Rising inflation and interest rate hikes are two main issues weighing on the minds of investors today. Amid a gloomy macroeconomic outlook, however, one bright spark could offer some respite and stability.
Elite Commercial REIT, Singapore’s first and only UK-focused REIT, offers stable returns with rental growth pegged to inflation, backed by the AA-credit-rated UK government and a strong occupier base that has remained resilient in times of economic uncertainty.
Occupancy rate remains high at 98% and weighted average lease expiry (WALE) stands at 5.2 years as at June 30. The REIT, which was listed on the Singapore Exchange (SGX) on Feb 6, 2020, just at the onset of the Covid-19 pandemic, recovered ahead of the wider industry benchmarks during the unprecedented period of UK lockdowns and Singapore’s “circuit breakers” to manage the pandemic.
Social infrastructure
Elite Commercial REIT is not your typical commercial REIT. Its asset base consists of a network of 155 functional, centrally-located properties, geographically diversified across the different regions in the UK.
Not only are the assets strategically located in town centres, the properties are also near amenities and transportation nodes.
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These attributes serve the REIT well as it serves the community as part of the social infrastructure through which the UK government delivers its services.
Currently, over 99% of its portfolio is leased to the UK government, which is credit-rated AA by S&P Global Ratings and Aa3 by Moody’s Investors Service.
The REIT’s assets are primarily occupied by the Department for Work and Pensions (DWP) — the UK’s largest public service department that is responsible for welfare, pensions and child maintenance services.
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Shaldine Wang, CEO of the REIT manager, says: “Although the recent pandemic sees an increased popularity for hybrid working, the REIT’s buildings are not typical commercial offices — the assets are used as centres to provide social benefits and support to the local communities, such as helping the unemployed get back into the workforce. Hence, the need for such centres increases in times of economic uncertainty.”
While the DWP contributed about 91.5% of the REIT’s annualised gross rental income as at June 30, the overall tenant mix also includes the UK Ministry of Defence (MOD), His Majesty’s Courts and Tribunals Service, Natural Resources Wales, Home Office and the Environment Agency, among others.
The majority of leases are signed directly with the Secretary of State for Levelling Up, Housing and Communities (formerly known as the Secretary of State for Housing, Communities and Local Government), which is a Crown Body and which management says “provides credit stability and certainty”.
Rents are collected in full and on time — three months in advance, says management. “For the period of three months to Sept 30 this year, 99.9% of rent was collected in advance, within seven days of the due date of end-June.”
Stability amid uncertainty
Elite Commercial REIT boasts unique attributes to serve as a hedge against market uncertainties. According to management, unitholders are largely shielded from inflationary pressures and interest rate hikes.
“The leases are all on a full repairing and insuring basis, where the operational expenses of the properties are borne by the tenant, hence the REIT is largely insulated from the effects of rising inflation and energy prices,” management tells The Edge Singapore.
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As assets, liabilities and distributions are denominated in British pounds, the REIT is naturally hedged against forex fluctuations, adds management. “With about 63% of interest rate exposure fixed, Elite Commercial REIT is also largely insulated from interest rate hikes.”
Additionally, the REIT’s properties have inflation-linked rental escalation clauses built into a majority of the leases, presenting potential upside from April 2023. The rental uplift is pegged to the UK Consumer Price Index (CPI), subject to an annual minimum increase of 1.0% and maximum of 5.0% on an annual compounding basis from April 1, 2018, to March 31, 2023.
Based on the four periods of inflation rates locked in so far, rental escalation is estimated between 11.0% and 15.4%, depending on the prevailing inflation rate of the final period. Staying resilient through economic cycles and delivering sustainable returns to unitholders remain first and foremost in the minds of the REIT’s manager.
Maiden acquisition and tax savings
Shortly after its first year of listing, the manager completed its maiden acquisition, growing the number of assets by 60% and increasing market capitalisation by 39%.
The newly acquired portfolio of 58 properties contributed positively to its revenue, diversified its occupier mix, increased exposure to London and added a large institutional investor into its investor base.
Next, to make its tax structure more efficient, the manager successfully listed the REIT’s wholly owned UK subsidiary — Elite UK Commercial Holdings Limited (ECHL) — on The International Stock Exchange (TISE) on Aug 26 last year.
With the technical listing, ECHL and its subsidiaries qualified as a UK REIT group and enjoy the same tax treatment as a UK REIT group, bringing it broadly on par with its peers there, says the REIT’s manager, who added that there is no trading of units involved in a technical listing.
Elite Commercial REIT’s UK entities are now exempted from UK’s corporation tax — currently at 19% — on its property rental business income and gains. “Instead, they are required to pay 15% of withholding tax on dividend remitted back to the REIT,” says management.
Effectively, headline tax has been reduced from 19% to 15%. With the UK corporation tax legislated to rise to 25% from April 1, 2023, the implied tax savings is material. “Hence, the qualification of ECHL and its subsidiaries as a UK REIT group also future-proofs the REIT’s capital structure against future tax increases. With a lower headline tax rate, there’s lower tax expenses and this may translate to higher distributable income to unitholders,” says management.
The achievement of these two key milestones can be seen through its outperformance over eight consecutive quarters, beating IPO forecasts and projections.
In the recent half-year results announcement, the distributable income for 1HFY2022 ended June increased by 9.7% y-o-y to GBP12.2 million ($20 million), derived from identical 17.7% y-o-y increases in both net property income (NPI) and revenue, with the maiden acquisition and tax savings from headline tax rate as among the key performance drivers.
This follows a 65.2% y-o-y surge in the REIT’s distributable income for FY2021 ended December to GBP24.5 million. Unitholders of Elite Commercial REIT will be receiving distribution per unit (DPU) of 2.56 pence for 1HFY2022.
Through extensive negotiations, the REIT’s manager has removed lease break options from 109 of the leases of properties occupied by the DWP and MOD.
The other lease terms remain intact, and the leases continue to enjoy the upside from the in-built inflation-linked rental escalation expected to start on April 1, 2023.
Following the removal of lease break options, about 87.5% of the total REIT portfolio’s annualised gross rental income as at June 30 is secured up to March 2028.
The weighted average lease to break also trended closer to the portfolio WALE, enhancing lease stability and income visibility.
First sustainability collaboration
In line with the UK’s 2050 net-zero goal, management began its first public-private collaborative effort with the DWP in February to boost sustainability and energy efficiency in its occupied properties.
This was later expanded to include the asset occupied by the MOD. The plans include replacing variable refrigerant systems, gas- or oil-fuelled boilers and air-conditioning systems with more energy-efficient systems, along with roof works.
So far, management has committed some GBP14.8 million over three years towards these asset enhancement initiatives. In 2Q2022, management paid the first tranche of GBP7.3 million towards this effort.
Better portfolio valuation
Following the positive lease re-gearing exercise in 1HFY2022, management undertook a voluntary mid-year valuation of its assets.
The REIT’s portfolio is valued at an aggregate of GBP517.7 million as at June 30, which represents an overall fair value gain of 3.5% over the previous valuation of GBP500.1 million as at Dec 31, 2021.
“This is remarkable in view of the recent overall real estate market condition in the UK, which is exacerbated by the current ongoing macroeconomic challenges and geopolitical uncertainties. The upward revaluation is testament to the REIT manager’s efforts in strengthening the portfolio’s attractiveness and enhancing income visibility. Looking ahead, we will continue to focus on executing active asset management strategies to create the best value outcome for the REIT,” says the REIT’s manager.
Unitholders also enjoy generous yield, adds management. Elite Commercial REIT’s 1HFY2022 annualised DPU yield of 8.26%, based on the REIT’s closing price of 62.5 pence per unit as at June 30, outperforms bonds and bond-like instruments like the Singapore CPF Ordinary Account, 10-year government bonds in Singapore and the UK, as well as fixed deposit rates in Singapore dollar and British pounds.
As at Aug 16, units in Elite Commercial REIT traded at 60.5 pence and analysts see upside ahead.
CGS-CIMB Research analyst Lock Mun Yee believes units could reach 76 pence, while DBS Group Research analysts Tabitha Foo, Dale Lai and Derek Tan think the REIT could trade at 70 pence per unit.
Says management: “With a pipeline of quality properties from the sponsors’ right of first refusal and potential third-party transactions in the open market, the REIT continues to exhibit strong growth potential. Using analytics and proactive asset management, the manager also formulates the best outcomes for the REIT’s properties to maximise value and deliver sustainable returns to unitholders.”
