Posted on 16 Mar 2017

Palace Capital's shrewd dealmaking


Shares in Palace Capital (PCA:355p), a property investment company focused on commercial property outside London, came within pennies of the 380p minimum target price at the end of last year when I advised running profits ('On the money', 12 Dec 2016), having initiated coverage on the shares at 335p last autumn ('A royal investment', 17 Oct 2016).

Progress on sales and lettings since that last update suggest that the shares are worth buying again at 355p. That's because the company has just sold off two commercial properties, in Leeds and Warwick, for £3.7m, representing a 25 per cent premium to book value. It's sensible to do so given the tenant on one of the properties, support services group Interserve (IRV:240p), has the option to exercise a break clause this summer, which would have resulted in the loss of £193,000 of annual rent. Also, the other property is vacant, so the sale removed £185,000 of annual running costs. And these are not isolated sales as the company announced yesterday that it has sold off the ICS Buildings in Maldon, Essex, for £3.9m, a price equating to £1.56m above the last independent valuation of the property as at 30 September 2016. These three disposals not only add 9p a share to net asset value, but free up capital for reinvestment and highlight the ability of Palace Capital's management team to enhance value through active capital management of the portfolio.

A good example of this is the conversion of a 10,000 first floor office space at a small shopping centre, Copperfields in Dartford, into 13 self-contained flats at a cost of £2.25m. The work completed in November and the units have now all been leased out to the local council on a 10-year lease at an initial rent of £146,500, rising annually at 2.5 per cent a year, and with no break clauses.

In an investment climate where yield compression looks to have run its course, then active management of portfolios is a great way to keep valuations moving upwards and explains why analysts believe that the company's net asset value will rise to around 429p in the 12 months to the end of May 2017, up from 414p the year before. Also, rental revenue from the portfolio underpins expectations of a 12.5 per cent hike in the full-year payout to 18p a share based on a 12 per cent rise in EPS to 21.3p, so the share price is supported by a decent looking 5 per cent prospective dividend yield.

The company is able to grow both EPS and is not reliant on valuation gains on the portfolio to pay dividends because its average cost of debt on £82m-worth of borrowings secured on its £185m portfolio is only 2.9 per cent a year, significantly below the average investment yield of 7.5 per cent on the properties based on annual contracted rent of £13.7m.

Trading on a 17 per cent discount to net asset value forecasts, the high-yielding shares look an attractive investment proposition for a company whose management team has delivered net asset value per share growth of 92 per cent over the past three years, and is garnering a shrewd reputation for buying off-market and adding value to assets through active property asset management and refurbishments.

I rate Palace Capital's shares a buy at 355p and have upgraded my target price from 380p to 400p. Buy.