Don’t worry if you missed this week’s event with Schroder Real Estate (SREI), you can watch the whole programme here!
In their presentation on Thursday fund managers Nick Montgomery and Bradley Biggins pointed out the strong rental growth UK commercial property enjoyed throughout the downturn since summer 2022, and sid pressure on real estate was easing with the Bank of England having pushed interest rates to their peak.
They also described the higher returns they are generating from upgrading properties to ‘net-zero’ environmental standards under their new ‘green premium’ strategy, and answered viewers’ questions.
Can’t watch now? Read the transcript
Gavin Lumsden:
Hello and welcome to ‘Schroders: Going green to generate sustainable property income’, a one-hour programme brought to you by Citywire and Schroders Capital. My name is Gavin Lumsden and I’m from Citywire. With me in the studio is Nick Montgomery, head of UK real estate and portfolio manager Bradley Biggins. They’re both here to talk about Schroder Real Estate Investment Trust, which they run, and which celebrates its twentieth anniversary this year. Nick and Bradley, very good to see you both.
This is the first time we’ve heard from a UK commercial property fund in the series. It’s an opportune moment to look at the sector, which is not only recovering from a period of sharply rising interest rates, but is also grappling with the challenge of climate change and the move to a zero-carbon economy. It’s the usual format today: Nick and Bradley will shortly give a presentation and then I’m going to ask them some questions. After that it’s over to you for Q&A in the last section of the show. Ok, let’s get down to business, Nick, Bradley, you ready to begin?
Nick Montgomery:
We are.
GL: Excellent.
Values down, but rents up
NM: Well, thank you very much, Gavin. Really, really great to be here. So, as you say, we’re going to start with a 20-minute presentation give or take on an update on why we think specifically SREI is in a really interesting point in its life.
And the key reason is we think the UK real estate market itself is in a really interesting place at the moment having had the correction you’ve mentioned, but in particular how we’ve evolved that strategy, the thematic approaches you can see here on sustainability, because we have real conviction it will allow us to enhance our shareholder returns.
First of all, just to set the scene on why we think the UK market is genuinely in an interesting position, the chart on the left-hand side here – what we’re showing with the dotted line is an index of UK largely commercial real estate capital values. So, these are an average for the index as a whole. From June 2022, which was the most recent market peak, to where we are at the end of December, using MSCI data for all UK real estate, what you can see in in really simple terms, the dotted line is, the market is pretty much off 25% at property level before leverage from the peak.
Now, as we all know, that’s largely been driven by the sharp rise in interest rates in response obviously to inflation and obviously the ‘mini-Budget’ – we saw that accelerate certain trends in the market. And so, what we saw, interestingly, was for lower yielding parts of the market, and the industrial sector became the lower yielding part of the market for reasons I’ll come onto, actually was most adversely impacted because it was all to do with rising rates and therefore the lower yielding sectors were more impacted by that.
But what you can see here in the dark blue line there, so you can see industrial values did fall more than others, ahead of others, but we are now beginning, as you’ve alluded to, to see values bottom out. And it was a very sharp decline in values, the rate of decline over that period was pretty much twice the rate we saw immediately after the Lehman fallout during the global financial crash (GFC).
What you can also see here, interestingly, is retail, perhaps somewhat surprisingly, holding up better than the other sectors. Part of the reason for that is if you were to go a bit further back, you’d have seen that since 2018 to June 2022, industrial values doubled over the five years during a period where retail values halved. So we actually think the retail sector now is also looking quite interesting. The orange line there I’ll come back to in a bit more detail later, which is the office sector where clearly working from home trends. But also a key focus for us in terms of sustainability is impacting how investors view that sector.
Going forward and the reason again why we think the market is in a really interesting place is if you look at the relationship between interest rates and real estate yields. So the chart on the right-hand side there, we’re showing in the green line the average initial yield from property. A bit of jargon – initial yield is very simply your rent today divided into your property value plus purchase costs.
Approaching fair value
So you can see today, depending upon which index you look at, the average yield from UK real estate is somewhere between 5% and 5.5%. Our yield is nearer 6% for the company we’re talking about today. And today you can see there that the 10-year bond yield obviously has moved around a bit, but is, give or take, around 4%. Now, long run, the relationship between those two is that you’d expect the real estate sector to have a premium of between 1% and 2%, so we are, in our view, approaching fair value and with an expectation that we will see rates continue to fall. And there’s a lot of noise, I understand, around the inflation prints. For that reason, we do expect the sector to look fair value with scope for improvement over the course of this year.
Now, the other really interesting point to note is, despite that very significant fall in capital values, actually, rental value growth, at least in nominal terms, remains really positive. In fact, the last 12 months represents the third-strongest rental growth compared to any period over the last 20 years, so you wouldn’t necessarily expect that.
And so what we’re showing on the left-hand side here is rental growth coming out of previous market highs, so during market corrections. We’ve got the dotcom boom there in late 1989, obviously the GFC there in 2007 and the most recent, June 222, and we’re tracking the movement in rental growth from that point. And what you can see for all property average is that actually rents are beginning to outperform the way that they did in those previous recoveries coming out of the downturn. So why is that?
It’s partly because across the market we have very low levels of new development. It’s also partly because there is obviously a positive correlation between rents and inflation. Businesses make more profits, businesses’ tenants can then prepare to pay more rent. But it’s also to do with some long-term structural factors and so that’s what we’re showing on the right hand-side – comparing the same analysis, but just looking at the industrials sector. Incredibly strong rental growth, particularly compared with coming out of the GFC. And that is also, we think, a reason to think that we will see values recover as we go into the rest of this year.
Opportunity in offices
Now, the office sector, it’s worth just touching on this. So we are underweight offices, but we think actually, there’s an interesting opportunity coming in the office sector. So the chart on the left is showing a couple of things. The first thing it’s showing is the light blue line represents the average yield on secondary offices, so grade-B offices, for want of a better expression, and the dark blue there, you’ve got prime offices, the best quality, you let them on the longest lease et cetera.
And you can see the gap between those two from 2009 to today has got progressively wider over the course of the last 12 months in particular. In fact, if you look at the spread, the spread between prime and secondary, which was represented by the grey bar with reference to the right-hand side, it’s never been higher. So that’s all about investors’ concern about secondary offices, impact of working from home, impact of high refurbishing costs, in particular to address sustainability requirements from occupiers.
Now, our view is that does potentially present an opportunity. We’ve got a very good specialist team within the real estate business. We’ve got specialists across all sectors, including offices, including a team based in Manchester. And the other point to note in relation to this is there is very limited supply coming forward, but the data on the right-hand side is showing you – in the dark blue line there – net additions as a percentage of total stock.
And essentially, the total stock of offices in the ‘Big Six’ regional cities is actually falling in absolute terms. And that’s because space is being taken out of supply, in many cases residential, but it could be student, and if you look forward, there isn’t a huge amount of capital going to development, there’s very limited supply coming through, so if you’ve got the ability to reposition space, particularly given councils’ increasing focus on retaining existing building stock because of the embodied carbon, we think that’s a really quite interesting place.
A brief snapshot on our portfolio, and some of these questions will come out later, so I’m not going to spend too long on this, but in headlines SREI has 40 properties. We’re very diversified, but with a focus on the high-growth parts of the market. We’ve got 300 tenants, again, very diversified in terms of income. Our portfolio is valued at just under £470m. That’s the number as of September because we we’re yet to release our December number, which we will do in February.
We have a very efficient debt structure and Bradley will provide a bit more colour on that later, and consistent with our thematic emphasis on sustainability, both our financial performance, and that’s illustrated by the data on the right-hand side of this slide, where you can see on a three-year rolling basis, we’ve delivered almost 500 basis points [5%] of relative outperformance at an underlying portfolio level, and the same can be said for all time periods.
High sustainability score
We’ve also continued to deliver good performance from a sustainability perspective. And some people may have heard of the GRESB survey, which is a global real estate sustainability benchmark, which we participate in and we’re delighted to say that on the most recent GRESB survey we scored 79 out of 100 and we’re actually first in our peer group, which included a number of companies that that are in our recognised Reit peer group.
From a sector allocation perspective, I’ve mentioned we’re overweight to the industrial sector and I’ll give you some examples of types of assets we’re invested in. We are underweight to offices, interestingly, and our approach of buying offices with good fundamentals in knowledge-based economies means that actually, of our 25% of office space, 10% is actually occupied by universities. So, it’s interesting where you get these buildings where you have a mix of uses, you can attract all sorts of different occupiers.
And our retail exposure, again, I’ll give some examples, but our retail exposure is very specifically focused on what we call value retail or convenience retail, both in terms of retail parks, but also catchment-dominant retail assets in very densely populated urban areas.
Six of our biggest properties
Now, just to bring that to life a little bit, we’ve got six images of current assets within our portfolio here. One of the great things about the company is people who don’t know us so well can get a really good idea quickly because actually these assets represent almost 50% of our portfolio value.
And on the left-hand side here, these are actually our first and second-largest assets. So Stacey Bushes industrial estate in Milton Keynes, 60-odd units, very granular income, all sorts of different businesses, which gives that asset real resilience in terms of income. Importantly, here, Bradley will give you an example of an asset we’ve just recently developed, but, actually, across our industrial estates we’ve been infilling where we have a land, creating new operational net zero warehousing, which gives us potential upside on that asset as we let that space up during the course this year.
Another really good example, Millshaw industrial estate in Leeds. This is actually one of the biggest contiguous industrial ownerships within Leeds, it’s right on the Ring Road. Also, interestingly, here we have a railway line behind us where a new station is going in, so although the current use is industrial, actually, long term, it is a really interesting potential alternative land play here.
Within our office portfolio, as I’ve mentioned, it is offices, but actually, you can see here, our biggest office, in fact, is used as a university in Bloomsbury, the University of Law, one of the bigger providers of legal training to the big London-based legal firms. Really interesting location obviously Crossrail. lots of interesting medical-related uses alongside UCL going up towards King’s Cross. And then City Tower there, you can see a really dominant asset that sits on a three-acre acre site right in the middle of Manchester city centre, and lots of upside there.
And then retail, this is really a very clear example of what we own, you can see a Little Home Bargains and various other uses in Bedford and also a catchment-dominant block just north of Leeds city centre, where we have a Premier Inn, Sainsbury’s and all sorts of other uses that does trade very, very well. So, a good quality portfolio with lots of potential for asset management and in particular, the ability to improve the sustainability credentials.
High covered dividend
So, I guess, just to stand back for a moment, why do we think outside of a market cycle, we think this company is particularly interesting? Well, hopefully I’ve been clear: we have a really good quality, diversified portfolio focused on the high-growth parts of the UK with a really attractive yield profile. Current rent today about £28m; market rent today – what we call the reversionary rent – approaching £10m pounds higher and that’s set in the context of a £16m dividend. So there’s significant potential for us to drive earnings growth.
We have a 7.6% dividend yield, which, based on the most recent interim financial reporting period to September, was fully covered by earnings. Part of the reason why we’ve been able to increase our dividend by almost 30% compared with the prior to the pandemic, is not only we have positive earnings growth on the top line, but we also have great visibility of our debt payments – 75% of our debt as Bradley will explain in a bit more detail shortly – is locked in for 12 years at 2.5%.
Despite all that shareholders can buy our shares today at a 28% discount to net asset value (NAV), having had that correction I’ve spoken about.
Shareholder vote
And finally, and most importantly, today, we have a really clear strategy focused on sustainability improvements and how we believe that will allow us to drive longer-term sustainable income growth. And I guess, just briefly on this, this summarises what we’ve done in terms of our strategy.
So, some people may know that we issued a circular and all of our shareholders were supportive of evolving our strategy and it is very much an evolution. So the financial objective remains the same, but we wanted to do something that makes it really clear that we believe that by setting clear key performance indicators (KPI), and this was the product of a long series of discussions with our board, who are wholly supportive of the strategy. We will firstly be even more able to drive our sustainable income growth, but also demonstrate to shareholders how we’re doing it.
Those KPIs will be linked to sustainability performance, they will be reviewed and monitored by the board and we will also be doing asset level net zero analysis, which we will also be reporting on in terms of the impact those interventions are having on our portfolio value and income. So, we’re confident, we have conviction that this will enhance returns for shareholders, but it will also differentiate us from our peers and hopefully drive more of the market share. So with that, I’ll pass over to Bradley.
The ‘green premium’
Bradley Biggins:
Thanks, Nick. It’s great to be here, Gavin, thanks for having us. A really important point we want to get across here is the reason for doing this strategy is, we believe, it will enhance total returns for our shareholders. And how is that going to happen? Well, what we’re seeing is that new laws and regulations that governments and other authorities are bringing in to combat climate change are impacting the behaviour of occupiers and investors, which, in turn, is having an impact on the valuation of real estate. So what we’re seeing is that for buildings that have the characteristics shown in blue at the top of this slide, they’re able to command a higher rent and a higher valuation as compared to buildings in a similar location and of a similar age that don’t have some or all of these characteristics. And that difference is referred to as the ‘green premium’.
But why would an occupier be willing to pay more rent for a building that has these characteristics? Well, as a business, you want to attract the best staff, you want to retain talent, you want to keep your utility bills low and you have your own corporate targets to meet these days, their own net zero carbon pathways. Then, as an investor, you’d be willing to pay more money for a building that exhibit these characteristics. Well, they let more quickly, they let at higher rents, there’s less void, there’s less capital expenditure (capex) required in the longer term and there’s less obsolescence risk as more stringent environmental rules start to become effective.
So what’s the opportunity for us? Well, we’re looking for mispriced assets because it’s hard to price these risks. So, we’d come in, buy an asset cheaply, implement a capex plan to put these sorts of characteristics in place and then we push the rents on and push the values on and then sell the asset. And in the meantime, we’re helping to decarbonise the built environment.
So what’s the quantum of this green premium? Well in London, we’re seeing around 20% on values. In the regions, our own research shows it’s around 8% and we believe that will trend upwards over time to match London to an extent. And our estimate for multi-industrial estates, which, as Nick says, is half our portfolio, we see at least 5% to 10% premium, and actually, we believe that’s a conservative estimate.
Big gain on Stanley Green
So that brings us on to an example, a proof in concept. So on the screen here you can see Stanley Green Trading Estate. This is a multi-let industrial estate located in South Manchester. We acquired it in December 2020 for £17.25m.
Now, the asset came with an existing site, so existing set of units, and a three-acre development site, and you can see that in the top photo there. Now, the strategy for the three-acre development site was to add 80,000 square feet of new-build warehouse accommodation. But what we did was we made a conscious decision to spend around 20% more on the capex to get the best performing units from a sustainability perspective.
So, for example, the new units are energy performance certificate (EPC) A+. They’re the first A+ units we have in the portfolio and they’re also BREEAM-rated ‘excellent’. And they’re also net zero carbon from an operational perspective. And then the result of that is what we’ve seen is we’re able to charge 21% higher rent in the sustainable units compared to the older units that are kind of EPC C Or even below. So that’s a 21% rental premium. But, in addition to that, the value will put a keener yield on that rent, so what that means is you get more value for each unit of rent.
And the result of all that has been really strong performance for this asset. So, in the roughly three years since we’ve owned the asset, we’ve made a 21% per annum total return, which is much higher than the benchmark. So it’s a really good result for our shareholders and is a really powerful example of the strategy in action.
Driving through rental growth
Now moving on, what we wanted to do was just give a bit more of a flavour of other asset management initiatives we have underway in the portfolio. And on this slide we’ve got three examples: we’ve got a retail example, an office example and an industrial example. So if we take the first column briefly, what we’ve done is we’ve partnered with Starbucks and now building two drive-throughs on two of our retail parks in the car park. Now, many of you would have used these drive throughs, they’re extremely popular, really profitable for the businesses and they’ve been great for us. We’ve made Starbucks build these to at least a BREEAM ‘very good standard’ rating that have to have PV on the roof to generate energy on site and there’s also going to be EV charging for customers.
And to put this into context in terms of financial outcome, the average rent at St. John Retail Park, which is our largest retail exposure, is around £20 per square foot across the site, whereas Starbucks are going to pay £86 per square foot, so it’s more than four times. So we’re really happy with that outcome and it also brings more users to the site, it will increase dwell time and increase footfall, so there’s these other ancillary benefits as well.
Tun of money
In the centre. we’re showing The Tun, which is a multi-let office we have in Edinburgh city centre. It’s close to the Royal Mile, it’s close to the Scottish Parliament. And what we’ve done at The Tun is we’ve recently completed a £2m refurbishment of some common areas of the roof and of some vacant units. There were three vacant units, two of them were already let and there’s one more to let.
And in terms of what we’re doing from a sustainability perspective, the result is they’re now EPC A-rated from EPC D-rated, and we’ve done that by putting in windows in the roof to improve the natural light, we’ve improved the fresh air provision, we’ve removed excess staircases to enhance the circulation and we’ve also put in end-of-journey facilities such as showers and cycle storage to encourage more sustainable transport to and from the office.
And in terms, again to give you some financial metrics, what does that mean? It all sounds very nice, but the vacant unit, the valuers have put an estimated rental value (ERV) on that reversionary rent, so it’s what they think the market rate of the rent is, of £27 per square foot. We have terms out at £32 per square foot, which is a 19% increase. So it really shows the strategy in action again, enabling us to push on higher rents for that better quality space.
And finally, on the right-hand side, we’ve got an industrial example. This is Sterling Court, which is comprised of three units on a well-established industrial estate in Swindon. We got all three units back about 12 to 18 months ago. One of them we let almost immediately to a tenant who wanted to do their own works to the unit. So we didn’t do any refurb there, which was great. The other two units, we’re close to completing or have just completed a really high-quality refurbishment. We’re pushing the EPC ratings on to at least a B and, again, to put that into context from a financial perspective, the previous tenants were paying £6 per square foot – we’re marketing these at £7.50. So that’s a 25% uplift. So again, it’s about picking the opportunities, seeing where you can push the rents on and seeing where it’s beneficial to shareholders to spend that extra money to decarbonise our real estate.
Bigger investment, higher return
Now, in terms of the impact on our returns, what we’ve shown here is analysis on our previous three years’ investment performance. So if you look at the left-hand side first, what we’re showing here is the percentage of our portfolio value that we spent investing into the portfolio over the last three years. So in round numbers, the portfolio value over the last three years has been around £500m and that means we’ve invested around £100m into the portfolio, which is around 20%. That’s formed of acquisitions, capex and developments. That’s much higher than the benchmark at 16%, which is indicative of our very active approach, but what the arrow indicates on the left-hand side is that as a result of this strategy we expect to invest more into our portfolio, so we expect the capex and development costs to increase.
However, on the right-hand side, what we’re showing is our three-year total return at a portfolio level and the first thing to note is for SREIT, it’s 6.7% per annum; the benchmark is 2.2% per annum. So, really strong outperformance over the last three years. And that’s shown in the blue and red bars: the blue bar represents income return and the red bar represents capital growth and we’ve outperformed in both respects. And so our aim with this strategy is to invest more in a portfolio to create more liquid and resilient assets to increase the rent and the valuations with a view to increasing the total returns for shareholders.
Moving on to the next slide. So this is our balance sheet. Really strong balance sheet, we think it’s a real competitive advantage compared to most real estate companies. We have two debt facilities, and you can see that on the left-hand side. We have a term loan with Canada Life of around £130m and a revolving credit facility (RCF) with RBS of £75m, but only £46m is drawn. Now the £130m term loan with Canada Life really underpins the strength of the balance sheet and it’s because it’s at an average fixed interest cost of 2.5%, which is extremely attractive in the current environment. In addition, the maturity of that term known is more than 12 years.
So, as Nick said, it gives us great visibility on our finance cost looking forward and has been a real factor in enabling us to push our dividend on, as we have done over the last 24 months, and we’re the only company in our peer group paying a dividend ahead of the pre-pandemic level. So, overall, really strong balance sheet, net loans are valued at 37% and an average interest cost, including the RCF, of 3.5%. The final point to note, 91% of drawn debt is either fixed or hedged. So, again, contributing to that really good visibility on finance costs. So, I’ll pause there and come back to Nick.
High ratings
GL: Bradley, just before you do, or Nick, before you come back, you mentioned a couple of acronyms, terms, there. EPC – I think that’s energy performance certificate?
BB: Absolutely.
GL: And there’s BREEAM – I think that might be less familiar to people.
BB: Yeah, so that’s a really complicated acronym. It’s another rating.
GL: Building research establishment environment assessment. I can see why you wouldn’t spell it out, but it’s another rating for environmental properties?
BB: It is. It’s more sophisticated than an EPC, it’s really well recognised in the real estate world and I think is going to grow in importance over time. So we look at EPC and BREEAM generally. It’s just a really good label to put on a building to kind of show that it’s great from sustainability perspective.
GL: And it’s scoring well on both?
BB: When we’re looking with our refurbishments and redevelopments, we have a minimum target and, yeah, it helps us push the rent on basically.
GL: Lovely. Ok, thanks for that. Nick –
NM: No, no, well, thank you. I’m conscious of a lot of questions, but I think what we’re trying to do here with these four bullet points is summarise why we think the company is in a really interesting place. Obviously, to set the context, the market environment, we think, is now going to become much more interesting – it’s been a difficult few years for the UK real estate sector. Obviously, I’ve talked about the impact of rising interest rates and inflation, but we’ve also had Brexit, we’ve had less international investment coming into the market. And I think a combination of factors, more political stability, but certainly a more accommodating interest rate environment means that we are expecting more capital flows to come into UK real estate because of the correction.
But I guess, specifically in relation to the company, we do think we now have a really interesting and differentiated strategy that sits very neatly alongside our financial objective to deliver a really attractive and growing level of income. We think within Schroders we’ve got the expertise, both in relation to the real estate specialism across sectors, but also in relation to our ESG capabilities more broadly, both in real estate but also across the platform more generally. We do have with this company a really attractive yield profile and, as Bradley has said very clearly, great visibility on our interest costs well beyond peers. And so I guess, in summary, we think that we’ve pulled a lot of levers, we’ve made some great progress, but differentiating the company this way is a good way for us to attract more interest from shareholders improve the rating and obviously ultimately hopefully position the company for growth.
Inflation scare
GL: Ok, thank you very much, Nick. There is a lot going on and I’ve got quite a few questions, but I’ll just remind the audience, I’ll ask some questions now, but do send your questions in for Nick and Bradley for later in the show. Ok. Well, I just wanted to begin with the fact that the commercial property sector has had a tough time, but at the end of last year there was a proper Santa rally going on hopes of falling interest rates, but more recently, we’ve had a surprisingly high inflation figure for December come through and that kind of knocked markets and got people worrying ‘Oh maybe interest rate cuts aren’t coming as soon as we had hoped.’ So where does that leave the prospect for interest rate cuts and what impact is that having on UK real estate.?
NM: Yeah. So, so look, I think, you’ve got share price volatility, which has obviously been a feature of the wider market, but particularly the Reit market over the course of the last few years. But, in particular, as you say, because of a lot of noise around the inflation numbers – in particular the core inflation number. Obviously, what drives NAV is a quarterly underlying property evaluation, which is less volatile. It’s based on market evidence. So what we’d say to shareholders is it’s probably at least as relevant to look at the underlying NAV, which is based on the actual independent valuation, versus what’s happening on the stock market of day one, day two. Directionally, notwithstanding, as you say, the noise around the inflation print, the trend is rates going down and we’ve seen that in the interest rate swap market. Five-year swaps today are significantly below where they were going back 12 months or so. And that means for people who are borrowing to buy real estate the cost of doing that is obviously falling quite dramatically.
Will we end up back at the Bank’s target of 2%? I don’t know. I think what we would say is there are big structural reasons why you may expect inflation to remain above trend, not least the cost of decarbonising the economy, and obviously we’re speaking to that trend now. But actually, as an asset class, as I say, with the correction that we’ve had, average yields of 5% to 5.5%, in our case a yield of pretty much 6%, if we do see interest rates trend down, above historic levels, but still in towards mid-3%, we think that that puts the sector in a really positive place.
Outperforming
GL: Ok. So, your half-year results recently showed that – and you alluded to this as well obviously – while the market fell just over 20% from July 2022 to September last year, your portfolio fell just under 14%. So outperforming. Was that an early example of what you’re calling the green premium?
NM: Partly. Yes, I think, as Bradley’s mentioned, if you look at the contributors to the underlying portfolio performance, the biggest single contributor was Staley Green Trading Estate. And that was partly about using our on-the-ground expertise in Manchester to dig out a really interesting deal off market. It was about our active management capabilities, but, as you say, actually, what’s delivered the real outperformance is delivering it to the operational net zero standard and extracting those high rents, which we would argue is the green premium. So yes, in part, it is due to that.
GL: Ok. And how much will it cost landlords to do all this upgrading for the net zero?
NM: Bradley may want to comment a little bit on this using a real life example, but I think it’s partly linked to the comments I made about the decarbonisation. So, it costs more to deliver buildings to a higher sustainability standard. There’s no doubt. We think Stanley Green might be 10% more, give or take, to deliver the new build, but we’re more than getting that back in rent. Our approach and the really rigorous approach that comes with this evolution in the strategy means that we should be really well placed to assess those costs, assess the risks and the upside of delivering those improvements. And it may be in some cases we conclude it’s not worth spending money and we will sell the asset and we’ll move on.
What I can say, which is really interesting, is if you look at the number of EPC certificates issued over the last five years to a B standard, which is a standard that the market is looking towards in order to achieve the government’s current target of the market being at B by 2030, the volume of refurbishments needs to be a multiple of where they are at the moment, literally a multiple. And so getting in there early, having a really clear strategy for how we’re going to deliver it is absolutely the right thing to be doing because there’ll be a number of factors if you leave it too long, not least we will see rising construction costs.
Recycling capital
GL: Ok. And how many of your non-core, I assumed those are secondary properties, are you looking to sell because it’s not worth?
NM: Bradley, do you want to touch on that?
BB: Yeah. So the strategy is to sell some of those smaller assets, so we can then use the proceeds to reinvest into our larger assets, to drive these improvements and really move the needle for the fund. Sometimes we can do some really great work on the smaller assets, but it’s not moving the needle for the fund.
GL: OK. And so a similar question, are you, Nick, I think you alluded to it, also looking to buy oversold assets? Prices have been knocked because of the concern about how much it might cost to to upgrade them. Are you seeing opportunities to buy those?
NM: We’re beginning to. I think at the moment, given there’s still uncertainty in the market, albeit, as I say, we’re feeling more optimistic now, I think we probably feel there’s more value investing in our existing portfolio, given the relatively limited resources that we have. We’ve got, as Bradley said, various refurbishments that are either in progress or planned where you don’t have friction costs associated with buying new assets and so that, for the moment at least, is our preference. I think, having said that, once we, as Bradley has outlined – we have a number of sales planned – assuming those proceed as planned, it would be lovely to think we do have a war chest because looking into the rest of 2024 into 2025, we do think there’ll be some really interesting mispriced opportunities where we’ve got the specialist expertise to extract that green premium through great stock selection and the active management.
GL. Ok. Brilliant. Just to remind you, I’ve got some questions coming in, which is great. Do keep them coming and I’ll them up later. But in the meantime, Nick, Bradley, I was reading you’re looking to earn a sustainable improver label under the City watchdogs new proposals. What does a sustainable improver mean in practice?
NM: Yeah. So you’re referring to a label within the new sustainable disclosure regulations (SDR) which the Financial Conduct Authority (FCA) has been consulting on for a while. I guess it’s worth just stepping back and saying, actually, our strategy in the evolution has been designed completely independent of that. Whether SDR’s here or not, we would be doing what we’re doing now because we have conviction it’s the right thing to do to drive more sustainable income and returns. Having said that, it has been designed also to, if we can, align with the label which we’re beginning to understand. Assuming we are eligible at some point for that, then we would expect to try and achieve that label. So as I say, we’ve run ahead of that, if you like, because we think it’s the right thing to be doing label or no label.
M&A: We want to be bigger
GL: Ok. And last question from me for now. Last year saw an increase in mergers and acquisitions (M&A) in the Reit sector. Institutional investors in particular say they want fewer, bigger funds. I think some private investors would agree with that as well. Are you prepared to play a role, presumably as a buyer?
NM: Well, I won’t talk about specifics, but what I will say is that this is a really strategically important fund for us. Obviously, Schroders runs a number of investment trusts and having something like this is a really important part of that range and we commit significant resource to it across all the disciplines. I think when we stand back and say, ‘where would we want to go?’ We tend to get more bang for our buck with our bigger assets. So long term, as Bradley has said, we want to be owning bigger assets and therefore that ideally means that we become bigger ourselves. I guess our approach so far, I think, is to try and control what we can most easily control, which is evolving the strategy, delivering sustained growth in dividends, refinancing in the hope that actually and, again, alongside things like this, that will drive demand for the shares, it will see an improvement in our rating. If those things happen, then we are absolutely interested in pursuing opportunities for growth that are accretive for our shareholders.
GL: That’s always the important line, isn’t it?
NM: Exactly. We’re most focused on generating income as we’ve seen head costs and headlines recently, some companies have got a bit distracted. It is difficult. M&E in the investment trust space. And that’s why, as I say, our first priority is what it says on the screen there: generating sustainable income. And if we get all that right, then, obviously, we would hope that that would be reflected in the rating and in due course that might create growth opportunities.
Is your dividend covered?
GL: Of course. Ok. Great. Well, that all the questions from me for now, so I’m going to pick up on the audience’s questions. And talking of sustainable income, you have a sustainable income to support a dividend. So KT’s asking two questions, actually, it’s good to clarify this point: is the dividend cash covered over the next five years? And is it inflation-linked?
NM: So we don’t provide forecasts, but what we do is provide shareholders with our results with real transparency about where we see the potential for the growth in our underlying rental income. So, as I said earlier on, we were fully covered for the interim period to September, we will be announcing our quarterly NAV to December in late February, but what we can say again, going back to some of that jargon, our current rent today is £28m, our rental value, so this is according to independent valuers, is £10m higher. Ok. And that’s partly through letting a vacancy, partly through the fact that market rents are ahead of our current rents and it’s also really importantly to do with projects like Stanley Green that Bradley has spoken about. There’s £1m just in letting up Stanley Green. So, to set that in context, and I hope this answers the question, to set that in context, that £10m compares with our current dividend of £16m a year. Ok? So you can see without putting a forecast on this, you can see how if we’re successful at driving that growth in underlying income then there ought to be further growth in earnings.
GL: Okay, that’s very good. And KT also asks, why was the dividend yield higher in 2012, going back a bit, than the last year? What happened? Was it something to do with the share price?
NM: The dividend yield. I don’t know, that’s yield. I mean what I can say – we haven’t got the stats here – but what I can say is the dividend today is give or take 30% higher than the pre-pandemic level. I’d need to look that up, I’m not quite sure what that’s driving at.
GL: But the recent change in the yield would reflect the fall in the share price?
NM: That’s correct. But going back 10 years, I’m not sure.
BB: But also the dividend increases over the last 24 months. We’re 8% ahead of the pre-pandemic level, whereas most peers are below their pre-pandemic level.
‘Please do a deal’
GL: Ok, brilliant. Moving on to a question from Andrew Moffat, who’s a shareholder, and he has two pressing points. One is that the trust is a small company, a small-cap Reit, unable to attract the large wealth managers, which probably accounts for some of the discount, he says, so surely the answer is to merge, as is occurring elsewhere in the sector. He does come up with one suggestion. Yes, I mean you said yourself you want to get bigger and shareholders like Andrew are telling you, ‘Please get on with it if you can.’
NM: Yeah, look, I mean, what I can say is, and we’ve obviously had a lot of engagement with shareholders, through this and in the run-up to the circular, our shareholders, our biggest shareholders are all supportive of what we’re doing. Our shareholders would like us to be bigger, but it needs to work, it needs to be a accretive and it needs to be deliverable. So I think if we can identify a transaction that delivers those things, then rest assured we’re working hard to try and deliver that.
BB: And I think we’re really well placed to manage a larger trust. As a real estate business at Schroders, we manage around £24bn in assets under management, and around half of that is in the UK. So what this trust benefits from is a team of 130 people, many of them front office asset managers, investment managers, fund managers, sector specialists, the sustainability specialists in real estate, in Schroders Capital,in Schroders, all those resources are helping us deliver this outperformance. We saw the 6.7% versus 2.2% – we’re ready to scale up.
Share buybacks
GL: That’s a good point. This trust is the tip of a big real estate iceberg. Jonathan Benstead wants to talk about the discount and whether you have plans to buy your own shares, which, of course, would actually counteract your plans to get bigger. But the discount at 28% is large and there are no share buybacks.
NM: We have bought shares back. We are one of relatively few in our peer group to have done it about three years ago. I think it gets back to the availability of capital and also borrowings because, the capital we have is allocated to projects that we think are going to drive good, long term returns. So the developments we’ve spoken about, for example. Also, obviously the other consequence of buybacks is you do increase your net loans to value and we have a strategic range. We don’t want to go out, materially outside of that, which is why, at the moment at least, we’ve chosen not to do the buybacks.
Is the ‘green premium’ temporary?
GL: There are some constraints there, obviously. Vivian Woodall says it’s good to see the green investment, which we all understand is necessary to combat climate change and it’s good to see it’s so central to your thinking. Presumably, the rent advantage will be temporary and will reduce as more and more properties in the national stock are brought up to a higher standard. So her question is, for how long do you think a green premium will be something you can expect?
NM: Yeah, really good question. So, we think it will be some time before we run out of opportunities. If anybody is sitting next to their window, if they look outside across any city, 70% to 80% of that building stock will still be here in 2050. So the challenge, the decarbonization challenge is significant and that creates the opportunity for us. What we’ve always tried to do with the strategy is buy assets, not quite the worst house on the best street, but buy assets that require that improvement, deliver that improvement, hold for income or sometimes sell those assets and recycle. So again, that’s exactly what we’ll be doing here. We will be adopting that same approach. There’ll be some assets we buy, reposition, deliver those sustainability enhancements and, as we’ve spoken about earlier, there are mispricing opportunities where we can potentially sell those assets and redeploy and go through that loop again.
GL: And in terms of Stanley Green, the completed net zero project, one of our viewers wants to know how much is let or under offer or advanced negotiation?
NM: 60+%is the short answer. We’re really positive about providing shareholders with some good news flow over the coming weeks and months. We’re on track in terms of lease-up versus our underwriting assumptions and we’re actually ahead in terms of the actual rents that we’re achieving.
GL: OK. I’ve got a question. You’ve got another project in Milton Keynes that you were saying in results recently was close to completion. Is it ready?
BB: Yeah, it was recently PC’d and we’re marketing it. It’s very similar to Stanley Green – we took the decision to pay a bit more on the capex, around 20% higher, and the unit we’re looking to let at around £13 and, again, the average rent across that estate is close to £9. So that shows that premium in action again. And also, if we are able to secure that £13, it lifts all the other rents on the estate, so it’s really important that we get that knock on effect.
How high are your voids?
GL: Ok. KT’s come back with another question. Good work, KT. What are your current voids? How many empty properties do you have currently?
BB: So it’s around 11%. The 10-year range is 5% to 13%. So we’re within that range. It is a bit higher than it has been in previous quarters, but the reason for that is the new developments. So when they suddenly complete, they come into our numbers and of course they’re empty, because they’re only just been built. If you adjust for Stanley Green, then we’re at 9%. We’re comfortable with the void. There always will be voiding in our portfolio because of our strategy to refurbish and because we have so many multi-let estates are always turning over. Right now we’re comfortable and we expect that 11% to trend down over the next year or so.
NM: The other important point KT is actually because of the investment in the portfolio, the vast majority of our void is refurbished. So we’re not having to refurbish and then relet and therefore incur that cost. We have already incurred that cost, it’s been reflected in the NAV, so it’s really just about letting it on the best terms possible.
Have you skin in the game?
GL: Right. Ok. One more viewer question. We’ve got time for more questions, so do send them in if you’ve got some, that would be great. But Andrew Moffat has also come back with a classic question for this forum. To what extent are the managers invested in their own cooking?
NM: We’re both invested.
GL: You’re both invested? Can you disclose what they are?
NM: No, we don’t, but it is meaningful.
GL: You’re aligned?
NM: Yes we are.
GL: Ok. And Vivian’s come back as well not with a question, but an encouraging observation. ‘For what it’s worth’, she says, going back to the merger question, ‘I don’t see an imperative for you to merge, I like what you do and would vote against any merger that compromised your approach.’
NM:We appreciate that comment. It gets back to what I said. I think fundamentally it has to work first and foremost for shareholders, it has to deliver the returns. We’ve spent a long time creating a portfolio we’re very happy with. We will only do that if we’re comfortable that we are at least maintaining the quality, but most importantly, continuing to deliver that sustainable growth and income.
How long are your leases?
GL: Ok. Ian Baker has nipped in with a question, which is great. Going back to lets, are the lets short or longer term in length? I mean, what is a typical length for your leases?
NM: It varies. To take Bradley’s point, we have a portfolio, which is very high yielding versus the average, but also it’s constantly managed. We’ve bought a lot of multi-let industrial estates where lease terms are typically between three and five years. So what that means is our average lease term, assuming all tenants break, so the earliest opportunity, is about five years, give or take. But what we do try to do, and we’ve had a lot of success with this, is because we can’t afford to buy long-leased assets ourselves because long leases to good tenants obviously cost more, yields are lower, what we do is, as part of our asset management strategies, work to increase lease duration by working with tenants, investing in the assets in return for those longer term lease commitments.
So a really good example that people would have seen on the screen earlier are our retail assets up in Leeds. We had a vacant office building that we acquired with the retail operators on top and we put in place a new Premier Inn hotel on a 25-year lease with RPI. Now, we couldn’t afford to go and buy that Premier Inn – the yield would be too low – but we’ve got capabilities in the team effectively to manufacture that long-dated income. So that’s what we do: we buy high-yield assets, but at the same time, we maintain that average on the lease term by delivering on the active management.
What is a ‘green loan’?
GL: Ok. We’re talking about your green investment strategy, so can I ask you about the green loan. You talked about Canada Life, Bradley, about that credit facility you’ve got with them, the £80.75m credit facility, but it’s referred to as a green loan. What does that mean?
BB: We work with RBS to agree three KPIs that, if we are able to meet these KPIs, and they’re linked to sustainability performance, such as EPCs, BREEAMS, carbon emissions across the portfolio. If we meet certain KPIs then we pay slightly less interest. And if we meet them to a certain extent, there’s no adjustment to our interest cost and if we don’t meet them, then we pay slightly higher interest. So it’s their way of incentivising us to do what we say we’re going to do. And it’s great from their perspective because they’re encouraging decarbonisation in the build environment.
GL: You said the trust is paying 3.5% on its current borrowing on average. In real estate investing it’s important, isn’t it, to do that? What you pay in finance costs is less than the yield of return you’re making on your investments. Do you want to flesh that out a bit more?
BB: Yeah, so out net initial yield in the fund is 5.8%, so there is that spread? You wouldn’t want to pay more finance costs than the actual yield you’re going to receive. And that was part of the problem that Nick described earlier about the lower yielding assets in industrial from June 2022 – they were starting to exceed the finance costs. The yield had to go up. How does that happen? Well, the value has to come down.
Good margin
GL: And so that 2.3% margin you’ve got between the finance costs and the net initial yield, is that is that a good margin? Historically, does that deliver good returns?
BB: Yeah, that is a good margin and we benefit from that long term-loan I mentioned at 2.5%, whereas many of our peers are currently paying higher interest costs and have importantly that refinancing risk coming around and that’s going to be really important driver of returns looking forwards – are you able to hold on to that lower debt? Otherwise, you’d have to basically sell out and pay down debt because it becomes non-accretive.
GL: In terms of capital expenditure costs in upgrading properties to environmental standards, is the capital for that going to come from borrowing or is it from selling properties? How do you make it work?
BB: At the moment it’s from selling properties because at the moment our RCF is expensive. We don’t want to draw down on that unless there’s a really good opportunity in which case we will. But the plan is to sell down those smaller assets and put those proceeds into the bigger assets to try and generate the higher end and the higher valuation to move the needle of the fund.
Retail revival
GL: Ok. Brilliant. We’ve got a couple more minutes. Would you like say a bit more about some of the segments in which you’re operating in? For example, retail, which you highlighted earlier, Nick, that obviously had a really tough time a few years ago, but actually, last year it looked like it was doing relatively well compared to office and industrial.
NM: Yeah, I think as I said, it’s a really interesting stat that in the period from the middle of 2018 to the end of 2023, or, sorry, to the peak of the market in June 2022, average industrial values doubled average retail values halved. So the tailwinds that were clearly driving the demand for industrial and particularly logistics as retailers restructured their supply chains was obviously having the opposite impact on retail as a whole. Now, what that means is virtually no retail has been built. But although that’s positive, actually, we still have concerns about the high street and we still have concerns particularly about some of the fashion retailer.
And so what we’ve been doing very deliberately is allocating our retail investments into what we call convenience retail. So for that, think Lidl, Aldi-anchored retail parks. Bedford is a great example where we took out Homebase as a retailer and we put in Little Home Bargains that really now anchors that park and is one of the reasons why we’re able to attract Starbucks. Or it’s that convenience retail, the basket shop that plays into those changing demographics. Smaller households, people will do perhaps a bigger online shop, but then between that, perhaps people will have a few more basket shops, hence the rise in small format supermarkets.
And so assets such as the one we have up in just north of Leeds in Headingley, absolutely plays to that. And if you get an anchor like Sainsbury’s, you can get your Costa and some of the other smaller retailers to drive those rents. We generally feel more optimistic. if you look across the retail portfolio, there are an increasing number of requirements from the discounters, as I say, for food, some of the leisure operators or the restaurant operators, which is helping drive performance.
Charges explained
GL: Ok. And can I also ask a question about costs and charges because investment company costs. It was a big issue last year, maybe one factor in the in the derating and opening up of investment company share price discounts. There’s the fact that investment companies have to disclose more costs, it’s a bit different from open-ended funds. Your own charges – your results recently showed that if you include property expenses, expenses of 2.4%, but the fund expenses was 1.2%. Is it the 1.2% should be focusing on? Or how important is the 2.4%?
NM: Well, I guess, if you’re an investor, you want to know all of those numbers. I think the question is, is it consistent with the way that open-ended funds, for example, are reporting their fees and obviously with the Priip rules, it isn’t in terms of that headline number. So just really simplistically, Schroders manages the company for 90 basis points as a fee and that covers all the work that we do: the asset management investment, the investment, the fund operation.
GL: 0.9% of NAV?
NM: 0.9% of NAV. The additional cost on top of that, the 1.2%, are all the other associated costs of running the company: directors’ fees, audit fees et cetera. So actually, we think that’s pretty efficient. I don’t think it’s right to then say for comparison purposes, for example, in the KID that you then also include leasing fees, legal costs, building surveyors’ fees, because those are the legitimate costs of investing properties. Equally, amortising acquisition costs within the KID or or finance costs, for example, they’re not always applied on a consistent basis. So I think we would say when you look at the actual costs of running a company, we are actually very attractive compared with the alternatives.
Loan lifts asset value
Gavin: Ok. Brilliant. So last question. Viewer Michael Tillman has resubmitted a question. Michael, very glad you did because I didn’t actually understand it the first time. So it’s about NAV. Michael wonders, ‘could the mark to market pence per share premium of the fixed-rate borrowings be disclosed with the quarterly release? This may help to highlight extra value not included in the NAV.’ This is the impact of different ways of measuring your debt and the impact that has on the NAV.
NM: Really good point. Actually, we did in our most recent interims, but we will, going forward, disclose that number. The point is, under accounting rules, we are not able to or required to disclose effectively the mark to market value of our fixed-rate loan in the way that you would do if it was a derivative or an interest rate swap. If you do calculate the number in the same way, the positive impact of our NAV as at 30 September was approximately £20m.
GL: So the current value of the debt is different from the eventual value of the debt?
NM: Essentially, the simple reason is the 2.5% fixed rate that we have for a further 12 years is obviously significantly below the equivalent market rates. And so to use the parallel in interest rate swaps, we would discount that effectively and that would result in a positive value that would sit as an asset. But because it’s a fixed-rate loan, we’re not required to put it in. But obviously there is a real value there because it’s 2.5% for the next 12 years.
GL: So the NAV can get higher than it currently is, which means the discount’s even bigger?
NM: Well, in a sense, yes, but it is supplied on a like-for-like basis across the peer group so it’s balanced. There are peers like us who have exactly the same – not quite as attractive – but they have those long-dated loans and they don’t either provide it. There is within the disclosures within the full-year results, there is a measure that does. For simplicity, what we have done, and hopefully this will appeal to Michael, what we are doing going forward is just noting that below the line, if you like, when we announce our quarterly NAVs.
GL: Ok, Michael, thanks for the question. Good question and, Nick, thanks for the answer, also a very good answer as well. I’m afraid that’s all we have time for. I hope what you’ve heard has whetted your appetite for UK real estate investment. But in the meantime, goodbye from all of us and happy investing.
