EXECUTIVE SUMMARY

• In Smartkarma Corporate Webinar | Elite Commercial REIT: Essential Assets at an Attractive Yield we conducted a fireside chat with Elite Commercial REIT.

• Elite Commercial REIT is a Singapore real estate investment trust established with the investment strategy of principally investing, directly or indirectly, in commercial real-estate related assets in the United Kingdom.

• The company has recently expanded its strategy to look at other commercial assets in the UK, beyond its existing portfolio of assets rented by the UK government.

This Insight is part of the Smartkarma Corporate Webinar series, supported by SGX through the Investor Education Fund.

DETAIL

Brief Company Background

Elite Commercial REIT (ECR) is a Singapore real estate investment trust established with the investment strategy of principally investing, directly or indirectly, in commercial real-estate related assets in the United Kingdom (UK). ECR is the only UK REIT listed in Pound sterling on the Singapore Exchange.

Elite REIT’s portfolio comprises predominantly freehold properties located mainly in town centres, and near amenities and transportation nodes. The portfolio offers a stable government-backed income stream with over 99% of the gross rental income derived from the UK Government, backed by AArated sovereign credit strength. The leases are on triple net basis and ECR is one of the largest providers of critical social infrastructure to the Department for Work and Pensions (DWP) and other UK Government departments. The DWP is the UK’s largest public service department that is responsible for welfare, pensions and child maintenance policy, serving over 20m claimants and customers. The portfolio is part of the crucial social infrastructure through which the DWP provides services to local communities. As of December 2023, Elite had a portfolio of 150 assets, spread across the UK, worth around GBP412.5m. The below snippet from ECR’s presentation provides an overview of its portfolio.

Industry Overview

ECR owns a unique portfolio of assets, which aren’t exactly like the traditional office spaces, as they are used by the DWP for assessing job claims and are hence, located near town/borough centers, to be easily accessible. In that sense, they aren’t your typical Grade A office assets located in central business districts. However, since the data for such assets isn’t widely available, we will use the overall UK office market data as a proxy for the industry. Moreover before talking about the overall office market, we’ll touch upon the recent occurrence of the UK economy as well, for the benefit of readers who aren’t well versed with the UK economy.

The UK economy overall hasn’t had a very great past few years, in our view. In 2016, the country voted for BREXIT, the finalization of negotiations for which dragged on till 2020. Which was just in time for the economy to face the full brunt of COVID-19 induced global disruption. By the time that was done, the higher global inflation led to the UK bank rate reaching a multidecade high.

All is not doom and gloom though, as the overall outlook for the economy has been improving, as per the Bank of England’s (BoE) Monetary Policy Report, February 2024, it upgraded its outlook for GDP growth versus its November 2023 report (the figures in parentheses below).

BoE expects inflation to gradually fall back to its 2% target by end 2025, after a brief resurgence in 2024, owing to higher oil prices.

The central bank is thus projecting a faster decline in interest rates, than what it was projecting in its previous report, see the solid blue line (February 2024) versus the dashed line (November 2023) below.

Coming back to the UK office market, as the below chart from Cushman & Wakefield – United Kingdom, Offices Q4 2023 report shows, post the COVID-19 disruption, rents in London and the big five cities (Birmingham, Bristol, Edinburgh, Leeds and Manchester) have been growing by mid-single digits over the past few years.

However, due to the higher interest rates, the investment volumes have fallen to levels below even the COVID-19 trough.

Thus, the elevated interst rates, along with a lack of transactions have driven yields higher across the markets.

This has resulted in asset values declining by 20-25% across the UK office market, as per CBRE - UK Real Estate Market Outlook 2024.

Improving Outlook Along With Expansion of Investment Strategy

Asset Values Might Have Bottomed

Given the turmoil in the UK office market due to the higher interest rates and yield, ECR’s portfolio valuation as well has suffered over the past few years with its asset value declining from a peak of GBP517.7m in June 2022 to GBP412.5m by December 2023 (we haven’t adjusted for assets that have been sold in the interim).

However, with interest rates probably having peaked, as per BoE’s own forecast, investment volumes have been picking up, as per our conversations with ECR’s management. Furthermore, ECR’s management stated that over the past few quarters most of the transactions that have been taking place have been for distressed assets, which has resulted in market yields being even wider than what they should be for normal assets. With investments volumes starting to pick up in 1Q24, more standard assets are likely to be transacted, which should further aid market recovery.

Bulk of Debt Refinancing Done

The drop in assets values for ECR over the past few years had caused ECR’s net gearing ratio to climb. ECR sold a few assets during the period and undertook a GBP28m equity fund raising that was concluded in January 2024, the proceeds were used to pay down debt, bringing its pro-forma net gearing ratio to 40.9%, as of December 2023 (see snippet below from ECR’s FY2023 results presentation).

However, in 2024 it still had a term loan facility of GBP125m up for renewal, as of December 2023. On 1st March 2024, ECR announced that it had secured GBP135m of debt for refinancing from new lending relationships that were sourced through the REIT’s sponsors. The new credit facilities are structured as 3-year term and revolving credit facilities.

ECR now has another tranche of GBP76m of debt maturing in January 2025. As per ECR’s management, refinancing conversations with lenders are already underway and the company should be able to provide an update on the same over the next few months.

Hoping to Spread Out the Lease Expiry, Assets Remain Under-rented

At the time of its listing, in 2020, ECR’s portfolio was entirely rented out by the DWP on a 10-year lease, starting 2018, with a 5-year rental review and break clause for some of its assets which fell in 2023. The leases also have an in-built rental escalation based on UK CPI, subject to an annual minimum increase of 1.0% and maximum of 5.0%, with the rent being rebased at the time of rental renew, i.e. 2023/28.

In 2023, at the time of its first rental review, ECR managed to record a rental escalation of between 11.0% to 15.4% for 134 assets, although 11 assets were also subjected to rent reductions following the rental uplift, in exchange for lease break removal.

Following up on the earlier rental review, ECR now has 96.6% of its portfolio by weighted average lease expiry (WALE) coming up for renewal in 2028, see snippet from ECR’s FY2023 results presentation below.

While the lease expiry profile appears daunting, ECR is also the largest landlord for the DWP and both parties have already engaged in conversations about the 2028 expiry. As per ECR’s management, both the DWP and ECR remain keen to spread out the lease expiry more evenly rather than making it a bulky affair which occurs every five years.

These buildings are used by the DWP to provide critical social services and hence, remain essential for DWP’s day-to-day operations. Although DWP did opt to vacate a few of the buildings at the time of the 2023 renewal event and ECR expects some more buildings to be vacated in 2028 as well, as DWP’s requirements evolve. On the other hand, as per ECR’s management, its portfolio remains under-rented versus the market rate and hence, should DWP vacate some of the assets, ECR might be able reposition the assets for alternative usage.

Expanding Investment Strategy

On 15th April 2024, ECR announced an expansion of its investment strategy to broaden its portfolio mix beyond its existing social infrastructure assets to living sector assets as well, including student housing, build-to-rent residential, senior living and social housing and other government housing.

As the below snippet from ECR’s recent presentation shows, the change in investment strategy fits in neatly with its asset repositioning strategy, wherein any vacant assets can either be relet to other tenants, sold to thirdparties or repositioned for usage as living sector assets.

As per ECR management, this will help to diversify the REITs offering beyond the government usage focused assets, while allowing ECR to maintain its UK focus and providing an alternative usage for some of its assets. As per ECR management, as a part of this investment strategy, it plans to first seek pre-planning approval for repositioning of vacant assets before deciding whether to sell the assets (after obtaining the approval) or to deploy its own capital to seek a full approval and re-position the assets.

Yield Remains Attractive

At the current share price (as on 22nd Apr 2024), ECR is trading at 0.53x FY23 book and offers 12.87% yield in GBP, at 100% DPU payout ratio based on its 2H23 DPU. Going forward, its near-term rental is likely to be steady with major debt refinancing already out of the way, along with its long-term leases with the UK government. In addition, the prospects of lower/more stable asset yields, along with a diversification of its asset usage could help the REIT to narrow its gap to its book value.