STRATEGIC REPORT

Operating review

Portfolio Overview

The income characteristics of the portfolio continue to be enhanced through disciplined capital allocation and active asset management. We are focused on all aspects of income growth including income-led development, asset management opportunities and ancillary income generation through our commercialisation process. With long-term real estate returns proven to be driven largely by income returns, the portfolio is being progressively positioned to provide consistent and sustainable income with potential for capital growth:    

·      32.3 per cent of the portfolio is subject to inflation-linked or fixed rental increases providing guaranteed income growth in a rising inflationary environment.

·      Our weighted average lease length of 7.5 years is complemented by only 21 per cent of leases by rental income being subject to tenant breaks or expiries in the next five years.

·      Our portfolio, diversified by sector and geography, provides a broad range of high quality tenants with little concentration risk.

·      Our internally managed commercialisation function is actively enhancing the quality of advertising and promotional activity within our retail assets. Commercialisation income of £1.1 million has already been secured in 2017, a 20 per cent increase on the same period last year.

Leasing activity

Portfolio occupancy by ERV increased to 98.0 per cent (31 August 2016: 97.7 per cent) driven largely by successful lettings in the UK Commercial portfolio totalling 42,500 sqft (3,900 sqm).

Key leasing activity completed during the period:

·      City Point, Leeds - all of the remaining vacant space at City Point, Leeds, comprising 10,900 sqft (1,000 sqm) on the second floor, was filled following the signing of a 10 year lease to Blacks Solicitors in January 2017, which was completed at £25.0 psf, in line with ERV. The 61,500 sqft (5,700 sqm) office building is now fully occupied and has a strong tenant mix including Ashcourt Rowan p.l.c., GVA, Savills, JLL, Starbucks and HSBC.

·      Schloss Strassen Centre, Berlin - REWE has agreed to a 10 year reversionary lease creating a 15 year unbroken term which will see it increase its floor area by approximately 1,900 sqft (200 sqm) subject to obtaining vacant possession of a neighbouring unit. The agreed annualised rent of €0.4 million p.a. is in line with the current passing rent of the combined units.

Rateable values

In January 2016 the UK Valuation Office Agency published an updated rating list for England and Wales which has been adopted from 1 April 2017. The change in rateable values for commercial real estate will have a direct impact on business rates and therefore the total cost of occupation to tenants and the cost of vacant space to landlords. In general, rates are expected to increase materially in London while many regional centres are anticipated to see a reduction in rateable values. Across our UK portfolio (excluding the UK Hotel portfolio) our expectation is for rates to reduce by approximately 6.9 per cent. Our hotels, which are largely London focused, are anticipated to see a 51 per cent increase in rates. The impact of the change in rates is to be phased in over a three year period, however, the change is now reflected in hotel property values.

Acquisitions

On 7 April 2017, the Company announced the acquisition of a controlling interest in the Leopard portfolio from its joint venture partner, Redefine Properties.

The Leopard portfolio comprises 66 properties and totals 1,505,500 sqft (140,000 sqm) of lettable area. It includes a mixture of stand-alone supermarkets, foodstore anchored retail parks and cash & carry stores. The properties are well located within their respective micro markets, with 86.4 per cent of the total annual rental income located in Western Germany and Berlin and the remainder in Eastern Germany.

Key portfolio attributes include:

·      Gross rental income of €13.9 million.

·      Edeka, Netto, Real and Rossmann account for over 85.6 per cent of gross rental income, providing strong tenant covenants.

·      WAULT of 8.4 years.

·      Portfolio occupancy of 99.2 per cent by estimated market rental value.

·      99.2 per cent of gross rental income is indexed, typically between 60 - 70 per cent of German CPI, subject to cumulative indexation reaching a hurdle of 10 per cent since the last rent review date.

The portfolio provides exposure to high quality, secure, indexed-linked cashflows with opportunities to extend existing stores and re-gear leases.

The acquisition provides an efficient re-investment of capital from recent disposals into a portfolio in which the Company already held a 50 per cent share. The acquisition also further simplifies the Company's portfolio and structure, with the Leopard portfolio assets now under our control, providing greater flexibility over future asset management and investment decisions.  

Disposals

It has been an active period with £95.0 million of assets sold in seven separate transactions, with a further £29.0 million completed or under offer post period end. Our disposal strategy has focused on assets where business plans have been successfully executed and values maximised, as well as assets with negative rental and/or capital growth expectations. Disposals completed during the period reflected a 12.4 per cent premium to August 2016 market value. Net rental income associated with these disposals totals £6.1 million.

Exchange House, Watford

As announced with our prior year end results, the sale of Exchange House was completed in October 2016 for £13.3 million, a 12.7 per cent premium to August 2016 market value. The sale price reflects a net initial yield of 6.9 per cent and a reversionary yield of 5.8 per cent. The 63,000 sqft (5,900 sqm) office building is occupied by the Department of Work and Pensions until March 2023 with a break option in March 2018. The annual passing rent was £1.0 million.

VBG

On 18 January 2017, the Company completed on the sale of four German office assets for a gross consideration of €106.0 million. The assets, which were disposed of via a share sale and included related debt facilities, were held in a joint venture with the Menora Mivtachim Group. The Company's 49 per cent share reflects an 8.6 per cent premium to the August 2016 market value in Euro terms. The Company's net proceeds of €24.9 million, which includes a performance fee of €2.4 million, delivered an IRR of 27 per cent over the investment period.

The properties, situated in Berlin, Dresden, Cologne and Stuttgart, total 485,900 sqft (45,100 sqm), and are let to a German government-backed social insurance body, VBG, on a combined WAULT of just under seven years. The portfolio generated a total annual gross rental income of €8.1 million, of which €4.0 million was attributable to Redefine International.

Deansgate, Manchester

On 31 January 2017, the Company completed on the disposal of 201 Deansgate in Manchester for £29.2 million. The property provides 83,700 sqft (7,800 sqm) of office space and delivered an annual net rental income of £1.1 million, with a WAULT of 4.1 years. The office was originally acquired as part of the AUK Portfolio in March 2016 and the sales price represents a net initial yield of 3.6 per cent and a 14.3 per cent premium to the last reported market value. The geared IRR over the investment period was 22 per cent.

Development and capital expenditure

Development activity is focused on refurbishing existing assets and adding incremental space and income to meet additional occupier demand.

City Arcaden, Ingolstadt

The redevelopment of this prime retail asset is anticipated to be completed in June 2017 and will transform the existing retail pitch. The completed scheme will total approximately 129,000 sqft (12,000 sqm) including two retail units let to Primark and H&M of approximately 100,000 sqft (9,500 sqm). The scheme is anticipated to generate €2.1 million in rental income resulting in a yield on cost of 5.4 per cent. 

Holiday Inn Express, Southwark

The twelve room extension and upgrade to the front and rear façade is on target with development works anticipated to be completed in the third quarter of 2017. The hotel's operating business continues to deliver consistent underlying revenue growth with revenue up 1.3 per cent year-to-date despite the disruptions from the extension and refurbishment works.

Albion Street, Derby

Terms have been agreed for a new 15 year lease with an international discount fashion retailer at a rent of £0.2 million p.a. The introduction of a well-known international brand will strengthen the retail pitch considerably and support the letting of the remaining vacant shop units.

Retail Parks

Four additional pods are at advanced stages of planning approval and the new Pure Gym unit at Banbury Cross Retail Park is under construction. In total, the new units will provide an additional £0.3 million of rental income reflecting a yield on cost of 12.2 per cent.

Foodstore extensions, Germany

Three extensions to foodstore units are being progressed which include extending the existing leases to new 15 year terms. The extensions for tenants such as REWE, Edeka and Netto will provide long-term indexed-linked income returns from strong covenants. They total over 12,900 sqft (1,200 sqm) and are expected to provide a yield on cost of 7.7 per cent.

UK Retail

UK consumer confidence has recovered quickly post the initial shock of the EU referendum result. However, inflationary pressure following Sterling weakness and its impact on import prices is yet to be fully reflected in economic terms. The outlook therefore remains cautious with value oriented retailers likely to be more resilient. 

Occupancy across the UK Retail portfolio declined marginally to 97.5 per cent (31 August 2016: 98.7 per cent). The portfolio value was broadly unchanged at £537.0 million (31 August 2016: £537.1 million). UK Shopping Centres declined 0.7 per cent largely as a result of a 0.5 per cent reduction in gross rental income reflecting a 150 bps increase in vacancy. Conversely, UK Retail Parks and Other Retail increased by 1.1 per cent to £202.0 million (31 August 2016: £199.9 million).

Shopping Centres

Occupancy across the UK shopping centre portfolio declined to 96.6 per cent (31 August 2016: 98.1 per cent). Rental income across the shopping centre portfolio declined marginally with annualised gross rental income down 0.5 per cent. ERVs have remained broadly unchanged. The 41,300 sqft (3,800 sqm) former BHS unit at Grand Arcade, Wigan is now under offer to a national operator.

Asset management activity has been targeted at income-led opportunities including the refurbishment of the food court and the reconfiguration of retail space at West Orchards, Coventry to drive new lettings, including 4,000 sqft (400 sqm) let to Footasylum. In aggregate, asset management initiatives at West Orchards are targeting additional net rental income of £0.5 million which would reflect an approximate yield on cost of 18.0 per cent.

Retail Parks

Our retail park portfolio remains fully occupied which, when combined with generally low vacancy rates across the sector, gives us cautious optimism in relation to occupier demand and rental value growth.

Asset management activity is focused on adding marginal income through the introduction of convenience food and beverage offerings, extensions for leisure use and commercialisation opportunities across the portfolio. Pre-let agreements have been secured for £0.3 million of rental income including a new 10 year lease with Pure Gym at Banbury Cross Retail Park. The 7,500 sqft (700 sqm) extension will deliver £0.2 million of rental income and a yield on cost of 15.0 per cent.

UK Commercial

The regional office market has remained robust with the availability of Grade A space well below historic averages.

Occupancy across the UK Commercial portfolio increased to 96.7 per cent (31 August 2016: 94.6 per cent) following over 42,500 sqft (3,900 sqm) of new lettings and renewals in the office portfolio and the sale of 201 Deansgate, Manchester which included 16,600 sqft (1,500 sqm) of vacant office space.

The portfolio value increased by 2.7 per cent on a like-for-like basis to £386.1 million. The overall increase was driven predominantly by strong uplifts in the distribution and industrial assets and in the office at Charing Cross Road, London, reflecting a strong investment market and clear evidence of underlying rental growth.

Office Portfolio 

An active period of leasing combined with the sale of 201 Deansgate, Manchester has increased occupancy across the portfolio to 96.3 per cent (31 August 2016: 93.1 per cent). Three leases totalling 15,100 sqft (1,400 sqm) were completed in the period providing rental income of £0.3 million, marginally ahead of ERV.

Our office at Charing Cross Road continues to benefit from the large-scale investment in the immediate area in connection with the Crossrail Tottenham Court Road Station which is due to start operating in 2018. Crossrail will link the West End to Canary Wharf in twelve minutes, Stratford in thirteen and Heathrow in less than 30, bringing an additional 1.5 million people to within a 45 minute commute of the popular retail and entertainment district. We have received strong occupational and investment demand providing a range of asset management options for the property. A pre-planning application has been submitted and the detailed planning process is on-going.

The major letting during the period was to Blacks Solicitors at City Point, Leeds. The firm of solicitors took the remaining 10,900 sqft (1,000 sqm) on a 10 year lease at a headline rent of £25.0 psf which was in line with ERV.

Distribution and Industrial Portfolio

The distribution and industrial sectors remain beneficiaries of the ongoing change in all aspects of retail. Demand from online retailers resulted in a record 34 million sqft of warehouse space being transacted in the UK during 2016. This demand, coupled with relatively low levels of supply and a relatively modest development pipeline, should be supportive of rents.

Given the strength of the occupational market, the investment market has been equally strong with £2.6 billion of acquisitions in 2016. Prime yields stand at around 5.0 per cent although investment demand is placing further downward pressure on yields.

These trends are evident in our own portfolio, particularly at Camino Park, Crawley where £1.6 million of rental income is subject to rent review in late 2017. Average passing rents on acquisition in March 2016 were £7.5 psf. Recent lettings have been completed at  £10.3 psf and more recent evidence indicates rents of £13.0 psf which would reflect an increase of approximately 73 per cent on passing rent since acquisition.

The refurbishment of 53,400 sqft (5,000 sqm) of vacant space at Colchester has been completed and is now being actively marketed.

UK Hotels

Following a relatively weak start to the financial year, underlying trading during recent months has recovered strongly with revenue figures for the six month period to 28 February 2017 ahead of management's budgets and the prior period performance by 1.3 and 3.9 per cent respectively. This recent strong trading performance has been partly offset by the anticipated impact of higher rates, particularly across the London portfolio.

The outlook for London hotels is mixed with uncertainty around the impact of the vote to leave the EU, security concerns and tighter corporate travel budgets offset by the positive impact of the significant fall in Sterling which is expected to support tourism and investment demand. Occupancy and RevPar are forecast by PwC to grow by 0.9 per cent and 3.3 per cent respectively. We have experienced a similar trend, with current trading performance showing modest growth over the same period last year. Supply of hotel space is expected to grow by approximately five per cent in London over 2017 with the majority still focused on budget hotels.

The portfolio value remained broadly unchanged at £229.3 million (31 August 2016: £229.2 million).

⁽¹⁾ Subject to annual review with reference to forecast EBITDA of the RedefineBDL managed portfolio.

RedefineBDL

The Company's 30.4 per cent stake in RedefineBDL, the largest independent hotel management company in the UK, produced underlying earnings of £0.3 million during the period, a decrease of £0.9 million over the same period last year which included a £1.1 million contract termination fee.

International Hotel Properties Limited

The Company's 17.2 per cent investment in International Hotel Properties Limited ("IHL") had a market value of £9.8 million at 28 February 2017 resulting in a fair value gain of £1.0 million for the first half of the year. No dividend has yet been declared in respect of the current financial period.

Europe

Strong fundamentals in Germany combined with low interest rates and uncertainty in other European investment markets has led to sustained capital flows into commercial real estate and significant competition for good quality investment opportunities. These dynamics have led to yields reaching historic lows in many markets, particularly for core assets. Given the strength of the investment market, returns will be increasingly reliant on income and rental growth with further yield compression likely to be limited.

The European portfolio occupancy increased to 99.0 per cent (31 August 2016: 98.5 per cent) following 64,200 sqft (6,000 sqm) of new lettings and renewals.

The portfolio value increased by 0.2 per cent on a like-for-like basis in local currency terms to €337.1 million. The shopping centre portfolio, including development property, increased in value by 2.0 per cent to €192.4 million reflecting strong investment demand, particularly for core assets in Berlin and Hamburg.

Asset management activity has focused on the Schloss-Strassen Centre in Berlin with plans to modernise the existing food court and improve the food offering, as well as increase the allocation of space to food and convenience offerings.

Bakery Junge, have taken 1,900 sqft (200 sqm) of previously vacant space at an annual rent of €0.1 million. The national operator provides a popular concept and will broaden the food offer to cater for commuter footfall associated with the centre's strong transport links.

REWE has agreed to a conditional lease extension which would create a 15 year unbroken term and increase its floor area by approximately 1,900 sqft (200 sqm). The agreed annualised rent of €0.4 million p.a. is in line with the current passing rent of the combined units.

The pharmacy chain, dm, has also agreed to extend their floor area by 1,100 sqft (100 sqm) into the neighbouring vacant unit on a new 10 year lease for a total rent of €0.3 million.