Elite Commercial REIT - CGS-CIMB Research 2020-06-26: Stability Plus Growth


Elite Commercial REIT - Stability Plus Growth

  • Elite Commercial REIT offers investors stability and growth, backed by a long lease profile and inflation-linked lease structure, in our view.
  • Its key tenant DWP is a counter-cyclical occupier that provides resilience to Elite Commercial REIT’s initial portfolio. Growth drivers include inorganic expansion.
  • We initiate coverage on Elite Commercial REIT with an ADD rating and a DDM-based Target Price of £0.76.

Elite Commercial REIT - First UK-focused Singapore REIT

  • Elite Commercial REIT (SGX:MXNU) is the first UK-focused commercial Singapore REIT. It has a portfolio of 97 assets with a total net internal area of c.2.6m sq ft spread across densely populated areas in London, South East, North East and South West England, Midlands, Scotland and Wales. Its assets are well located and highly accessible, with c.74% in town centres and c.60-100% within a 10-15 minute walk to bus stops and train stations.

Stable cashflow, long-term portfolio relevance to DWP

  • Cashflow is supported by a long weighted average lease to expiry (WALE) of 8.6 years and backed by UK sovereign credit as over 99% of the portfolio’s gross rental income is derived from leases to the UK Government via The Secretary of State for Housing, Communities and Local Government, all with The Department of Work and Pensions (DWP).
  • In our view, the portfolio provides crucial public infrastructure for the provision of DWP's front-of-house and back-office services. For the medium term, we believe an ageing population should drive long-term structural demand for DWP services, ensuring the relevance of these offices, and Elite Commercial REIT, as one of the largest owners of DWP assets.

Favourable lease structure with embedded inflation-linked growth

  • We believe Elite Commercial REIT's inflation-linked rental escalation structure which states a minimum of 1% increase in rent annually (capped at 5% p.a.) facilitates its organic expansion while triple-net leases ensure minimal capex requirements near term. The UK Consumer Price Index (CPI) averaged 1.8% in 2019; Bloomberg consensus projects this to rise 0.9-1.8% p.a. over 2020F-2022F. This provides Elite Commercial REIT with growth visibility, in our view.

Potential for growth via asset enhancements

  • We believe Elite Commercial REIT's current portfolio has asset enhancement potential, namely Peel Park in Blackpool. The property has a net lettable area (NLA) of 156,542 sq ft and sits on 15.7 acres of land (including associated carpark space). It is currently used by DWP as its technology hub.
  • Elite Commercial REIT believes the untapped land provides it the opportunities to either work with DWP to increase its footprint on the site, or carve out a portion of the of the land for alternative uses in the future. Aggregate leverage was 32.8% as at end-1Q20.

Well-located assets

Predominantly freehold office portfolio

  • Elite Commercial REIT’s initial portfolio comprises 97 commercial properties located across the UK, in densely-populated areas in London, South East, North East and South West England, the Midlands, Scotland and Wales. The portfolio has a total net internal area (NIA) of c.2.6m sq ft spread across a total site area of c.47ha. The portfolio is predominantly freehold, with only one property on a long leasehold tenure expiring on 19 May 2255.
  • The portfolio is valued at c.£319m as at 31 Aug 2019, based on the valuation report prepared by property consultant Colliers International Valuation UK LLP. London and South East England locations, such as Canterbury, Newport, and Chatham, account for 16.5% of the 97 properties and 24.5% of portfolio value. Scotland, including Glasgow and Falkirk, makes up 20.6% of the properties and 23.6% of portfolio by value. The North West England locations, including Blackpool, Manchester, Liverpool, make up 16.5% of the number of properties and 23.2% of portfolio value.
  • The top 10 properties by value are situated in Glasgow, Blackpool, Canterbury, Falkirk, Swindon, Warrington, Derby, Chatham, Newport and Harlow, and account for 37.5% of total asset under management (AUM).

Located in highly accessible areas

  • By number, 53.6% of the properties are located in London and South East England, North West England, and Scotland. The majority, i.e. 82.4% of the properties are used as Jobcentre Plus or for front-of-house and public-facing services. Only 17.6% of the properties are used for back office and call centre facilities as at Aug 2019.
  • Furthermore, 74.2% of its portfolio (as at Aug 2019) are centrally located within city centres, town centres or city suburbs. All the properties are located within a 10-minute walk to the nearest bus stop and more than half are within a 15-minute walk to the nearest train station; its assets' locations make them highly accessible, in our view.
  • In the longer run, we believe these attributes could also be attractive to other space consumers, such as for other commercial, residential or student accommodation uses.

DWP – The Department of Work & Pension - a strong tenant with sovereign credit rating

  • Elite Commercial REIT derives over 99% of its portfolio rental income from the UK Government via The Secretary of State for Housing, Communities and Local Government with the The Department of Work and Pensions (DWP), under a group sharing agreement. The UK Government is rated highly at AA by Standard & Poor’s and Aa2 by Moody’s Corporation as at Aug 2019.
  • According to the independent UK property market research report produced by Jones Lang LaSalle IP, Inc. (JLL), the UK has operated an extensive welfare state since 1945. Other than the National Health Service (NHS), the main pillars of this have been the provision of financial support to those who are out of work (or unable to work) and the pension system. Over time, these have been supplemented by a number of other benefits extended to low-income earners (mainly via tax credit system and housing benefits). DWP, alongside its Jobcentre Plus delivery arm, is responsible for allocating and delivering most of these benefits and pensions.

Portfolio offers crucial public infrastructure

  • As the UK’s biggest public service department, DWP is responsible for welfare, pensions and child maintenance policy. It administers the State Pension and a range of working age, disability and ill health benefits to around 20m claimants and customers. It is a ministerial department that employs about 77,000 full-time equivalent staff and is supported by 14 agencies and public bodies as at Aug 2019.
  • In 2018/19 the total benefit spend of the DWP was £182.5bn or an average £9,126 spent per DWP claimant. This is equivalent to about 30.9% of the median UK wage. The bulk, i.e. 60% of this, went to pensioners (excluding those who are disabled or sick); another 29% of total benefit spend went to disabled and sickness benefits, and the remaining 11% went to working age benefits such as housing benefits, Universal Credit and maternity benefits, amongst others, according to the DWP Annual Report 2018/19, cited by the independent UK property market research report produced by JLL.
  • In 2018, The UK government reported that the DWP’s holdings were split between 808 Jobcentres and Medical Examination Centres and c.121 offices. Total floor space amounted to 1.43m sq m, split 60%/40% between Jobcentres and offices. The 2017/2018 period saw significant change within the DWP estate. Its Private Sector Resource Initiative for Management of the Estate (PRIME) contract with property company Telereal Trillium (Unlisted) came to an end, and new tenure and occupation arrangements were set up for leasing and management of the properties. This involved a significant consolidation and rationalisation programme, including a move towards co-location which saw local authorities, departments and other services moving into shared public buildings or hubs.
  • As part of this programme, DWP increased the number of Jobcentres co-located with local authorities, and vacated 149 operational buildings. While DWP states that further rationalisation is anticipated, the scale appears to be minor compared to recent changes, in our view. DWP anticipates a reduction in the number of buildings from 808 in 2018 to 781 in Mar 2021F and 770 in 2023F, or a 4.7% reduction over a 5-year period, according to the DWP Annual Report 2018/19, cited by the independent UK property market research report produced by JLL.

DWP – a counter-cyclical occupier

  • We believe Elite Commercial REIT offers investors resilience and recession-proof characteristics, thanks to DWP’s counter-cyclical occupier trend. As the usage of DWP’s Jobcentres reflects claimant counts, Jobcentre footfall and DWP benefit spending is highly correlated to unemployment. Evidence cited by the independent UK property market research report produced by JLL showed that the number of claimants increased c.74.3% during the Global Financial Crisis.
  • Given the increase in demand and activity at Jobcentres during difficult times, we believe DWP demonstrates strong tenant resilience characteristics.

Elite Commercial REIT - Growth drivers

Embedded inflation-linked growth within lease structure

  • Elite Commercial REIT has one of the longest lease profile amongst SREITs, in our view. The UK government has signed new 10-year leases for Elite Commercial REIT’s portfolio of properties in 2018. Leases to the UK Government undergo rent reviews every five years, based on the UK Consumer Price Index (CPI), subject to a minimum increase of 1% and a maximum of 5% p.a. This translates into a long weighted average lease to expiry (WALE) of 8.6 years (as at Aug 2019) and a weighted average lease to break term (WAULT) of 3.6 years (as at Aug 2019).
  • According to Bank of England statistics, UK inflation averaged 1.8% in 2019. Based on Bloomberg consensus estimates as at 12 Jun 2020, UK CPI is projected to range between 0.9% and 1.8% over 2020-22F. We believe this provides Elite Commercial REIT with a visible organic growth profile.

Asset enhancement potential

  • Elite Commercial REIT's initial portfolio has asset enhancement opportunities that can provide it another avenue of growth over the longer run, in our view. These can be from assets with under-developed land sites that are located in regions with regeneration plans such as Peel Park in Blackpool (the second-largest in its portfolio by asset value), and redevelopment or conversion opportunities, such as Duchy House and Palatine House in Preston. These asset enhancement opportunities have not been factored into our existing estimates or valuations.
  • Peel Park - Peel Park in Blackpool is currently used by DWP as a technology hub to spearhead its digital and change transformation. The property has a net lettable area of 156,542 sq ft and sits on 15.7 acres of land (including associated carpark space). Elite Commercial REIT believes the untapped land provides it the opportunities to either work with DWP, or to increase its footprint on the site, or carve out a portion of land for alternative uses in the future. Elite Commercial REIT believes this asset can also benefit from Blackpool’s Council Plan 2019-24 including new visitor attractions, such as the £300m investment into Blackpool Central, new conference facilities and museums, improved transport and housing infrastructure, and a 144ha Airport Enterprise Zone.
  • Palatine House and Duchy House, Preston - A number of Elite Commercial REIT’s properties are centrally located in town centres and some have potential to be redeveloped into a higher specification office or converted to other uses to maximise the yield or capital value of the assets. One example of this is the Preston asset consisting an island site complex of four buildings – Palatine House and Duchy House owned by Elite Commercial REIT, and Red Rose House and Elizabeth House owned by a third party. The latter two have received planning permission to be redeveloped into a higher-value residential-led mixed-use development with 130 apartments proposed.

Growth potential from acquisition opportunities

  • The potential to grow through acquisition exists for Elite Commercial REIT, in our view. According to Elite Commercial REIT, each of Elite Commercial REIT's sponsors will provide it the right of first refusal over all future UK commercial acquisitions. We highlight that one of its sponsors, Elite Partners Holdings Pte Ltd (Unlisted), has examined over £3bn worth of potential acquisitions over the past two years, primarily with similar high credit quality tenancy profiles as Elite Commercial REIT’s initial portfolio.

UK office market

  • According to property consultant Colliers International UK’s Jun 2020 property publication, there is a slowdown in occupier activity across the London market, with the running 2Q20 take-up figure standing at 650k sq ft, more than 70% below that of 2Q19 equivalent. There is still a healthy amount of space under offer, albeit with Covid-19 clauses. Meanwhile, supply levels within the regional Central
  • Business Districts remain constrained. Rental growth has slowed, but is still positive. Colliers’ view is that demand remains stable and supply is limited, and it expects that London and regional markets will see rental growth beyond the Covid-19 impact.
  • Meanwhile, according to Colliers, office investment activity remained subdued in May 2020, with preliminary data suggesting that £217m was transacted across 16 deals.
  • Given that DWP is a counter-cyclical occupier with an inflation-pegged rental structure and long WALE of 6.8 years, we believe Elite Commercial REIT has minimal lease reversion downside risk and anticipate its earnings to remain stable over the next two years.
  • Based on Colliers International UK reports, yields of office transactions have remained relatively stable from Jan-Jun 2020, even as transaction volumes have declined. Elite Commercial REIT’s portfolio has an initial NPI yield of 7.1% as at Aug 2019. Given its stable income profile, we believe Elite Commercial REIT's portfolio valuation is likely to remain stable over the next 2 years.

Elite Commercial REIT - REIT structure

  • Elite Commercial REIT is the first UK-focused commercial Singapore REIT with 100% of its initial portfolio located in the UK. Its investment strategy is to principally invest in commercial assets and real estate-related assets in the UK. Its key objective is to achieve long-term DPU and NAV growth per unit to unitholders via acquisition growth, active asset management and enhancement activities, as well as through prudent capital management strategies.
  • Elite Commercial REIT Management Pte Ltd, the manager of Elite Commercial REIT (Manager), will adopt a rigorous selection process for acquisitions of quality income-producing properties across the UK used mainly for commercial purposes, as well as seek to drive organic growth in revenue and net property income and to maintain strong tenant relationships. It will also seek to optimise debt funding costs as well as utilise interest rate hedging strategies, where appropriate.
  • Elite Commercial REIT’s trustee is Perpetual (Asia) Limited (Unlisted). The Manager is 85%-owned by Elite Partners Holdings Pte Ltd and 15%-owned by Sunway RE Capital Pte Ltd (Unlisted).
  • Jones Lang LaSalle Limited (JLL) (JLL US) has been appointed as the property manager by Elite Commercial REIT. JLL has entered into a property management agreement with Elite Gemstones Properties Limited (Unlisted) to provide support services relating to record management of the properties, relationship management with occupiers of the properties, and general management and administration of the properties.

Elite Commercial REIT - REIT management team

  • Elite Commercial REIT is supported by a dedicated and experienced management team with deep and broad experience across retailing, fund management, and real estate sectors.
  • The Manager of Elite Commercial REIT is helmed by Ms Shaldine Wang (CEO), Mr Cheah Zhuo Yue (CFO), Mr Jonathan Edmunds (CIO), and Ms Leng Tong Yan (Investor Relations Senior Manager).
  • CEO Ms Wang has over 20 years of experience in corporate finance, finance management and investments. Prior to joining Elite Commercial REIT, Ms Wang was the Head of Projects at Sime Darby Real Estate Management Pte Ltd where she was responsible for investments and development opportunities of the Sime Darby Property private fund from Oct 2016 to May 2018.
  • The rest of the management team has 11-17 years of experience in their respective areas of expertise. Hence, we believe the team is well equipped to bring in valuable knowledge and experience to Elite Commercial REIT.

Elite Commercial REIT - Sponsors

  • The sponsors of Elite Commercial REIT are Elite Partners Holdings Pte Ltd (Unlisted), Ho Lee Group Pte Ltd (Unlisted), and Sunway RE Capital Pte Ltd. Ho Lee Group Pte Ltd and Sunway RE Capital Pte Ltd together hold 19% of Elite Commercial REIT post listing in Feb 2020.

Elite Partners Holdings Pte Ltd

  • The company is an investment holding firm of Elite Partners Group, established to deliver long-term value to investors. Backed by a management team with proven expertise in private equity and REITs, it has a three-fold investment philosophy – protect initial capital, enhance investment value, and create new growth opportunities, in our view.

Ho Lee Group Pte Ltd

  • Ho Lee Group Pte Ltd’s business expanded from a single entity dealing with general plumbing works, to include construction-related businesses from general building construction to specialised metal works, formwork fabrication and sales and rental of construction machines and equipment currently. These various components were grouped together in 1996 into Ho Lee Group (HLG). HLG acquired BCA A1 grading civil engineering construction company Wee Poh Construction Co (Pte) Ltd in 2005 and ventured into the development of industrial and residential properties.
  • HLG was also a major sponsor of Viva Industrial Trust (SGX:T8B) during its IPO in Nov 2013.

Sunway RE Capital Pte Ltd

  • Sunway is a wholly-owned subsidiary of Sunway Berhad (SWB MK). Sunway Berhad Group is one of Malaysia’s largest conglomerates with three public listed entities – Sunway Berhad, Sunway Construction Group Bhd and Sunway REIT, with a combined market cap of RM17bn as at 30 Sep 2019. The Sunway Berhad Group is a strong advocate of the United Nation’s Sustainable Development Goals, and its listed entities are included in the FTSE4Good Index, which recognises companies with strong environmental, social and governance practices.

Elite Commercial REIT - Fee structure

  • We believe Elite Commercial REIT’s fee structure aligns the interests of the REIT with shareholders’ interests. The manager’s management fee consists of
    1. a base fee at a rate not exceeding 10% of the annual distributable income of the REIT, and
    2. performance fee of 25% p.a. of the increase in DPU in a financial year with the DPU in the preceding financial year multiplied by the weighted average number of units in issue for such financial year.
  • Performance fee is only payable if the year-on-year DPU is higher.
  • From our analysis, Elite Commercial REIT’s fee structure matches the fee structure of S-REITs which have chosen to peg their fees to distributable income. We estimate £1.6m in REIT management fees for 2020F; this would represent ~0.5% of Elite Commercial REIT's AUM of c.£296m as at end-1Q20, largely in line with S-REITs' 2019 average total fee to AUM of 0.51%, based on our analysis.

Elite Commercial REIT - Financials & capital management

  • Elite Commercial REIT’s gross revenue comprises contracted gross income from the leasing of office spaces. Over 99% of its gross rental income is derived from the UK government via the Secretary of State for Housing, Communities and Local Government (with the DWP occupying each property under a group-sharing arrangement).
  • Net property income is generated on a triple net basis with all the properties let on co-terminus, fully repairing and insuring leases. Property operating expenses comprise lease management fees, property management fees, and insurance expenses. This translates into a projected net property income (NPI) margin of c.97.3% in FY20-22F.
  • Elite Commercial REIT, via Elite Gemstones Properties Ltd, has entered into a property management agreement with an independent third-party property manager, Jones Lang LaSalle to manage its portfolio of properties. The property manager is entitled to a monthly property management fee which is paid quarterly in arrears. Elite Gemstones Properties Limited has also purchased property-related insurance for the portfolio of properties.
  • Based on our FY20F projections, Elite Commercial REIT’s property management fees account for less than 1% of gross revenue while insurance expenses made up c.0.08% of property value.
  • We estimate that Elite Commercial REIT will generate gross revenue of £23.3m p.a. in FY20-22F. In its 1Q20 business update, Elite Commercial REIT announced that the break option for the lease at the Lodge House, Bristol was not exercised in 1Q20 and as such, the lease will expire on 31 Mar 2028F. Meanwhile, the break option for the lease at John Street, Sunderland has been extended by 12 months to 31 Mar 2022F. This has further extended Elite Commercial REIT’s income visibility.
  • In terms of investment property value on its balance sheet, Elite Commercial REIT’s investment property portfolio of £319.1m is the higher of the two valuations by property valuers Colliers International Valuation UK LLP (£319.1m) (CIGI CN) and Knight Frank LLP (£300.1m) (Unlisted). Based on our projected FY20F NPI of £22.6m, this translates into an NPI yield of c.7.1%.

Elite Commercial REIT's 1Q20 performance in line with management’s forecasts

  • Elite Commercial REIT announced that its 1Q20 results (for the period from its listing on 6 Feb 2020 to 31 Mar 2020) were largely in line with management’s forecasts. Elite Commercial REIT posted revenue of £3.520m vs. its estimated revenue of £3.497m for the period which represented a variance of 0.7%.
  • On the other hand, PBT and PAT were well ahead of management’s expectations. Elite Commercial REIT recorded PBT of £0.7m and PAT of £0.4m, 15.2% and 84.8% greater than its forecasts, respectively. Distributable income of £2.5m and DPU of £0.74 for the period were both a slight 1.4% ahead of what management expected. 1Q20 revenue and distributable income represented c.15.1% and c.15.2% of management's full-year forecasts respectively.
  • Management highlighted that Elite Commercial REIT had collected its 1 Apr-30 Jun 2020 rent one quarter in advance. In addition, as 99% of its portfolio is leased to the UK government (rated AA by S&P and Aa2 by Moody’s) it sees low risk of defaults. In our view, this provides visibility and high certainty of rental income and cashflows. We believe Elite Commercial REIT remains on track to achieve its FY20 targets as outlined in its IPO prospectus.

Prudent capital structure

  • Elite Commercial REIT projects an aggregate leverage of 32.8% at end-1Q20, well below its targeted internal threshold of 40% and the Monetary Authority of Singapore (MAS) 50% guideline ceiling. Elite Commercial REIT has a debt maturity profile of about five years. It guided for an effective interest cost of 2.30% in FY20F. The Manager has hedged at least 50% of its debt into fixed rates post listing. We believe this will protect Elite Commercial REIT from interest rate volatility. Elite Commercial REIT's interest cover stood at a high 7.1x at end-1Q20. It had undrawn credit facility of £16.8m as at end-1Q20.
  • Assuming a ceiling leverage of 50%, our analysis shows that Elite Commercial REIT has additional debt headroom to acquire c.£100m worth of new assets.

Elite Commercial REIT - Valuation & Recommendation

Elite Commercial REIT - Property details

  • Click 'view full report' button below to see appendices of PDF report attached for details.
  • See also the key risks of Elite Commercial REIT in the PDF report.

LOCK Mun Yee CGS-CIMB Research | Darren ONG CGS-CIMB Research | https://www.cgs-cimb.com 2020-06-26
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