Regional REIT (RGL) provides a focused exposure to UK regional commercial real estate, predominantly secondary assets. The regional property recovery began later than in London and we believe RGL offers the potential for above average late-cycle income and capital growth. It has an established and diversified high-yielding portfolio that already supports the attractive 8.1% prospective yield. RGL’s focus on underexploited properties provides additional internally driven potential from asset management initiatives, with potential for accretive asset growth. Brexit has raised uncertainty about the pace of UK economic growth, investor appetite and future occupier demand, but particularly for City of London offices, while sterling’s devaluation may provide a boost to regionally focused industry. Meanwhile, interest rates show no sign of increasing.
RGL’s property assets are relatively high yielding (31 December 2015 net initial yield 7.6%). Lease breaks and expiries over the next three years are significant, but the management team, well-resourced with cross-cycle experience, has a detailed plan for each property and aims for structural occupancy of c 90% compared with 80.9% currently. This should see income grow with favourable prospects for capital growth. The underlying expense ratio in 2015 (before potential performance fees) was a competitive c 26% despite external management and a highly diversified portfolio. We see scope for continuing accretive acquisition-led asset growth.
The manager expects RGL to benefit from a growing share of capital inflows into the regions, following a period of stagnation, attracted by higher yields and the potential for greater returns. Secondary property yields remain extended versus prime yields, although the gap has begun to narrow and, while post-referendum uncertainty may slow a market-wide normalisation, we see economic recovery and the longer-term development of the regions as key for RGL. Regional commercial rents have been increasing against a background of improving occupational demand and declining availability. Brexit adds uncertainty about economic growth, but other drivers of demand (such as business relocation) are structural.
RGL’s prospective dividend yield of 8.1% is the highest among UK REIT sector constituents and it is also fully covered. As we show in the financial section on page 11, we believe there is scope for accretive acquisition activity to further increase DPS above our forecasts. The shares are at a c 13% discount to our 2016e EPRA NAV, which assumes no valuation yield tightening.