Last year, I warned for Intu Properties’ (OTCPK:CCRGF) capital allocation method as about 55% of its rental income had to be spent on making the interest payments on its debt. An unsustainable situation and after two recent potential deals to sell the company fell through, Intu Properties had to take adequate action to protect its future.
Source: Yahoo Finance
Intu Properties is a British REIT and it’s listed on the London Stock Exchange with INTU as its ticker symbol. The current market capitalization at 111.5 pence is 1.5B GBP, and the average daily volume in the UK is 3.5M shares.
What were my main concerns last summer?
In August 2018, I was incredibly surprised to see Intu Properties spending in excess of half its rental income on making interest payments. The dividend was eating away the remainder of the incoming cash flow which left very little room to start tackling the net debt of the company.
Source: company presentation
Leverage is fine. In fact, some leverage is great if you can borrow at a lower cost than the ROI you are making on the borrowed money (why else would you borrow money). But when your cost of debt is pretty close to the rental income yield, it doesn’t make as much sense to add too much debt to the balance sheet as the marginal incremental benefit of deploying debt is very low.
Cutting the dividend isn’t a popular move for a REIT as a lot of its shareholders are relying on the dividend stream to diversify their income, but sometimes drastic action is needed.
Intu Properties now finally seems to realize it needs to take action
Intu finally realized something had to be done when it published its full-year financial results, which included a 1.4B GBP impairment charge on the valuation of its real estate assets. Not a surprise, as those assets were almost ‘priced to perfection’ and even the current valuations based on a net rental yield of less than 5% are a bit optimistic. Especially considering Intu Properties calls divesting properties in the UK ‘challenging until a political resolution on the Brexit issue is achieved’. Perhaps I’m over-cautious, but when I read such statements, I’m really wondering if the net initial rental yield of just below 5% still isn’t too optimistic…
That’s confirmed in the management’s comments that accompanied the financial results: Intu mentioned the ‘retailed failures picked up substantially, impacting our net rental income by 1.9%. Increasingly negative investor sentiment towards retail property fed through to a 13.3% fall in the valuations of our UK assets’.
Source: company presentation
That’s tough as Intu Properties’ revaluation of the real estate assets has pushed the LTV ratio to 53%, which is higher than the company’s self-imposed maximum LTV of 50%. That’s the main reason why Intu has suspended its 14 pence annual dividend, as this was costing the company almost 200M GBP per year. And right now, every Pound counts to reduce the net debt and strengthen the company. I’m all in favor of the dividend cut as skipping the dividend for one year would reduce the LTV ratio by about 2%.
Selling the Spanish properties?
Intu is mulling over selling its Spanish portfolio to further reduce its leverage ratio. While I’m not necessarily in favor of falling back on assets in just one country (the UK), especially given the uncertainty created by the Brexit issues, I think there’s a good case to be made for the Spanish properties.
Source: annual report 2018
As you can see in the previous image, the rental income in Spain was just 33.4M GBP, while the Spanish assets have a book value of 860M GBP, which includes 232M GBP attributed to a new mall that’s not generating any rental income yet. This means the income-generating malls are valued at almost 630M GBP, or at a rental yield of approximately 5.3%.
However, Intu owns just 50% of its three operating malls, and has a ‘land bank’ worth in excess of 200M GBP in Spain, a site at the Costa del Sol where it intends to permit a new mall.
So let’s assume the book values are quite correct, then Intu would be able to sell its Spanish portfolio for 860M GBP while giving up less than 34M GBP in rental income. Additionally, as the new Costa del Sol mall is in the final permitting stages, the value of a fully-permitted project could (and should) be higher than just the pure land value.
Intu could also elect to just sell its 50% stakes in the three existing malls and use the proceeds to build the new Costa del Sol mall, but it should only do so if it expects the net initial rental yield of the new mall to exceed the current malls. But in any case, I think generating 860M GBP in proceeds for giving up just 33.4M GBP in rental income would be a good move.
My own NAV and LTV stress test scenario
So, taking all these things into consideration, I wanted to see how the NAV/share and LTV ratios behave if I would apply more conservative parameters to the base case scenario.
Please note, this NAV calculation is meant as a back of the envelope calculation and isn’t meant to be exact science. I will be using a required gross rental yield of 7%, in line with the percentage I have used for the Tier-1 commercial REITs on the European Mainland, Klépierre (OTCPK:KLPEF) and Eurocommercial Propertied (OTC:EUCMF). Considering the risk-free interest rate in the UK (the 10 year GILT) is 1.16% (versus 0.48% for France and 0.15% for the Netherlands – although Eurocommercial’s assets aren’t based in the country), the 7% required yield actually represents a lower risk premium than its European counterparts where the sovereign bond yields are lower. So I don’t feel like I’m too demanding. As Intu converts approximately 85-88% of its gross rental income into net rental income, the required 7% gross rental yield represents a net rental yield of 5.95%. At the end, I am also adding the 210M GBP book value of the land for the Costa del Sol mall back to the equation. The net debt used in the model includes the cash positions, long-term and short-term debt but also includes the 232M GBP book value of the Costa del Sol property, which in this case, I deem to be ‘as good as cash’.
Source: Author calculations, based on publicly available information
And what would happen if I would assume the sale of the Spanish portfolio: I am removing 33.4M GBP from the revenue (applying a similar occupancy ratio) and 860M from the net debt position.
Source: Author calculations, based on publicly available information.
As you can see in both models, Intu Properties is trading below its fair value. But it’s the LTV ratio that’s worrisome, and that’s why I’m glad Intu took decisive action by slashing the dividend as a first step. A good second step would be to sell some properties at the current valuations as that would provide a boost to the NAV/share, and would reduce the LTV ratio to less than 60% again.
Please note these calculations don’t take the extensions of the existing malls into account that should start contributing cash flow from 2019 and 2020 on. The numbers are based on the situation as is.
The impairment charge on the value of its real estate assets was long overdue, and even at this point I’m not sure Intu Properties will be able to use a rental income yield of less than 5% for much longer, and I think a second revaluation will have to occur within the next two years.
This gives Intu some time to get its act together by cutting the dividend (allowing it to retain cash to reduce the net debt and LTV ratios) and by selling off some assets, hopefully at a price close to the respective book values. I think selling the Spanish portfolio is an option that should be explored as that would reduce any immediate liquidity and debt ratio concerns, while it would allow Intu to get better conditions to refinance its existing debt and to fund its development pipeline.
I am planning to initiate a long position in Intu Properties because I do believe in the underlying value of the properties. But Intu Properties will have to reduce its balance sheet risks.
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Disclosure: I am/we are long EUCMF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am considering initiating a long position in Intu Properties
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.