Listed retail REITs in the UK have been much-maligned when there is still plenty of value in the shopping centre market, writes Kieran Lee, analyst at Berenberg. Here, Lee explains why the German bank gave intu a “buy” rating last week.
Our “Buy” rating for intu and the other UK listed retail REITs has been both contentious and contrarian. Despite this, we remain cautiously optimistic on companies that own the right assets let to the right tenants in the right locations, despite the challenges facing the wider retail sector.
Although changing consumer habits, retailer right-sizing and asset underinvestment are likely to result in a material capital value decline for low-quality assets with a poor tenant mix in oversupplied or weaker locations, intu, with a £9.5bn portfolio of dominant retail and leisure destinations, continues to be implicated in the wider sector malaise, despite its materially higher asset and income quality.
Intu’s asset quality is often misunderstood. Although there are weaker centres in the portfolio, 62% of intu’s assets by value are ranked in the top 10, increasing to 87% for the top 30. The tail shouldn’t wag the dog. Operational outperformance also highlights quality: footfall has increased by 1% since 2013 against the benchmark of -8% footfall over the period; occupancy of 97% is 3% ahead of the UK prime average; rents have increased by 4% from 2009 lows, and continue to be agreed at 6% ahead of prior passing values; the UK shopping centre average ERV is down by more than 7%.
Resilient income
With a 7.4-year average lease length, 17% reversion potential and deep tenant demand for space in the best locations, income remains resilient, cost ratios are sector-leading and income cover has increased. We expect intu’s sector-leading 8.9% dividend yield to remain resilient and covered.
We do acknowledge intu’s flaws, predominately surrounding leverage and the balance sheet, but believe that the current share price – a 56% discount to last reported NAV, implying a 35% capital value correction or 8% yield – is materially overdone. A correction on this scale would imply 22% more yield expansion than experienced for prime shopping centres in the financial crisis.
Although we do anticipate some valuation impact with lower systematic leverage and a more sophisticated, longer-term, direct asset investor base, we expect this to be materially lower than that experienced last time around, with revaluation losses offset partially by development gains.
Debt covenants
There remains significant headroom to debt covenants; we calculate it would require a capital value fall of around 27% to breach the lowest debt covenant. Should the quantum of asset value correction be greater than we anticipate, management has numerous levers that can be used with substantive effect prior to requiring additional equity.
Intu’s asset ownership structure, with 100% or significant majority ownership in its largest, highest-quality and most desirable assets, provides flexibility.
Intu’s four largest centres account for 55% of total portfolio value. If stakes in these assets were sold at current values, reducing ownership to 50% but retaining management rights, portfolio LTV would fall to 30%.
With the market implying a 35% valuation fall, a sale at a 10% discount to current book value would likely be viewed favourably and would increase the likelihood of a timely sale. Additional asset stake sales, the delay or cancellation of value-accretive development programmes and a reduction or cancellation of the dividend all remain options but are unlikely to be necessary, in our view.
With the shares trading at a 56% discount to last reported NAV, a take-private approach from a major shareholder or private equity remains a possibility.
Although both would likely maintain (or increase) current leverage levels, it would allow the true market asset valuation to be recognised and a long-term view to be taken. It may also bring about material benefits, especially if current intu share ownerships are charged against other borrowings.
