Regional REIT — Update 26 July 2016

High yielding assets with growth potential

RGL came to market with an established portfolio of high yielding properties, which we estimate are capable of immediately supporting an attractive, fully covered dividend yield of 8.1%. The active asset management strategy, built off detailed plans for each property and targeting a 10-15% IRR on each, provided by a well-resourced, dedicated team with cross-cycle experience, aims to achieve occupancy and rent increases to drive income and capital growth from existing assets. Regional commercial rents have been increasing against a background of improving occupational demand and declining availability. Brexit adds uncertainty about economic growth, but other drivers of demand (such as business relocation) are structural. Additionally, the manager sees a particular opportunity for a narrowing of the yield spread on secondary assets vs prime.

Our forecasts effectively model RGL on the existing portfolio, making no allowance for property acquisitions other than the reinvestment of Q216 net disposal proceeds (c £10.5m) by the year end. We have assumed that portfolio occupancy gradually increases from 80.9% at Q116 (down from 83.9% at FY15 due to post-lease expiry refurbishment and acquisitions, for asset management, at lower than average occupancy) to 90%, the level that management considers a structural norm for the portfolio as a whole, over the forecast period (2016 to 2018). Our NAV per share forecasts benefit from our assumption that market rents continue to grow at c 2-3% pa (generating revaluation gains, despite our standard assumption of unchanged property yields), but there is no assumed benefit to the P&L or dividend-paying capacity due to lease expiries. These amount to c 57% of the current contracted rent roll over the next three years and represent the key challenge for the managers during that period. The underlying cost ratio of 26% in 2015 positions RGL competitively, despite the diversified nature of the portfolio, and the balance sheet is conservatively structured (we estimate a 2016 year end LTV of 39.3%). In the financial section we highlight the potential uplift to our forecasts from accretive property acquisition and in the valuation section we show the sensitivity of NAV to alternative ERV and valuation yield assumptions.

RGL is targeting a total return of 10-15% pa with a strong focus on income. In this context we view our forecasts as conservative in a number of areas (we do not factor in acquisitions or yield contraction, and asset management initiatives may well create value in excess of that implied by our assumed gradual increase in occupancy) and these imply an average NAV total return of c 10% during the forecast period (2016-18). Even so, this puts RGL on the highest prospective dividend yield (8.1% and fully covered) within the UK REIT universe while trading at a c 13% discount to NAV.

The commercial property sector is cyclical. Occupier demand is sensitive to the general economy while valuation yields and capital values are affected by investment flows and monetary conditions. Over the longer term, income returns tend to be considerably more stable than the wider swings in capital values. RGL starts with an above-average asset yield, spread over a diversified portfolio of 130 properties (and 700 tenants) at 31 March, as well as maintaining a relatively low-risk balance sheet (a 2016e year-end LTV of 39.3%) with all debt effectively fixed or hedged.

Regional REIT (RGL) is a UK-based real estate investment trust (incorporated in Guernsey) that was admitted to the premium segment of the Official List and to trading on the Main Market of the London Stock Exchange (LSE) in November 2015. It aims to deliver an attractive return to investors through investments in commercial property (predominantly office and industrial property) in the main regional centres of the UK, effectively outside the M25 motorway. Legacy non-core retail assets will be sold when suitable prices can be achieved, and the significant weighting in Scotland is also likely to fall. RGL is externally managed by London & Scottish Investments (LSI), the asset manager, and Toscafund Asset Management (Tosca), the investment manager, and was formed from the combination of two existing privately owned property funds that had previously been created by the managers. RGL is differentiated by its focus on regional property assets, predominantly quality offices and industrial units, while active management is a key element of the investment strategy, provided by a well-resourced, dedicated team with cross-cycle experience. The manager seeks properties where there are opportunities to create additional value through occupancy improvement and rent increases, targeting an IRR of 10-15% that is not reliant on market-wide rent growth or yield contraction. When properties have met their return objectives they are assessed for sale, or to hold if their income and capital growth outlook looks strong, allowing the recycling of resources into new value-creating opportunities. In this section we give an overview of the company and its history. In following sections we review 1) the UK commercial property market outlook and opportunity for regional property, 2) RGL’s portfolio in more detail, 3) our financial forecast, and 4) our valuation conclusions.

RGL came to the market with an established portfolio of 128 properties valued at £386m, which had been created from the combination of two limited-life, offshore private property funds that had been created and managed by LSI and Tosca. Prior to establishing LSI, the management team ran a property company called Credential Holdings. Having identified a significant mismatch between the available yields on prime commercial property throughout the UK, outside of London, and those available on regional secondary commercial property, LSI began to work with Toscafund, helping to launch and subsequently manage its Commercial Property Fund I (2013) and Fund II (2014). The first significant acquisition by Fund I was £88m of debt secured against the Credential portfolio. The combination of the two funds to create RGL provided the existing investors with a way to extend their investment in a longer-term vehicle, taking advantage of an opportunity for value creation in regional commercial property. RGL additionally provides greater scale, access to capital for acquisitive growth, liquidity and tax efficiency.

Regional REIT has a five-member board and is chaired by Kevin McGrath (biography on page 17). There are four non-executive directors, two independent and two non-independent, the latter representing the asset manager (Stephen Inglis) and investment manager (Martin McKay). LSI is responsible for the day-to-day management of the portfolio, subject to the investment objectives of the board, advises on the acquisition, management and disposal of the real estate assets and is also responsible for debt funding negotiations. Tosca is responsible for the management functions of the company.

LSI is a privately owned property investment manager, established in 2012. The senior management team has worked together for a much longer period (managing the Credential portfolio) providing experience of managing portfolios for cash in down cycle. It is based in Glasgow with offices in Leeds, Manchester, and London. It manages c £500m in real estate assets, the majority of which represent the RGL assets, and employs c 45 staff of which around 37 are wholly committed to the management of RGL (around half directly in property management). The senior management team has more than 150 years of combined experience in the real estate sector.

The asset and investment management contracts both run initially for five years, at which point 12 months’ notice could be given; beyond five years the contract has a three-year term subject to 12 months’ notice being given at any point. The management fee is initially 1.1% of net assets, split equally between LSI and Tosca. On incremental net assets above £500m the fee will drop to 0.9%. In addition, a property management fee of 4% of annual gross rental income is payable to LSI. We estimate that the combined fees will represent 11% of gross rental income. An additional incentive is provided to the managers by way of a performance fee, which is payable from listing but will be satisfied for the first time at the end of FY18. The performance fee is 15% of total EPRA NAV per share return (EPRA NAV growth plus dividends declared) exceeding 8% pa, subject to a high-water mark (the greater of the highest year-end NAV per share in prior periods or the IPO price of 100p). The first performance fee is payable in 2019 in respect of performance from listing until the end of 2018. It is payable 50% in cash and 50% in shares. Starting with FY19, the performance fee then will be calculated annually and is payable one-third in cash and two-thirds in shares.

After the initial five-year term of the asset and investment management contracts, subject to EPRA net assets having reached £750m, the board and managers may decide to internalise the management of Regional REIT, subject to approval by independent shareholders.

The reported cost ratio (non-recoverable property costs and administrative and other costs as a percentage of gross rental income) for 2015 is distorted by the shortened period of trading. Management has guided to it being c 26% on an underlying basis and we have used this as a basis for our forecasts with an allowance for assumed additional costs relating to its public company status. The H116 additions to the portfolio of lower occupancy properties will also tend to increase void costs in the period. Our 2016e cost ratio is 27.5% excluding performance fees. We believe that this is broadly comparable with the peer group average despite the level relatively high number of properties in the portfolio, their geographic spread and active asset management. These all point towards a higher cost ratio, which is offset primarily by the relatively high yield that RGL achieves on the properties, and in part by LSI’s regional management offices from which it manages the assets. RGL estimates that performance fees would have been £95,000 had they been calculated in respect of the 2015 reporting period. We have included performance fees in our forecast estimates and, based on our NAV assumptions, these add an average 2.4% pa to the expense ratio over the forecast period (2016-18). The calculation of EPRA earnings excludes performance fees. .

The conversion of the Toscafund funds into a REIT and the IPO gained strong support from the former investors in the limited life funds. 30% took the opportunity to sell out, but for the others this provided a tax efficient and tradeable means of maintaining their exposure to potential future upside.

Both the asset and investment managers are shareholders in RGL, creating a common interest among all shareholders. We believe that currently LSI owns 5-6% of the shares and holdings under the control of Toscafund are 17.03%. These shares are included within the 23.54% of shares that were locked up at IPO for periods of six or 12 months. Additionally, the sale of shares awarded to the investment and asset managers by way of performance fees is restricted: by one year in respect of the first calculation in 2018. As noted above, half of any incentive shares awarded from 2019 will be locked up for one year and the remainder for two years.

Overall UK commercial real estate has recovered strongly from the post-global financial crisis low in March of 2009. Recovery in the London area began before that in the regions and the recovery in prime properties led the recovery in secondary. Brexit introduces increased uncertainty for the market as a whole, but management identifies the differences that persist between the London market and that of the rest of the country, and between secondary and prime, as continuing to provide opportunities. We also note that management primarily targets returns from asset management initiatives rather than market-driven increases in rents or reductions in yields. RGL’s strategy is based on targeting underexploited properties and actively managing them to improve occupancy and rents. In terms of regional commercial property in the context of the UK market as a whole, we note:

Since reaching a low point in 2008, UK commercial real estate (CRE) investment volumes have grown strongly to reach a new peak in 2015 (Cushman & Wakefield estimates £61.5bn). Regional property investment also reached a record level in 2015 with investors, including an increasing share of foreign investment, attracted by higher yields and the potential for greater returns. Foreign investment has represented c 45% of the total on average in the years since 2009. The share of London in total investment has also been declining. CoStar estimates that central London received 31% of all UK investment in 2015, which was down from the peak of 46% in 2012 and was at its lowest level since the start of the financial crisis.

Coming into 2016, this strong pace of investment was widely expected to flatten off. Foreign investors in particular, a notable driver of the central London market, had become more cautious as a result of general global uncertainties and strong yield compression in certain parts of the market. The Brexit vote has added a new dimension to this uncertainty, although we would note that the more than 10% fall in the sterling exchange rate has reduced the cost of investment for overseas buyers while the low interest rate environment globally looks more entrenched than it did just a few months ago.

Ahead of the EU referendum, CoStar estimated that UK CRE investment in Q116 was 26% lower (albeit at a still quite healthy £12.1bn) than in the same period a year ago. It estimates that foreign investment was 44% lower. Q2 data are unavailable as yet, but it seems unlikely that this trend would have reversed. It is entirely possible that the H1 reduction in foreign investment reflected a postponement of investment decisions until after the EU referendum, but the outturn has dented hopes of a quick rebound.

The most recent quarterly market forecasts by the Investment Property Forum (IPF, canvassing a group of fund managers and surveyors under the IPF Research Programme) were published in May and already showed signs of pre-referendum uncertainty The IPF forecasts relate to the whole of the UK including London and do not specifically refer to regional properties. In the May survey, the average IPF forecast for the All Property category capital value growth across the whole of the UK in 2016 reduced to 2.2% from 3.0% three months earlier, although 2017 and 2018 average forecasts were each increased by 0.3%. Rental growth forecasts for office and industrial properties were increased, with each showing a 0.2% pa uplift on average for the 2016-20 period.

The average forecast for All Property total return in 2016 is lower as a result of the change in near-term capital growth assumptions, but the 2016-20 average is unchanged at 5.6% pa with both office and industrial property showing a small 0.1% pa increase over three months since January. As things stand, we think it likely that the next survey, in November, will show a further deterioration, particularly for near-term capital performance. It is possible that for the UK market as whole, capital returns may be negative for the year, with City of London offices taking the brunt of downgrades.

The overall UK market appears to be entering a stage of the cycle where capital gains will be more difficult to find, compounded by Brexit, putting greater emphasis on occupier demand and rental growth prospects as the drivers of income return. It is worth remembering that income represents c 75% of total property returns over the long term and has been very much more stable than volatile capital value movements. Rents in London and the South East were first to recover after the global financial crisis, while regional rent growth began much later.

RGL management believes regional assets can still deliver superior late-cycle returns, particularly income returns from regional offices and industrial properties, and that Brexit should have less of an immediate effect on these than on, say, City of London offices or general retail assets that may be exposed to a decline in consumer confidence or disposable income. The main income drivers are:

In terms of overall regional property returns (capital value as well as income), the manager notes that:

Exhibit 3 shows that the London prime to secondary yield spread began to reduce in 2010; in the regions, the prime/secondary yield spread only began to fall in 2013 and is still above historical norms.

As investor demand focused on prime property, particularly in London, in the early stages of the market recovery, the yield spreads between central and inner London offices and the rest of the UK, and between prime regional and secondary regional office property, expanded greatly (see Exhibit 3). As the manager was anticipating back in 2012, both have begun to narrow, but in respect of prime regional property versus secondary the gap remains historically wide. The manager continues to see a particular opportunity from a narrowing of this gap, expecting it to be achieved primarily by further yield contraction on secondary property, although prime yields may increase a little in the near term with Brexit uncertainty, providing the prospect of capital appreciation.

UK economic recovery, growing levels of employment and relocation to regional centres have all been positively affecting on tenant demand for both the offices and multi-let industrial sites that RGL is targeting. There is an additional uncertainty that the outturn of the EU referendum may have dented the previous positive growth outlook.

In 2015, take-up of space in the main regional offices reached a record 5.6m square feet. Importantly, supply has been constrained by a relative lack of new development since the global financial crisis and the conversion of older offices for residential use. Given a steady decline in vacant space, take-up may naturally slow but rents have begun to grow. The manager expects the very low vacancy rates for prime offices to continue to push demand towards secondary offices and anticipates that this should continue to put upward pressure on rents and limit the need for rent incentives.

The escalating cost of accommodating staff in London is encouraging employers to consider moving away from the capital to major cities around the UK. Herbert Lambert Smith Hampton (annual Office Market Report) estimates that staff and premises costs in Midtown London to be c £80,000 pa, nearly twice the cost for cities such as Birmingham, Manchester or Bristol. They believe that relocation to the regions could be a long-term trend, while recent examples include HSBC’s decision to move the head office of its retail banking arm (1,000 people) out of London to Birmingham. Freshfields is moving its back office functions to Manchester from London, relocating about 400 jobs in 2015 and perhaps twice as many in 2017. Similarly, Allen & Overy relocated people out of London to Belfast in 2011/12. But most growth in regional cities seems currently to be coming from the opening of new offices, ie expansion by large companies opening new regional offices rather than relocating existing jobs.

For regional industrial property, the dynamics are similar. Demand for space from manufacturers has been increasing, particularly logistics operators, while new supply has been constrained, again leading to rental growth. Historically, demand was greatest for larger industrial units in locations near the main conurbations. More recently, the growth of the internet and new distribution channels has boosted demand for more widely spread, medium-sized distribution units. RGL’s portfolio is more highly represented in the latter.

“Northern powerhouse” is a term introduced two years ago by the government, which encapsulates its strategy for a rebalancing of the economy away from London and pooling the strengths and potential of the major towns and cities in the North of England. Lower than average per capita output and productivity are evidence that the North is not achieving its full potential and so the key cities of Manchester, Sheffield, Leeds, Liverpool, Hull, Newcastle and the Tees Valley are being encouraged to work more closely together to attract more inward investment. Improved transport links (road and rail) within the region and between the North and London are a centrepiece of government plans, along with devolution of decision making to local authorities, giving them a greater say in how their areas are managed. Devolution agreements have been agreed with Manchester, Sheffield, the North-East and Tees Valley.

The effectiveness of the government’s strategy is not without its critics, sometimes labelling it as political rhetoric, and the results in any case will take a great many years to emerge (HS2 construction does not commence until 2017 and it is unlikely to open before 2025). However, the political commitment to the project seems to be as strong now as before the Brexit vote and importantly it sets a direction of travel. It is possible that the attention given to the northern powerhouse project may already be affecting long-term business planning and reinforcing an existing commercial argument for relocation and investment in the North. A recent report by Ernst & Young shows that while the UK as a whole benefited from record foreign direct investment (FDI) in 2015, 90% of the growth came from outside London and the South East. The report estimates that FDI in the northern powerhouse more than doubled compared with 2014.

RGL’s 100% focus on regional property assets is a differentiating factor within the sector. The charts below show the portfolio split by sector and geography as at 31 December 2015, the latest date for which comprehensive data is available. The predominance of office and industrial property (91.5% by value at 27 May 2016) can be seen, as well the diversified geographic positioning of the portfolio with the relatively large historical weighting towards Scotland (c 27% as of 27 May 2016).

The Q116 trading update shows that at 31 March 2016 the portfolio contained c 130 properties, around 970 units, and approximately 700 tenants. The portfolio value (£404m at the end of 2015) had increased to c £507m as a result of acquisitions less disposals in the quarter. Portfolio activity has continued since the quarter end, the most significant being the disposal of the Blythswood House student accommodation in Glasgow for £17.4m (c 3.4% of the Q116 total portfolio value) at a price in line with the 2015 year end valuation. This transaction furthers the strategic aims of increasing focus on the targeted office and industrial properties and reducing the Scottish weight in the portfolio. We estimate that, year-to-date, property acquisitions total c £131m and disposals c £40m. The 30 June 2016 interim portfolio valuation was recently release at £501.3m. The decline from 31 March reflects the net disposals made during the period, which our modelling assumes will be reinvested by year end. On a like-for-like basis the portfolio has grown by 1.8% since 31 December 2015 and by 7.7% since 30 June 2015.

Adjusting the disclosed Q116 sector weighting of the portfolio for the Blythswood House sale, we estimate that offices (by value) represented a pro-forma 61.5% (IPO 58.4%) and industrial sites c 30% (IPO 25.3%).

The company website provides details, including the asset management strategy, for each of the top 15 properties with an aggregate investment value of £230m at 31 March 2016, or c 46% of the overall portfolio.

The most recent of the six monthly external valuations was undertaken by Cushman & Wakefield as at 31 December 2015, representing a net initial yield of 7.6% (down from 8.3% at IPO), an equivalent yield of 8.3% (down from 8.6% at IPO), and a reversionary yield of 9.0% (down from 9.8% at IPO). The net initial yield on offices (7.9%) and industrial sites (7.6%) were higher than for retail (7.1%) and the now sold student accommodation (5.0%).

The gross rent roll at 31 December 2015 was £35.9m (it increased to £43.5m in Q116) with occupancy at 83.9%. Occupancy at 31 March was 80.9%, down from 83.9% at year-end due to refurbishment activity on lease expiry and because two portfolios (Wing and Rainbow) with an aggregate value of £117.5m were acquired at void rates above the portfolio average, providing the opportunity to benefit from planned improvements. The expected rental value at full occupancy (ERV) at 31 December 2015 was £40.4m.

At 31 December 2015, the weighted average unexpired lease term (WAULT) was 4.4 years or 3.8 years excluding Blythswood House. As shown in Exhibit 12, lease expiry and lease breaks during 2016-18 represented c 57% of aggregate contracted gross rental income at that date.

Managing the lease expiry and lease breaks over the next three years is key to RGL achieving its targeted returns. Each property is being managed to a detailed plan and, as we discuss above, market conditions (improving occupier demand and limited supply) are positive. Using year end data, and assuming the entire portfolio were to re-price to ERV immediately, we estimate that 89% occupancy would be required to maintain the current contracted gross rent roll. This is in line with management’s view of structural occupancy of c 90% and meanwhile we expect ERV to continue to grow.

In this section we set out the basis for our estimates. We believe that there is considerable scope for RGL to exceed these estimates in a number of areas and in the sections that follow we provide a sensitivity analysis for each:

The gross contracted rent-roll run rate at 31 March 2016 was c £43.5m. We estimate that the announced property transactions since that date represent net sale proceeds of c £11m and a reduction in the contracted rent roll of c £0.3m. As it is management’s intention to grow the portfolio we have assumed re-investment of these net disposal proceeds (at a net yield of 8.5%, similar to the Q1 average on acquisitions), to give an estimated adjusted gross contracted rent roll of £44.1m. This is the number that our forward-looking estimates are based on, making no assumption about additional net acquisition activity (purchases less sales) given the uncertainty about timing and quantum, even though we believe this to be highly likely. While our modelling captures an anticipated increase in occupancy, income and value from the current portfolio, the limitations of modelling make it difficult to capture the potential for management to recycle the existing investments into new, value-creating assets. We show a sensitivity analysis of earnings and dividends to a range of possible asset growth scenarios on page 14. Our base case estimates make the following additional assumptions:

Given the positive spread between available yields and funding costs, we estimate that additional asset growth through acquisitions would be accretive of earnings per share and dividend-paying capacity, although potentially dilutive of NAV per share. We believe that RGL will look for opportunities but will remain selective and will seek to balance any trade-off between earnings/dividend enhancement and NAV dilution.

The board is targeting a long-term LTV ratio of c 35%, although it has previously indicated that it would be prepared to see this increase to around 45% over shorter-term periods. There is a hard limit of 50%. We estimate that the company could add c 10% to our forecast property assets, or c £50-55m of additional property, before the LTV ratio would reach 45%. Net asset growth above this level would require additional equity and, despite the share price discount to NAV widening post the Brexit vote, we estimate that acquisitions, partly funded by equity issue at around the current share price or higher, would still be accretive of EPS and dividend-paying capacity, but potentially dilutive of NAV per share. We do not believe that management would look to raise equity for cash at a price below NAV per share, but we do believe that it would consider issuing equity as payment in kind for accretive acquisitions.

In the illustration below, we demonstrate the potential for accretive acquisition growth, locking in the positive spread between available yields and the cost of debt on that part of the consideration funded by debt, and spreading the fixed cost base over a larger pool of assets.

Our chosen assumptions suggest that a net addition of £50m of property assets could enhance our forecast earnings and dividends by c 2% and £250m of assets by c 6%, despite requiring greater new equity support (assumed to be issued at the current price). The manager cites a strong track record of executing on deals with a wide range of vendors (banks, receivers, institutional investors) that positions it as a recognised player in regional office and industrial markets. At the IPO in November 2015 the manager indicated that it was actively exploring a number of acquisitions of up to £250m in value, although it would be unlikely for all of these to reach completion. Since then, five acquisitions have completed with a total value of just over £130m. Two large transactions accounted for £117m of this total and the smallest was £3m. With the publication of the FY15 full year results in March 2016, the manager indicated that it was reviewing up to £500m in possible transactions. If one were to apply a similar completion ratio to this pipeline as to the IPO pipeline, it could translate into c £250m of firm investment opportunities over time.

In Exhibits 13 and 14 we illustrate the potential impact of net asset additions (acquisitions net of disposals) of between £50m and £250m. For clarity the impacts are shown on an annualised basis as if they had occurred at the beginning of 2016 and contributed for a whole year, whereas in reality the impact would depend on timing. Exhibit 13 sets out the assumptions. We assume that assets are acquired at a net yield of 8.5%, similar to the yield achieved on acquisitions in Q116. We take off investment management and property management fees, and assume a modest incremental increase in other administration expenses, noting management’s view that the current cost base (excluding management fees) can broadly support up to c £750m in gross assets. Marginal debt funding is assumed at 3.35%, assuming 3.0% interest and hedging costs and 0.35% pa amortisation of loan arrangement fees. The required equity funding is assumed to be raised at 92.5p per share, a slight discount to the current price. We have determined the mix of cash/debt funding versus new equity funding by fixing the overall portfolio LTV (existing and new assets) at 40%. While this is higher than the long-term target of 35%, we note that we have assumed no benefits from the asset management of the newly acquired assets. Given the strategy of targeting undermanaged, under-let and under-rent properties, we think that we have been conservative and that there would be additional income and valuation upside (lower LTV) that is not captured by our illustration. New equity is assumed to be issued at the current market price.

In Exhibit 14 we show the outcome from our illustration. In each scenario there is an uplift to EPRA earnings and, assuming an unchanged pay-out ratio, to DPS. Given the positive spread between income, net of expenses, and funding costs, the higher the asset growth, the higher the accretion. Because of the assumption that equity is issued at the current market price, a discount to NAV, and that acquisitions are made at fair value, NAV per share is diluted by a similar amount. In practice we believe that management would anticipate significantly reducing the immediate NAV dilution over the medium term through the application of asset management initiatives.

As the share price recovers from the immediate post-Brexit sector sell-off, it is worth considering the range of outcomes depending upon the price at which equity may be issued (our illustration being based on 92.5p).The higher the price at which shares can be issued, the higher the earnings accretion and the lower the NAV dilution. We show the potential impact on 2016e EPRA earnings per share and dividend paying capacity in Exhibit15 below. If shares were to be issued at our expected 2016e NAV per share of 112.9p then there would be no NAV dilution, but at 85p the NAV dilution would be 9.5%.

RGL is targeting a total return of 10-15% pa with a strong focus on income but with additional capital appreciation driven by specific asset management initiatives within the portfolio. The continued strengthening of the regional property market more generally would additionally support overall returns. As discussed above, we view our forecasts as conservative in a number of areas, and these imply an average NAV total return of c 10.0% during the forecast period (2016-18). Nonetheless, our forecasts show RGL on the highest prospective dividend yield (2016e 8.1%) within the UK REIT universe while trading at a discount to NAV (2015: 10%, 2016e: 13%) that is slightly wider than the median.

Property funds have been hard hit in the immediate aftermath of the Brexit vote with much of the open-ended fund sector putting a halt to or limiting immediate redemptions (“gated”). This is hardly surprising given the illiquid nature of the underlying assets and the need to treat all investors fairly. This is a clear advantage for the closed-ended REIT sector (like RGL), where liquidity is provided by investors being able to sell their shares in the market without the company being forced to sell assets. Discounts to NAV have widened significantly post the Brexit vote, particularly for those REITs most heavily exposed to London assets.

In the financial section we highlighted the potential uplift to our forecasts from portfolio growth. Later in this section we show the sensitivity of NAV to alternative ERV and valuation yield assumptions.

We forecast a 2016 dividend per share of 8.0p, increasing to 8.2p for 2017. On 2016 forecasts, this represents a 2016e prospective yield of 8.1%, the highest among REIT sector constituents as shown in Exhibit 16, and it is also fully covered. As we show in the financial section on page 11, we believe there may be scope for accretive acquisition activity to further increase DPS above our forecasts.

At 98.75p, RGL is trading at a 10% discount to the FY15 EPRA NAV per share of 107.8p and a larger (13%) discount to our FY16e EPRA NAV per share of 113.1p. Taking a similar peer group, this places RGL at a slightly higher than median discount.

In the section below we discuss the sensitivity of our forecast NAV to different ERV growth and valuation yield assumptions to those contained in our forecasts.

Our base case forecasts assume that valuation yields are unchanged from the FY15 level of 7.6% on average across the portfolio such that our estimated revaluation gains are driven entirely by assumed growth in ERV. Faster ERV growth or a reduction in valuation yield would be expected to increase the level of gains, and NAV per share, above the level that we have forecast, and vice versa. In Exhibit 18 we show how are our 2018e EPRA NAV per share would change were we to assume alternative valuation yields and/or a difference in the annual rate of ERV change across each property asset type. At the extremes of the table (obviously either variable could move more than we have allowed for), an extra 1% pa rental growth compared with our forecasts and a 100bp reduction in the valuation yield would suggest an increase in the 2018e EPRA NAV per share from 118.4p to 142.1p (+20%), while a 1% pa lower rate of rent growth and a 1% increase in valuation yield would lower EPRA NAV to 99.0p (-17%).

The commercial property market is cyclical. Occupational demand is influenced by economic growth trends, so the overall health of the economy is important to commercial property income. The risk of an economic downturn affecting rental income is mitigated by having a large number of low-risk tenants in different business sectors across the UK. Before the sale of Churchill Plaza, Barclays Bank was the largest tenant by rent, accounting for 8.2% of gross rental income at year end. We believe this is now less than 5%, but remains the largest tenant. The second largest tenant by rent at year end was E.ON UK at 4.3%. At year-end the top 15 tenants paid 39.5% of RGL’s gross rent and include four government departments and six FTSE 100 companies. The company does not engage in any speculative development of properties that are not pre-let. The potential impact of a rise in interest rates increasing borrowing costs is offset by hedging any variable interest rate debt (100% of such debt is hedged). In addition, the company has a relatively low LTV ratio.

Lease expiries and breaks over the next three years amount to c 57% of RGL’s portfolio by rental value, presenting both a risk and an opportunity for the company to improve rents and tenant covenants. The management team maintains close relationships with current and prospective tenants and has plans in place for each property to increase rents and therefore capital value. Typical lease terms for RGL’s market are 10 years with a five-year break, implying a normal WAULT to first break of 2.5 years. RGL’s WAULT to first break was 3.8 years at 31 December. While the manager believes RGL will benefit from yield contraction, should market yields unexpectedly rise we would expect the current high yield on RGL’s assets to provide some protection.