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CGS International likes Elite Commercial REIT’s expanded mandate, but trims TP on 1QFY2024 results

Jovi Ho
Jovi Ho • 7 min read
CGS International likes Elite Commercial REIT’s expanded mandate, but trims TP on 1QFY2024 results
High Road, Ilford, one of the properties within the REIT's portfolio. Photo: Elite Commercial REIT
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The managers of Elite Commercial REIT are future-proofing the UK-focused REIT with a recently announced expanded investment mandate, say CGS International (CGSI) analysts Lock Mun Yee and Natalie Ong. For now, however, vacancies have weighed on the REIT, with its operating metrics for 1QFY2024 ended March impacted by such costs. 

As such, Lock and Ong have kept their “add” call in a May 8 note, while trimming their target price to 33 pence from 38 pence previously. 

Elite Commercial REIT reported on May 3 1QFY2024 revenue of GBP9.3 million, up 0.8% y-o-y, while net property income (NPI) dipped 3.7% y-o-y to GBP8.3 million as rental escalations were offset by higher holding costs from vacant assets. 

This led to a 4.1 percentage point decline in NPI margin to 90.1%. 1QFY2024 distribution per unit (DPU) came in 21.2% lower y-o-y at 0.67 pence due to higher interest cost and a 21% expansion in unit base from its preferential offering in 1QFY2024. 

Elite Commercial REIT’s portfolio occupancy stood at 92.3% at end-March. Aggregate leverage stood at 43.7%, with average debt cost at 5.2%

Investment strategy

See also: Elite Commercial REIT reports 1QFY2024 DPU of 0.67 pence, 21.2% lower y-o-y

Elite Commercial REIT’s unique value proposition lies in its portfolio of what CGSI analysts describe as 150 “bite-sized” assets in the UK, as at end-2023. The majority of these properties are leased to the UK’s Department for Work and Pensions (DWP). 

In April, the manager announced an expanded investment mandate, into newly identified growth sectors, such as purpose-built student accommodation (PBSA) and built-to-rent residential (BTR). 

“We believe this would allow it to diversify its tenant base, enhance value and future-proof its portfolio while remaining focused on the broad and deep investment market of the UK,” say Lock and Ong. “We believe earnings stability and defensive cash flow provided by its sovereign-rated tenant, augmented by visible growth drivers from secular tailwinds in the PBSA and BTR sectors, would enable investors to benefit from the current attractive dividend yield and capital appreciation from a narrowing of the 40% gap between share price and net asset value.”

See also: Elite Commercial REIT expands investment strategy to include UK PBSA

Lock and Ong think the REIT could achieve a potential 7.5% boost to book NAV and lower gearing to 37.7%.

“Our deep-dive assessment of potential value creation from Elite Commercial REIT’s vacant properties show that Elite Commercial REIT’s book NAV could be potentially lifted by 7.5% to 42 pence/unit (from 39 pence/unit as at end-2023) while its aggregate leverage could be reduced to 37.7%, from 43.7% as at 1QFY2024 over the next two to three years,” say the analysts. 

This will come from a valuation uplift from selling and reinvesting in a stake in repositioned assets, such as Lindsay House and Hilden House, divesting Peel Park land and monetising the remaining five vacant assets at FY2023 book value, according to CGSI. 

“There could be further improvements to our projected NAV and gearing estimates should Elite Commercial REIT be able to sell the vacant properties at a premium to book value,” they add.

Lindsay House

The manager has shared that Lindsay House in Dundee, Scotland, is a prime candidate for a PBSA conversion opportunity and that it is in the pre-planning and approval stage. 

Lock and Ong believe conversion of this commercial property into a PBSA development will likely be accretive to Elite Commercial REIT.

See also: PhillipCapital sees ‘valuation upside’ from Elite Commercial REIT’s expanded mandate

According to a May 6 note by PhillipCapital Research, the property is slated to be converted into a 40- to 200-bed student housing facility upon approval from authorities. Typical values are around GBP130,000 per bed with yields of 5.5%. 

With a total net lettable area of 38,803 sq ft, sitting on a land area of 0.36 acre. the property was vacated as part of DWP’s lease re-gearing exercise and dilapidation settlement was completed in the latter part of FY2023. 

According to CGSI, the property is located near two universities and existing PBSAs. The property is an 11-minute walk from the University of Dundee and a seven-minute walk from Abertay University. The property is also located near other student accommodations, such as Prestige Student Living Marketgait and Mears Student Life properties. 

Dundee has an estimated undergraduate and graduate student population of 40,000. The city has one of the highest student-to-population ratios in the UK of 1:5, of which the University of Dundee makes up 40% of the student pool, with some 16,000 students last year. 

That said, Dundee is not the largest PBSA market in the UK and it remains relatively undersupplied, with the highest student-to-bed ratio of 3.15:1 as at August 2023, compared to the national average of 2.1:1.

Based on Cushman & Wakefield’s UK 2023 report, the development pipeline remains fairly limited. In CBRE’s UK real estate market outlook 2024 report, it also quoted Unite Student, UK’s largest owner, developer and operator of PBSA, as predicting rent growth of more than 5% for the 2024/2025 leasing cycle. 

A potential 200-unit PBSA development at Lindsay House could be valued at GBP30 million upon completion, say Lock and Ong. “Taking this into account and after factoring in development costs, we project a net gross asset surplus of GBP2.2 million or 0.4 pence/unit.”

Hilden House

Additionally, management has shared that Hilden House could be evaluated for conversion into a BTR residential project. Lock and Ong believe this will likely be accretive to Elite Commercial REIT.

Hilden House is located in Warrington Town Centre, opposite Warrington Town Hall and surrounded by a mix of office, retail and residential properties. Warrington lies between the business hubs of Liverpool and Manchester.

The five-storey property was leased to the DWP for its back-office operations and was vacated as part of the agency’s lease re-gearing exercise with dilapidation settlements completed in 2023. The property sits on a 0.32 ha site and has 50,841 sq ft of net internal area. 

According to Knight Frank, there are 5.7 million households renting in the private sector across the UK as of end-2023. The current operational BTR supply caters to some 1.9% of these households and the proportion is expected to rise to just 3%, including those in the construction pipeline, according to the report. 

Savills UK projects an additional 360,000 units of new BTR supply by the end of the next 10-year period. This is significantly lower than the projected 1 million new PRS household formation over the same period.

In comparison, UK’s BTR stock stood at 101,875 units as at 1Q20224, with another 54,814 units under construction and 108,917 units in the future pipeline, including those in the pre-application stage, revealed Savills’s report. This brings the total size of the sector to 265,606 homes, both completed or in the potential pipeline

Based on a potential conversion into a 77-unit BTR development with an estimated gross development value of GBP12.2 million, Lock and Ong calculate the implied residual land value for Hilden House to be an estimated GBP3.1 million, or at a 12.3% premium over its FY2023 book value of GB2.8 million. 

“Given the relatively low development amount, we believe Elite Commercial REIT could sell the property to a joint venture vehicle and participate in the next phase of value creation through taking a stake in the development JV as seed asset for its expanded investment mandate, which includes the BTR asset class,” note the CGSI analysts. 

They estimate the Hilden House BTR development could command a market value of GBP13.6 million upon completion. 

“Taking this into account and after factoring in development costs, we project a net gross asset surplus of GBP0.5 million, or 0.1 pence/unit. We believe Elite Commercial REIT can utilise the divestment proceeds to pare down debt in the near term while waiting to deploy equity commitments in the joint venture, based on construction progress.”

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