I have been taking a close look at Palace Capital (PCA:335p), a property investment company focused on commercial property outside London. The share price has drifted southwards since hitting a high of 380p at the end of last year and is now trading almost 20 per cent below the last reported net asset value (NAV) of 414p at the end of March 2016. The shares also offer a prospective dividend yield of 5.4 per cent assuming the board raise the payout from 16p to 18p in the current financial year to end March 2017 as analyst Chris Thomas at house broker Arden Partners predicts. That looks a distinct possibility given that the company’s half year results at the end of November are likely to make for a good read.
I have been waiting patiently to initiate coverage on the shares having noted the progress the company’s management team have been making under the leadership of chief executive Neil Sinclair, a property sector stalwart with over 50 years experience. He was a non-executive director of Tops Estates, a fully listed company I advised buying shares in and which ended up being taken over by Land Securities (LAND) in 2005. Prior to that Mr Sinclair held the position of deputy executive chairman of Conrad Ritblat. Finance director Stephen Silvester joined the company last year and was previously group financial controller at NewRiver Retail (NRR), the REIT that specializes in the UK retail sector, so has valuable industry experience.
What has sparked my attention is the financial returns Palace Capital has been generating on some shrewd off market property purchases. This has been achieved by enhancing income returns and reducing voids through active asset management, generating valuation uplifts through refurbishment and development initiatives, and by recycling capital through profitable disposals and the release of equity in current developments for further investment. In fact, in the past three years the company has increased net asset value per share by 90 per cent by pulling off some pretty smart purchases.
For instance, the acquisition of the Signal Portfolio of 24 mixed-use commercial properties from Quintain Estates & Development for £39.25m three years ago produced immediate returns. The purchase price was based on an 11.7 per cent net initial yield and was funded by a £23.5m equity raise at 200p a share, and a three-year debt facility with Nationwide. The portfolio is now worth £71m and Palace Capital has also disposed of £3.9m worth of assets. The acquisition of the privately held PIH portfolio of 17 commercial properties a couple of years ago has worked out well too. The £32m purchase price equated to a gross initial yield of 7.8 per cent and was funded largely by debt facilities. Palace Capital has made £2m worth of disposals and the portfolio was last valued at £36.5m.
Weaving their magic
The company’s shrewd team of property experts have been weaving their magic again because just before the company’s March 2016 financial year end it acquired Broad Street Plaza, an award winning leisure development in Halifax, West Yorkshire, in an off market transaction. Broad Street Plaza was completed in 2012 and is on an island site in the heart of Halifax opposite the bus station and Town Hall. It comprises 113,000 sq ft of space and a large multi-storey car park. Major tenants include JD Wetherspoon (JDW), Pizza Express, Restaurant Group (RTN), Nando’s, Mitchells & Butlers (MAB), Prezzo, TGI Friday’s, Pure Gym, and Vue Entertainment.
The development has a weighted average unexpired lease term (WAULT) of around 15 years to the next break clause and 21 years to expiry, so not only has a high quality tenant mix but also high visibility of future rents. Moreover, it is producing a decent annual net income of £1.78m, rising through fixed rent increases to £1.94m next year. The £24.2m purchase price equates to an initial net yield of 7.25 per cent, rising to at least 7.9 per cent in 2017 when rent reviews on a number of units take place.
Palace Capital funded the acquisition by taking on the existing short-term credit facility of £15.2m secured on the development with Barclays (BARC) and on which it paid a margin of 2.75 per cent over LIBOR, and using £9m from its existing cash resources. However, post completion of the acquisition, the company took advantage of the historically low 10-year swap rates on offer to refinance the debt with Scottish Widows on a 10-year fixed rate loan at 2.9 per cent including margin, which means that net of debt servicing, the development is now producing annual cashflows of £1.36m, rising to £1.51m next year. This implies an initial pre-tax return on equity of 15 per cent, rising to 16.8 per cent in 2017. As an added bonus the company will be able to take advantage of considerable capital allowances which were not claimed by the vendors since the development completed in 2012. It looks a rock solid buy to me.
Importantly, the company’s investment strategy is underpinned by management’s ability to uncover unrealised development potential in its targeted purchases. For example, around 20 per cent of the company’s current open market valuation of the aforementioned £71m Signal Portfolio is invested in Hudson House, a 1960’s 103,000 sq. ft office building directly opposite York Railway Station. Transport links to the city are excellent with a direct fast rail service to London and Edinburgh. The company has since obtained planning consent to convert the property into 82 residential units as well as create 37,000 sq. ft. of grade ‘A’ office, and has also obtained an alternative planning consent to convert the building into 139 residential units.
The board are evaluating all options to maximise value at Hudson House and will update shareholders in due course. Bearing this in mind, the former Terry’s Chocolate Factory development in the city is a 170,000 sq ft listed building that’s being converted into luxury apartments ranging from one bedroom starting at £194,000 to penthouse three bedroom flats priced at £749,000. It’s a scheme I know well as small-cap construction and property firm Henry Boot (BHY) is behind it (‘A quartet of small-cap buys’, 30 Aug 2016). Henry Boot reported at the time of its half year results that “reservations (in York) are strong and have remained so after the EU Referendum with further sales secured for completion in the second half of the year”. The point being that the average residential plot value of around £100,000 for Palace Capital’s Hudson House is very low for a residential development in York, implying potential for investment upside.
Regional value opportunities
The company’s purchase of an 88,000 sq ft Grade II listed commercial property in Leeds about a year and a half ago is of interest too. The building is part let out to Walker Morris, one of the largest independent solicitors in Leeds, and also to the Bank of England. The purchase price of £10m equated to a net initial yield of 8.6 per cent, since when the company has extended the Bank of England’s lease until July 2023 and doubled the annual rent to £232,000 at the March 2020 rent review. The first floor of the building has just become vacant and is being refurbished to provide 17,000 sq ft of office space which should attract decent interest from potential occupiers. This highlights the ability of the company to buy well and then add value through active asset management.
This is certainly the case at the 200,000 sq ft Sol Central development in Northampton which the company acquired for £20.7m on a net initial yield of 8.86 per cent in May 2015. The site includes a 10 screen cinema, casino, 151 room hotel, gym and 375 space car park, but had not been trading at its optimum level for a number of years, and significantly the scheme lacked restaurants. To facilitate this Palace Capital accepted the surrender of the lease to Gala Casino on 27,500 sq ft of space in return for £3.8m to account for loss of rent, dilapidations and has also received a rates rebate of £200,000. The space has been stripped out in anticipation of agreeing new leases with prospective tenants.
It’s therefore worth pointing out that there is considerable development activity in Northampton, much of it within 15 minutes’ walk of Sol Central. A new County Council headquarters office building, No. 1 Angel Square, is due to be completed later this year. It will accommodate 2,000 people and bring a minimum £12m additional spend into the local economy. In addition, the town’s new £330m University campus is under construction. These, together with other initiatives, can only have a positive effect on Sol Central.
Portfolio well funded
At the March 2016 financial year-end, Palace Capital owned 54 properties worth £175m, comprising 1.85m sq ft of space occupied by over 140 tenants who provide a contractual rent roll of £13.5m. The WAULT of 6.3 years, up from 4.5 years in March 2015, reflects new tenancies agreed with a number of blue chip clients which has improved the quality of earnings. The portfolio mix is around 43 per cent office; 21 per cent leisure; 18 per cent industrial; 8 per cent retail; 6 per cent retail warehouses; and 4 per cent car parks. The residential development schemes element I have outlined largely falls within the office segment.
It’s reassuring to know that balance sheet gearing is conservative with the loan-to-valuation ratio only 37 per cent and net debt of £63.4m has a weighted average cost of 3.1 per cent per annum, so is well within total credit facilities of £110m. Furthermore, with annual rents covering borrowing costs more than three times over, the company is able to recycle cash into new purchases and invest in refurbishments to enhance value, while at the same time reward shareholders with a steady increase in the payout.
For instance, a few months ago Palace Capital acquired a 75,000 sq ft multi-let 1970s office building in Manchester for £10.6m funded by a £6m four-year debt facility with Santander at a margin of 2.25 per cent above LIBOR. When current rent free periods end the property will produce a net income of £775,000, and this will increase once 13,500 sq ft of vacant space is refurbished and let out to generate a 13 per cent plus return on equity. Around the same time the company sold two properties in Stoke-on-Trent and Surbiton, Surrey for a total of £2.3m, or 15 per cent above their combined book value, highlighting potentially conservative valuations of the portfolio.
Factoring in £66m worth of acquisitions made in the last financial year, analysts at brokerage Arden Partners expect the company’s underlying pre-tax profits to rise by a fifth to £6.8m to produce EPS of 21.9p and support that higher payout per share of 16p. There is a decent chance of valuation uplifts too driven by active asset management initiatives and new lettings, so I can see upside on the company’s NAV per share of 414p. For a company that has outperformed all its listed peers in terms of NAV per share growth in the past three years, I feel that Palace Capital’s shares should not be trading 20 per cent below historic book value.
Needless to say I rate the shares a decent buy on a bid-offer-spread of 325p to 335p, and have an immediate target price of at least 380p, coinciding with last year’s highs. The forthcoming interim results could just be the catalyst to send the price back towards that level, and beyond. Buy.