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UOB Kay Hian keeps ‘buy’ on Elite Commercial REIT with removal of break clause following lease renegotiation

Chloe Lim
Chloe Lim5/26/2022 5:20 PM GMT+08  • 3 min read
UOB Kay Hian keeps ‘buy’ on Elite Commercial REIT with removal of break clause following lease renegotiation
Koh has trimmed his FY2022 and FY2023 distribution per unit (DPU) by 6% and 15% respectively
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UOB Kay Hian Group Research analyst Jonathan Koh has kept a ‘buy’ rating on Elite Commercial REIT but with a slightly lowered target price of £0.87 ($1.50) from £0.95.

Koh’s update call follows the REIT’s negotiation of new terms with its key tenant, the UK government – specifically, the Department for Work and Pensions (DWP), which occupies 146 out of its 155 commercial properties.

A majority of the 136 DWP leases have no break clauses which represent 83.8% of total contractual rent. Out of which, 27 of the DWP leases are straight leases without break clauses, while 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.

Koh observes how rental rates are affordable for the UK government, with the average rental rate for Elite Commercial REIT’s 155 commercial properties low at £9.60 per sq ft per year in 2021.

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The average valuation of its commercial properties is £130 per sq ft, which is below the current construction cost of £190-£250 per sq ft in the UK.

Koh also notes how Elite Commercial REIT has a long WALE of 5.5 years as of March 22 post re-negotiation of lease terms, signalling income stability.

The leases with the UK government are full repairing and insuring triple net leases that provide a high net property income (NPI) margin of 97.1% in 2021, the analyst says. “Thus, Elite Commercial REIT is sheltered from the negative impact from higher cost of electricity,” Koh explains.

The leases have rent reviews every five years benchmarked against the UK Consumer Price Index (CPI), where the built-in rental escalation is subject to an annual minimum increase of 1% and maximum of 5%.

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“Based on the consensus estimate of 7.5% for the UK’s CPI in 2022, we estimate the step-up in rents at 15.4% for April 23,” writes the analyst.

The REIT’s aggregate leverage was 42.8% as of March 22, where its Distribution Reinvestment Plan (DRP) serves to allow Elite Commercial REIT to deleverage gradually. Its average cost of debt is 2.1%, with 63% of its total borrowings hedged to fixed interest rates as well.

“Assuming that the Bank of England hikes Repo Rate to 1.25% by end-2022, we estimate that cost of debt would increase to 2.3% in 2023,” says Koh.

Koh has trimmed his FY2022 and FY2023 distribution per unit (DPU) by 6% and 15% respectively due to the re-negotiation of lease terms and higher interest rates.

“We have conservatively assumed that break options for the remaining three leases with break options were exercised, and a worst-case scenario that commercial properties with break options exercised are vacant for nine months and rental income is halved after securing replacement tenants,” says the analyst.

As at 4.05pm, units in Elite Commercial REIT are trading flat at £0.64 at FY2022 P/B ratio of 1.2x and dividend yield of 7.9% on May 26.

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