Elite Commercial REIT - UOB Kay Hian 2022-05-19: Break Clauses Becoming A Thing Of The Past


Elite Commercial REIT - Break Clauses Becoming A Thing Of The Past

  • Elite Commercial REIT's renegotiation of lease terms with sovereign tenant DWP has led to break clauses being removed from 108 leases, of which rents for 97 leases were maintained while rents for 11 leases were reduced. The properties have rent reviews every 5 years benchmarked against UK CPI, and rental escalation of 15.4% is expected to kick in in Apr 23. Exor NV is the largest shareholder with a 23% stake.
  • Elite Commercial REIT is a recession-resistant counter-cyclical yield play. Maintain BUY. Target price: £0.87.

Elite Commercial REIT embarked on renegotiation of lease terms with DWP

  • Elite Commercial REIT (SGX:MXNU) has embarked on renegotiation of lease terms with sovereign occupier Department for Work and Pensions (DWP) since Feb 22. DWP occupies 146 out of Elite Commercial REIT’s 155 commercial properties.
  • Majority of 136 DWP leases have no break clauses (83.8% of total contractual rent). 27 of the DWP leases are straight leases without break clauses. Break clauses were removed from 108 leases, of which rents for 97 leases were maintained while rents for 11 leases were reduced. The reduction in rents for the 11 commercial properties is estimated at 36% (before positive impact of rental escalation). DWP also signed a new five-year lease for one commercial property at East Street, Epsom.
  • Break options for 10 leases were exercised (7.2% of total contractual rent). DWP has exercised break options for nine leases. It will vacate from one building in Mar 22 and another eight buildings in Mar 23. HM Revenue & Customs has also exercised the break option for Sidlaw House at Dundee and will vacate the building in Jun 22.
  • Elite Commercial REIT will consider three options for these 10 commercial properties:
    1. re-let to other potential new tenants,
    2. divestment with vacant possession or following re-letting, or
    3. seek alternative uses, such as conversion or redevelopment.
  • Only three leases with outstanding break options (3.9% of total contractual rent). DWP has only one remaining lease with a break clause that occurs in Mar 23. DWP has not decided on whether to exercise the break option for this building. Two other leases with National Records of Scotland and Natural Resource Wales also have break options that occur in Jan 23 and Aug 23 respectively.

Mid-year valuation.

  • Elite Commercial REIT plans to conduct a mid-year valuation exercise to update the valuations of its properties post the renegotiation of lease terms.
  • Rental rates are affordable for the UK government. The average rental rate for Elite Commercial REIT’s 155 commercial properties is low at £9.60psf per year in 2021. The average valuation of its commercial properties is £130psf, which is below the current construction cost of £190- 250psf in the UK.

Income stability with long WALE.

  • Elite Commercial REIT has a long WALE of 5.5 years as of Mar 22 post renegotiation of lease terms.
  • Benefitting from higher inflation. The leases with the UK government are full repairing and insuring triple net leases that provide high NPI margin of 97.1% in 2021. Thus, Elite Commercial REIT is sheltered from the negative impact from higher cost of electricity. The leases have rent reviews every five years benchmarked against the UK Consumer Price Index (CPI).
  • The built-in rental escalation is subject to an annual minimum increase of 1% and maximum of 5%. Based on consensus estimate of 7.5% for the UK’s CPI in 2022, we estimate the step-up in rents at 15.4% for Apr 23.

Recession-resistant counter-cyclical yield play.

  • Elite Commercial REIT benefits from recession-resistant and counter-cyclical cash flows from its sovereign tenants. The UK government is rated AA by S&P and Aa3 by Moody’s. Rent collection in advance for 2Q22 was 100% within seven days of due date.

Covea to become the largest shareholder.

  • PartnerRE, the largest investor of Elite UK Commercial Fund II, has increased its stake in Elite Commercial REIT from 1% to 23% post Elite Commercial REIT’s acquisition of 58 commercial properties located across the UK for £212.5m in Mar 21.
  • PartnerRE is a top-5 reinsurer on a worldwide basis. Excor NV, the Dutch holding company for Italy’s Agnelli family, has sold PartnerRE to French insurer Covea Cooperations for US$9b in Oct 21.

Gradually deleveraging through Distribution Reinvestment Plan (DRP).

  • Elite Commercial REIT’s aggregate leverage was 42.8% as of Mar 22. Its Distribution Reinvestment Plan (DRP) serves to allow Elite Commercial REIT to deleverage gradually. Its average cost of debt is 2.1%. 63% of its total borrowings are hedged to fixed interest rates.
  • Assuming that Bank of England hikes Repo Rate to 1.25% by end-22, we estimate that cost of debt would increase to 2.3% in 2023.

Elite Commercial REIT - Earnings forecast and recommendation

Jonathan KOH CFA UOB Kay Hian Research | https://research.uobkayhian.com/ 2022-05-19
SGX Stock Analyst Report BUY MAINTAIN BUY 0.87 DOWN 0.95