Interview with Andrew Jones from LondonMetric Property

Great, thanks. Morning, yeah still morning. And thank you for having me on. Just a quick slide here on the backdrop. I mean, a lot of this data will be familiar to most of you listening this morning. At the macro level, we continue to live in a rather turbulent environment. The combination of various black swan events that seem to be taking place at an increasing frequency these days. We've got a huge amount of central bank intervention taking place across the various jurisdictions at the current time, as central banks try to get the inflationary pressures under control. This affects obviously real estate as you might expect. The biggest impact is actually the five-year swap curve, because that's what most real estate debt is based off. And whilst there's an awful lot of equity investors in real estate, certainly the larger ticket items and the big investors in real estate are all using debt to try and turbo their returns, so elevated five-year swap curves make that very, very difficult as a result. It has a massive impact on pricing and obviously liquidity. That said, the glass is always half full. I think there are a lot of positives out there. We think that inflation pressures are moderating. This week's print suggested that, and our views from the various research that we read is that inflation could be down at five-ish percent by the end of the current year, and then hopefully traveling through to lower as we travel through 2024. Cost of living: there's a lot of chat in the market and the press around cost of living crisis, the impact of higher mortgage rates. Good news is that energy costs have been coming off a bit, reflective inflation has been moderating, and the fact of the matter is we have a job full economy. People are in work with record low unemployment, relatively full wage growth, which is helping to avert any cost of living crisis. The mortgage bit works: mortgage costs are obviously going to impact as people come off fixed rate mortgages. I think it's around about 800,000 people a year are going to come off fixed rate mortgages, but you've also got 500,000 people who are repaying their mortgages every single year. So we've got a turbulent macro environment, and then what we've got going on is structural change, structural evolution accelerated through technological advancements, which are having an impact on how we work, live, socialize, and obviously that has an impact on various real estate sectors which are winning and which are losing and which are coming under pressure. I can talk about that in a bit more detail later. And then together with urbanization, the lack of residential accommodation almost across the United Kingdom is seeing an awful lot of commercial buildings, certainly those obsolete ones, being replaced by residential. And increasingly in real estate today is this sustainability and making sure that we are improving the energy efficiency of our buildings, and that has massive implications particularly for some of the sectors, offices, shopping centers, etc., and that's going to affect liquidity and pricing over the next number of years. So on the next slide.

You take all that in and not surprisingly we're seeing a bifurcation of performance and a polarization of sector performances across the traditional real estate sectors. We find it very difficult to look outside sheds, beds, and breads, to be frank, as winning sectors that are delivering not only income but income growth. And it's that growth bit that I think is increasingly sought after, particularly with bond yields and borrowing costs so elevated. You need rental growth for real estate to really have a place in your investment portfolio, and that growth is missing in large parts of the office sector and also the retail sector. I'll come on to talk about the logistics, warehouse, industrial sector in a minute because it is the backdrop and the backbone of our own portfolio. But you are also seeing good growth in students and PRS. Numbers that have come out from Grainger and Unite in that space support that, and groceries. I mean, the flippant comedy: everybody's got to eat. But the growth in the convenience grocery market is still in pretty rude health. What I would say is that I think we've seen a number of new entrants over the last decade or so that extend well beyond what was traditionally called the big four, and now we have alternatives to the big four in terms of meeting our grocery needs. Whether that's online with people like Ocado, or whether it's convenience groceries with Aldi and Lidl, or with Marks & Spencer's Simply Food, Waitrose, Co-op, Food Warehouse, Iceland. There are a number of new players now that mean the days when our grocery demands were met by an hour and a half visit to your big Tesco or your big Sainsbury's, Asda, Morrisons, is no longer the case. And as you can see there, I've shown the stats for one and five year shareholder returns across those various sectors. Looking at LondonMetric, we increasingly look at the structural shifts and that helps frame how we allocate capital and the makeup of our own portfolio. You'll see in a moment how the portfolio has evolved over the last 10 years or so to focus on the logistics market. Quite frankly, looking at where we can best get a return, our objective is to allocate capital into sectors where the money will be looked after and over time it will grow, and in the meantime we will deliver an income and a progressive dividend. Again, we'll come on to talk about that in a little bit more detail. I think we are in our eighth year of dividend progression, and obviously we hope that that will continue for many more years.

Obviously the macro backdrop has changed an awful lot over the last 12 months. I think we're supposed to be coming up to the anniversary of the Truss quasi-budget, but it was changing well before that. Anyway, the fact about the market, the heaps coming out of the real estate market, and as a result, for the last year we've actually undertaken a discipline of disposal of a number of non-core assets to make sure that we reduce any, we have our loan to value, credit finance under control in the event of downward pressure on valuations, but more importantly to make sure that if there is refinancing, we actually have equity to be able to repay it if we've got floating rate debt. We would look to reduce our exposure to that because it's become extremely expensive. And then finally, the last bit was something I always, a lot of shareholders forget to ask me when I see them face to face, is the alignment of interest. It's not, we are an internally managed business, we are not an external manager. The company does not get paid, we do not, the bigger we get, we do not get paid any more money. This is not, the remuneration here is not about AUM, it's actually more around TSR. And the fact of the matter is the management team are large material shareholders in the business, and we enjoy dividend progression as much as the next person. I can assure you it's an important day four times a year in the Jones household. Just looking at the portfolio, I said I touched on the evolution over the last 10 years of our portfolio. As you can see there on the right pie charts, the navy coloring shows our exposure to the distribution market, so it's just under three quarters of our portfolio today across urban, regional, and mega warehouses. And then we have, the remainder is effectively made up of our long income grocery investments, the likes of Aldi, Lidl, Costco, M&S, Waitrose, etc., as well as some of the other brands that you see down there. That evolution has obviously involved a huge amount of liquidity in the property market. But we have an ownership culture, we want to invest in the best buildings, we'll hopefully pay a fair price for them, but making sure that we have long leases, we have full occupancy, and that we have income growth. Whether that is through open market negotiations or whether it's through indexation, I'm not that bothered really. I just want growth, and that growth in our sectors is coming through without us having to buy it or necessarily invest heavily in our buildings like you have to do, I think, across some of the shopping center and the office sectors. And that's important to us. We try and operate the best of our ability on what we call a triple net model that strips out real estate costs and they are recoverable, because it means that after paying our interest costs and our staff, all of our rent flows through as efficiently as possible to our shareholders via the quarterly dividends.

Then just, I think Richard suggested that we've been busy recently. We closed earlier in the summer on an all-share acquisition of CT Property Trust, which was a close on a £200 million offer, all share-based offer. And the attraction for us of this is a company that's trading at a big discount to its NTA, but it gave us access to the two areas of the real estate market that we cover the most: urban logistics and long income retail and convenience. And that was the driving opportunity for us. The non-core retail and offices will be disposed of over the coming months. We thought that there was strategic rationale actually for both sets of shareholders. More efficient management structure because we go from an external manager to an internal, that obviously saved management fees. We actually haven't had to increase, we haven't taken on any additional employees. The 34 assets have been absorbed into the existing platform that we have here at LondonMetric. It was marginally NAV accretive, it was EPS accretive, it was LTV accretive, and we were buying it at a national initial yield that was slightly higher than what the existing metric was delivering, so arguably it was income accretive as well. And the economies of scale are such that we will deliver greater income granularity. And we've taken a lot of costs out which will allow us to progress earnings over the current year. And we think we have a more intensive management approach as internal owners of the business as opposed to external managers might have. And the fact of the matter is it's all gone relatively well so far. We've made, started to make our first divestments. We've sold some high street retail properties and we will announce some further disposals shortly.

So I've already touched on real estate not only delivering a coupon but also delivering growth as well, and that's quite important to us. And that comes essentially through rent reviews and lettings for us. And that's why we allocate our capital into the winning sectors. For us that is at the moment sheds, beds, and breads. We've been seeing some good income growth. And I think this is, outside of maybe the PRS and the student sector, I think we're probably delivering superior rental growth in these sectors, better rental growth than anything else in the UK property market today. And we will continue to capture these reversions as they come up over the coming periods. We have at least £11 million of embedded reversion to collect over the next couple of years, and again that's all part of delivering this progressive dividend policy for us. And that will see us actually look at taking some money off the people in some of the sectors and reallocating it into those where the money will be treated best. Lettings: we have a very low vacancy rate as I touched on before, so actually open market lettings are less relevant for us except asset management initiatives where we look to capture reversions through taking back a surrender of a building. I mean, we took back a picture there of a warehouse in Uckfield that was previously let to John Lewis. We agreed to take a surrender of that from John Lewis, they paid us some money for doing it, we re-let it immediately at a higher rent to another business, and that will help us with that earnings and rental progression. And then on the environmental bit, we are very plugged into this. You can see there that 90% of our assets are classified as EPC A to C. That's a material uplift on where we were a few years ago, and we've obviously still got further work to do on that. But we are constantly looking at new initiatives, installing new solar PVs in partnership with our occupiers to try and improve the energy efficiency of our buildings. And that also now extends to EV charging, which is going in all the time. We have a partnership particularly with InstaVolt but also with MFG to put in EV charges across our portfolio. I think we would have added at least £100,000 worth of income from EV charges over the last nine months or so. And that's important not just for income generation but actually for attracting different customers to our locations and improving the energy efficiency of our tenants' costs. So that's something that we're, excuse the pun, pretty much plugged into, and it's something that is high on our agenda. So look, the outlook, and I've probably gone past five minutes I'm afraid Richard, but it remains challenging. Fundamentals in the preferred real estate sectors remain strong, and I think that market uncertainty will continue to create some opportunities, particularly as debt refinancing becomes challenging for some people and some investors. So I won't go any further than that, and I'm sorry, we can cover some of those topics in some Q&A.

Well, it's really the office and the retail that you see there in the pie chart, which is roughly 22%. So we went into this knowing that it was non-core. We went into it putting an appropriate price against each individual asset, and the price we put was what we call the clearing price rather than the valuation price, because there can be some discrepancies between those two numbers. We as I said we've already sold the high street retail, we announced that last week. We've got a little bit more of that to go, not too much. And then offices, there are numerous offices scattered around the UK, some are going to have more appeal than others. We are probably agreed terms to sell three of them at the moment. So we're pretty motivated and I think we've priced them to sell. Those are sectors that we don't really want to spend too much time in. We think that the challenges facing regional offices of an age are pretty tough, both from an occupier perspective but also from an ESG, EPC perspective. And in some ways, that's not what we're about. That's not to say that the buyers of these can't do quite well, but it takes a different type of discipline and a different approach, and our time is better off spent in sectors where we do have some level of competence and some dominance.

Yeah, look, I think certainly the real estate investment trusts in the real estate sector, there are a lot of them, a lot of them are sub-scale, their capital structures are sub-optimal. They trade, well they don't trade much at all to be frank, but the prices on the screen are at 30, 40, 45, 50% discounts to their supposed NAVs or NTAs. And actually they seem to be serving more of a purpose for the board and for the manager than they do for the shareholders. And I think the reason you've seen a tick up in M&A in that sector is for exactly that. At the end of the day, these companies are owned by the shareholder and not the manager, and therefore there is a duty on the board that has in order to deal with that. And if those discounts are going to persist, and they have persisted now for closer on a decade or certainly somewhere between seven and ten years, it's beholden upon boards to look at doing something about that. Whether it is a sale to somebody else, whether it's a merger, or whether it is a liquidation. I think that this can't be allowed to continue because at the moment it seems that shareholders are losing out whilst managers and boards take their fees.

Yeah, that's a good question. The large majority of that would have been our decision about a year ago to exit multi-let industrial estates. These are your traditional industrial estates, small units, big concentration around Birmingham, aging buildings which were going to require quite a lot of capex, and also they are operationally management intensive. And we made a decision about a year ago that actually that wasn't our core competency, and that increasing capex requirements and if there was going to be a downturn in the economy, maybe some of those customers of ours or tenants of ours were going to feel a little bit exposed. And so we set about doing that in various transactions. It was a sector that's been well received. The final piece of that jigsaw so to speak was executed about a week or so ago, which was a sale of multi-let estates that we sold to an American investor for just over £40 million. And we're pleased with that. There was always leakage in the income, there was always costs of keeping the doors open and the buildings wind and watertight, so we're pleased with that. Within that £280 million, there will be a little bit of high street retailers that we acquired through CTPT. We've also sold a number of some of our more mature grocery investments. We've been selling some Aldis, Lidls, we sold a Waitrose recently down in Malmesbury that we sold to a private family at a yield that was well below our cost of capital. We sold it for just over 4.6% because somebody else had a lower cost of capital than we did. So that will be monetized and then the capital is reinvested into other opportunities. We're working with, for example, we're just on site, we're finding new Marks & Spencer's down in Uckfield, we're talking about building another Simply Food facility for them as well down in Weymouth. And so we'll recycle it where we get a higher return on that than the 4.6% we've just received. We don't start any year off with a sales target. We have a desire to sell certain assets when we think they've reached maturity. Where we've just done an excellent rent review that exceeded our expectations, we might take the view that going forward the growth returns might be a little more muted because we've taken some lofty returns up front. So we do that, and also we react to approaches that we get from people interested in some of our buildings at prices maybe that exceed our own view. So we're not emotionally attached to any building. Every building has a number which we will trade it at.

The long income is completely triple net, so there's no service charge shortfalls. It's 100% let. I think 75% actually might be a bit higher than that now of the rent is linked to inflation. It is what we call internally low energy. It is those people that you see there: it could be a BP, it could be a Range, Pets at Home, Screwfix, Wickes. These are largely in sectors that we think are pretty protected from changing consumer behavior. Grocery convenience grocery we think is a winner. The DIY market looks pretty solid, trade and DIY, you see it there: Screwfix, Wickes, B&Q, and then we have MKM as well actually would fall into that. And so it's very much at a yield that sits way above our cost of capital with inflation growth on top of that. Let's remember, whilst we have elevated bond yields today, the government indexed yield is trading around about 1.3%. So if you can buy a Lidl or an Aldi for five and a half with RPI, albeit capped at say three and a half or four, that is nearly 400 basis points above what you pay for an index government bond. And I'm not convinced that the Aldi or Lidl covenants are that much weaker. So they obviously are weaker than the government, but I'm not sure they're 400 basis points weaker. But similarly, we come in at, we'd be happy to sell out at mid-fours to reinvest at mid-sixties under a funding or development or even an asset management initiative with the occupiers.

Well, all rents, 63% of our rent roll is indexed, but all of it will be capped. And the caps normally bite at somewhere between three and five percent per annum compounded. So what that means is that you don't capture periods of elevated inflation that we've had over the last 12 months or so, but they also have a collar or floor that normally kicks in at somewhere between one and two percent, so in periods of very low inflation you're guaranteed some element of growth that might not be available in the index market. What I would share with you is, for example, I was looking at the data recently. Over the last six months we've settled a number of rent reviews, and our RPI/CPI rent review settlements on a five yearly basis have come in at about 24% up. So whilst we haven't been necessarily collecting the highs of inflation over the last 12 months or so, we have still managed to capture close on 5% per annum over the last five years, which I think is a very credible return. And also one of the things about uncapped RPI is the big danger you'd have. I've no doubt that if I said to you all of my indexed leases were uncapped, as a real estate expert Richard, you'd be saying to me, 'Does that not worry you that some of your assets are now going to become over-rented?' So we would rather, we're pretty happy with the profile of the RPI pieces actually. But they're all secure, it's 100% let, and they are secured by and large. There's always going to be an exception in there, I could pick out one for you just in case somebody else does, but by and large I think the credits there are pretty good for us, and the desirability of our real estate is illustrated by the fact that it's 100% let.

It absolutely varies depending on the deal. What we've often done is it depends on who's paying for it. Obviously if we're paying for it, we expect there to be a return. What we tend to do is, my ideal scenario is that we pay for the installation and then we effectively lease it back to the tenant at a number that allows them to benefit from a saving, but also gives us a relatively attractive return on our capital. It's not excessive, but it's an attractive return on our capital. And then they're responsible for its ongoing maintenance, so that if it drops off for whatever reason, there's no claims coming against me. So that's our ideal scenario. And that also allows us to structure it such that if we were to sell that building, the additional rent will then get capitalized out at probably the same capitalization rate as the buyer would apply to the core rent on the underlying building. That would be our perfect scenario, but everyone's got a slightly different view and a slightly different preference, and it's not like one size has to fit all. We're pretty flexible about that sort of thing.

Well, yeah. I mean, we look, you can't do it without them. Would we like to see more? Yes. Are we seeing an uptick in it? Yes. I mean, there's nothing like a spike in energy prices to get people to open their eyes and start looking at these various initiatives. We're working with some big players. We've worked with Currys, we've worked with Primark, we've worked with Eddie Stobart. We're working with some serious players, and we're also working on some smaller buildings as well. So we really like it. We think this has got a long way to go, a long, long way to go. And let's be honest, we didn't start off as being experts in this field, but we're learning very, very quickly. And the same goes with our EV relationships. We're understanding how the owner of an electric vehicle behaves differently to the owner of a combustion engine.

The one thing I should just point out with our buildings is warehouses are relatively simple constructions. I'm probably not going to say that when I'm letting a big building, but anyway, they're relatively simple. A warehouse is relatively simple, an Aldi is a relatively simple building. It's not like offices or shopping malls or hotels and things like that. So we start with a pretty simple sheet of paper. The costs involved therefore are not dramatic. What we've been finding is that the money we spend on the building is more than returned from the tenant being prepared to pay a little bit more for a more efficient building. And let's be clear, whilst A to C 90% is good, we really would like that 90% to be A to B. It's got to get better. It doesn't always go in a straight line. Despite all our efforts to improve the efficiencies, there are times where we see an opportunity to buy a poor building, a building that might be rated D or unrated, because we think that we have the desire, the expertise, and the capital to bring that building back into economic use and economic relevance. So there's no doubt going to be periods where our energy efficiency might drop below 90%. That doesn't mean that we're not doing the job, it just means that we're helping poorer buildings get better. The fact of the matter is, I think we are great stewards of bad buildings because we have the capital, the desire, and the expertise. There are an awful lot of landlords out there who don't have that, they have no interest in improving. And the fact of the matter is, by not buying that building, it might help my ratings, but it's not helping the planet. So we shouldn't be castigated if that drops sometimes because we're doing the right thing. I'll be honest with you, on a personal level, one of the greatest satisfactions I have in my job is when we buy a poor building, we spend money on it, we bring it back, we re-let it, and then we sell it. That's one of the highlights of my job. I really, really enjoy doing that. I've been doing it in shopping malls and retail parks and logistics for a very long time.

Yeah, they're not. The truth about it is they're not being discounted because of energy efficiency. They're probably going to be discounted because the vendor's capital structure is all wrong and he's got debt problems and leverage issues and hedging expiries or whatever else. So the truth of the matter is it will come into price without a doubt, because buyers are going to start setting money aside for bringing them back. I think the first wave of opportunities today, and I said it in my closing slide, market uncertainty will create opportunities for longer term investors, but most of that first wave is definitely coming from a debt-backed position rather than the EPC at the moment.

Yeah, so I think demand for the bigger box, 150,000, 200,000 square feet plus, I think the demand is moderating post the massive spike we saw during COVID. And also you are seeing supply coming into the system that will basically deliver a closer equilibrium between demand and supply. So we think that's going to happen. However, I think that when you get through '24 into '25, on the basis that there's no development being undertaken, there are no new starts being committed today because of the cost of materials but also the cost of finance, I think there is a danger that you end up when you travel through '25, '26 with a shortage of new modern warehousing. So I think demand is okay, but there has been a tick up in supply which means that rental growth will probably moderate over the course of the next year rather than the current year. It doesn't really affect us because we don't have any speculative developments going on site at the moment, and our rent reviews will still capture incredible periods of rental growth over the preceding four or five years. So I don't think the demand drop-off is anything to do with the economy necessarily, but it was more the fact that it's coming off a COVID spike where we saw emergency demand for warehousing from a number of operators. As far as online penetration is concerned, it's still growing according to its long-term trajectory, albeit it's off the highs during lockdown as you might expect. We're moving from pre-COVID, I think total penetration would have been around about 20%, and we're heading up to 30% on an overall basis. GM will be much higher than food. I think food pre-COVID was 7%, it peaked at 15%, and it's probably hovering around about 10%. So we're still seeing ongoing online penetration because the modern consumers, you look at the generation, my children's generation, they're much more likely to buy online than maybe I am. And therefore that will continue to grow, but what we're not seeing is the massive growth that we obviously saw in lockdown when we were probably up at 50%. For our own portfolio, we've increasingly pivoted into urban warehousing, so sub-100,000 square foot space around major cities, London, Birmingham in particular, where the range of occupiers that we deal with is just vast. I mean, if I look at some of the lettings that we've done this year, we've done coffee roasting facilities, we've let a warehouse to Screwfix, we've got another warehouse to McDonald's, we've let another warehouse to a business that ships fine art across Europe, we've let a warehouse to an accident repair center that deals with bangs and scratches on your car, a frozen fish wholesaler. The sort of people we deal with, if we do get a vacancy, we just have no idea what sector that occupier will come from. It's vast. And so we prefer that to being beholden to a bigger box whereby we either have to try and let it to an online retailer or normally a channel retailer to satisfy the growth in their business, or we have to let it to a 3PL, a DHL or a FedEx or an XPO or GXO or whatever else. So we just got a much wider circle of depth of businesses.

No, no, no, no, no. Okay, that's a nice quick one.

I think the valuers actually did react very quickly. I think they certainly have done a much better job than they did when we came out of the GFC, that's for sure. Logistics yields, the valuations feel as if they reflect where the market is trading. So I wouldn't expect that the market will move too much between March and September, unlike for example the office market where you're probably going to see some big drops, ongoing drops, because actually as you said, I think logistics not only took it hardest but took it first. I remember looking at the numbers, some of the shopping center valuations hardly moved, some of the office valuations hardly moved, and I couldn't understand it. But the relationship between NAV and share prices, it ebbs and flows. At times you trade at a premium, at times a discount. The fact of the matter is, I think income and income growth is an equally important measure. We are the only jurisdiction in the world that seems to be obsessed with NAVs. I was talking, you look at the American model and it's all about free cash flow and growth. You ask the chief exec of some of the American REITs, 'What's your NAV?' They'd say, 'I don't know, why would we calculate that?'

Yeah, you'd be amazed, you would be amazed. I wouldn't mind if they were trading at NAV, but when they're trading at a 45% discount, you would have thought they might just want to take a coffee.

That's a brilliant question, that's a brilliant question, that's a really, really smart question. Look, I think you've got to accept that technology is impacting our lives and that in turn is going to impact our desire for certain types of real estate and how important they are. So I would start with let's look at the sectors. I think it's a brave person to go into offices and shopping malls today. So for me, it would be look at the beds, sheds, and breads market. The second thing I would look at is, is it internal or external? Without a doubt, you get better behavior with internal. Without a doubt, there's alignment of interest. The problem with external, there's always an incentive to try and grow or artificially inflate your NAV in order to maximize your management fees. So look at internal versus external. Do you really need to take the risk of external? We've had a few blow-ups in the housing sector where people have been spending other people's money as opposed to investing their own. Thirdly, look at management alignment. How many shares, what sort of monetary alignment does the management of the company have in the company? What's their ownership like? There are some wonderful companies out there where the chairman, the chief exec, the board, the directors have big meaningful holdings that mean they've got to do a good job, otherwise that family's position is at risk. And then look at earnings. It amazes me about looking at earnings, look at what's driving the earnings and also the dividends. I can easily, so many people talk about, 'Oh, we pushed the dividend up, it's now 8%.' Well, it's not really because it's uncovered. What it means is it's yielding you an income dividend maybe of 6% and actually they're repaying you 2% out of your capital because uncovered dividends are paid for out of capital, they don't come from thin air. So look at the sectors you want to be in, look at the management structure, look at the management alignment, and then start looking at the earnings and its trajectory and its relationship with the dividend. The NAV can follow after that, to be honest with you, but it would be in that order I think.