all those refinancing, if you assumed an interest cost of sort of between high 4s for the Rennes and say, 5% for the Saint-Cloud, you end up with an average interest of 3.9%, which means that our interest expense goes up by about EUR 200,000 per quarter. So what needs to happen in order for us to maintain 100% dividend cover. Obviously, we've got 106% cover at the moment. We basically need rents to go up by 2% to ensure that the dividend remains sustainable. And obviously, we -- in terms of the forecast we've given there around where inflation is between 2.5% and 3%. You can get comfort there that we're going to see indexation that covers the interest expense that we're going to be seeing. So I still feel comfortable that we'll be able to maintain the dividend that we have going forward. So in summary, we think it's a very compelling investment case, particularly where the shares are priced today, particularly given the cities that we have exposure to. So these are growth cities that include Berlin, Hamburg, Stuttgart, Frankfurt and Paris. We're diversified, so we've got 1/3 in offices, roughly 30% on the industrial side where we see stronger growth going forward. The retail that we've got is very good retail and very liquid retail, so we're very comfortable about holding that. We've got a little bit of exposure on the alternatives with the data center. And overall, the portfolio has held up really well from an occupancy point of view. And I think moving forward, having a team and having expertise on the ground being able to deliver the sustainability side, having that operational excellence and also being able to provide solutions to tenants, that's becoming increasingly key as an asset manager and how we're going to drive returns going forward. So I'm happy to stop there. I'm sure there's a couple of questions, but that's over to you, James, for any questions.

Thank you, Jeff. Thank you, Rick. And yes, we do have a couple of questions. If you do have any as we go through the Q&A, then please do send them in. I will ask the team. Just kicking off with a relatively high-level question, probably one for you, Jeff. One of our listeners is -- has inquired into one of the comments we made actually in the deck at the start where we spoke about the return resilience of the European REIT strategy versus the U.K. peers. Could you just elaborate a little bit on what it is that has been driving that relative resilience in returns over the past year?

Yes. I think if you think about the valuation side, although you've had yields sort of deteriorating and I think for this portfolio, we've seen between 50 and 200 basis points depending on the asset. But you have the income side increasing on the back of inflation. And that's a unique difference that European leases have relative to the U.K. So you have a -- sorry, let me -- I think the slides are getting a bit wild. So you have a situation where, although you've got the denominator in terms of yield deteriorating, you've got the income increasing. So that's sort of offsetting and that's what's led to this sort of valuation fall that's relatively modest compared to what the U.K. peer group have seen.

Great. That's really useful context. And just staying on the sort of the more sort of higher-level sector areas where we've also had a question on offices. The question here is really around what you're seeing -- you've spoken previously on these calls around the different types of office you're seeing and also the bifurcations between particularly primary office, secondary, tertiary areas of the market. It's something we particularly see in the U.K. market where that's spread between primary and secondary as high as it has ever been almost. Is that the same trend you're seeing in Europe? How are you feeling about the offices in the portfolio in SEREIT?

Yes, very much so. And I use Paris as a good example. I mean, Central Paris is seeing rents now driving through to sort of EUR 1,000 a meter. And anything that is Grade A certified is seeing very, very strong demand and vacancy there is very, very limited. As you get to sort of some of the secondary locations, it's a bit more difficult. So if you look at La Défense, the vacancy there is certainly sort of high teens, I think we don't have any exposure to there. We do have Saint-Cloud, which is in the southern -- sort of on the river in the southern part of Paris, that's an asset that will be bumpy. I mean, we are having some success in terms of leasing. At a call yesterday with the team, we were in discussions with about leasing a potential floor in that. But really, the driver for that asset is going to be once we have the infrastructure improvements coming there. But definitely, for offices, it's the certification where we're seeing stronger rental growth, we're seeing sort of less vacancy, better demand, and we definitely know that actually having certified buildings in that particular sector, you're going to see stronger returns. And that's where we potentially can compete. We've only got 3 office assets. Thankfully, with Stuttgart, obviously, vacancy there is 2%. We're off rents there that are so affordable that we could -- if we had to improve the quality of that building, we could move the rents. They're less than half of where prime rents are so that would help us pay for the refurbishment that we do. Just like we did in Paris with the slide I gave before, where we took a grade C building that was leased at sort of EUR 320 a meter, we invested the EUR 40 million, turned it into a grade A BREEAM rated asset, but we moved rents to EUR 450 a meter. Similar sort of mindset that we can do. And that's the benefit of being able to come off sort of affordable rents with office buildings like this. I'd be a bit more nervous if I didn't have that luxury of that affordability.

So clearly a requirement to be more active in the current environment than previously. Would you say that's the case?

Yes. And that's the solution-based case that I sort of touched on before about being a house that can actually derisk and provide a solution to a tenant, whether it be an office tenant, a data center or a retail tenant, that expertise is so key, and that's what, certainly, the bigger occupiers want. It's not their expertise. It's ours, and that's what we can deliver to them. That's how we see we can grow returns going forward.

So then just picking you up there, we've had a question coming in on the tenant side. Could you just give us a couple of comments around how tenants are feeling on the ground, the tenants in the portfolio? Obviously, rent collection has been strong in this period. So they must be doing relatively well, but just a bit of color, I think, would be useful for our listeners.

Yes, rent collection has been very strong and actually even through the pandemic, which seems obviously a long time ago now, but we did hold up exceptionally well. We've got sort of 100% rent collection. We've got around 50 tenants that were a cross-section of industries, whether it be from sort of government through logistics, telecommunications, health care, insurance. So a good cross-section there, all holding up very well. We haven't had any tenants sort of come forward not being able to pay, for instance, the indexation that I touched on before. I mean, in the Netherlands, we had letters sent out to tenants where we were increasing their rents by 14%. So they were still paying that. They're contractually obligated. And again, this point about coming off affordable rents is a bit more palatable to apply an index of between sort of 5% and 14% to a lower rent than it is to say, having a prime asset in Paris. So Yes, the rental side of things is holding up very well. And again, that affordability is key to this strategy.

Thanks, Jeff. And so just moving on to a slightly different topic, and it is related to the cash that we have on the balance sheet. I'm going to -- there are a number of questions on this. So sorry if I don't ask your asked question specifically, but I'm going to try and bundle them in sort of the interest of time. There's a number of questions that are coming in asking around how you assess the relative attractiveness of purchasing new assets with that cash versus buybacks? And then there's a number of other questions on buybacks. So if you could just give us some thoughts about cash management, deployment versus buybacks, I know it's the million-dollar question and buybacks haven't actually always worked in recent times, but how are the Board thinking about that? How are you thinking about that?