Richard Shepherd-Cross is fund manager of Custodian Reit (CREI ), a £440m, 5.5%-yielding UK real estate investment trust that specialises in buying smaller properties in the regions outside London. In this 17-minute interview recorded in May, Shepherd-Cross explains:

• The higher yields he can obtain without taking on risky properties;
• Why large warehouses have sold off this year but smaller industrial properties have preserved their value;
• The drawback of inflation-linked rents for encouraging investors not to focus on the merits of the underlying properties;
• What’s driving the recoveries in high street and office properties after the pandemic;
• Why buying back the trust’s shares on an 18% discount is not necessarily the best thing the Custodian board could do with shareholders’ money.

Can’t watch now? Read the transcript 

Gavin Lumsden: Hello, I’m at the Frostrow Investment Company’s conference in the City of London and with me is Richard Shepherd-Cross who manages the Custodian Real Estate Investment Trust (Reit), which specialises in smaller commercial properties outside London. Richard, very good to see you. Perhaps we’ll just start-, that approach is a little unusual in the UK generalist Reit space. Why do you do what you do?

Richard Shepherd-Cross: The very short answer is income, and the longer answer is that by targeting smaller lots, we can drive out a marginal income return because there is less demand and a greater supply. So many of our peer group funds and indeed, the wider market from PE [private equity], pension funds, sovereign wealth funds, overseas investors, all targeting relatively large prime assets, creates a huge amount of space for an energetic Reit who is prepared to get out into the regions and find those smaller lots in strong micro-markets and we’ve got data that will demonstrate this, but the marginal income return we can get is 150 basis points.

GL: So, 1.5% more than a comparable Reit.

RSC: The instant challenge would be, but you must be taking more risk because you’re buying small properties and you’ve got weaker tenants. The answer is that with good stock selection you don’t buy weaker buildings, worse locations. You could run an argument to say the risk premium of 75 basis points because that was the long-term marginal difference between small and large properties, but it’s currently 150 basis points.

GL: So, it’s twice what it should be.

RSC: Even if the risk premium is 75, we’re getting 75 basis points of return for taking no additional risk.

GL: That’s been reflected in the dividends.

RSC: Exactly right.

GL: You pay quarterly dividends?

RSC: Quarterly dividends, 5.5 pence in prospect. It’s been 5.25 for the year just closed. So, seeing some growth in dividends.

GL: The dividend for the year just went was covered by earnings?

RSC: Fully covered. 110% covered by earnings. Earnings are really important. Far too much focus, in my view, is on net asset value. Last year, we saw a 28.5% net asset value total return, but so what, if you’re a shareholder? As a shareholder, you don’t net asset value, you own shares. So, what you should be focusing on as a shareholder is, yes of course, it’s good to know that the engine room of the business is at full throttle and delivering positive growth in the underlying real estate, but what you really want to know is, what are the earnings? I don’t think there’s enough focus given on earnings. So last year earnings were 5.9 pence per share, up from 5.6 and dividend of 5.25. You can see that earnings cover in real life. Our earnings at 5.9-, earnings yield against share price, 5.9% against an average across our peer group of closer to 4%. So, Custodian is really churning out the income.

GL: So, a good, solid high yield there. Over 40% of the portfolio is in industrial properties. So, I’m thinking warehouses, distribution assets. So, they’ve seen big price rises. Are they sustainable?

RSC: That’s a really key question. It’s something that we question ourselves all the time. The real centre of that market and the growth that has pulled the whole sector up, has been large format logistics units. We’ve seen a growth in e-tailing. We’ve seen onshoring of the supply chain and we were following on from three years of political uncertainty. Referenda, elections, Brexit. All of which suppressed development. So, we started with a restricted supply.

GL: Then you get a boom during the pandemic when everybody wants to shop online.

RSC: All of that led to growth, but the focus of development has been on exactly that sector. The large format logistics units. So, no one has been building the smaller lot sizes that we like to buy. So, we haven’t seen that increase in supply, yet demand from SMEs [small, medium-sized enterprises] around the country is very, very strong. That’s putting pressure on rents.

GL: That’s small and medium-sized enterprises or businesses which is in contrast to Amazon. Amazon was in the news recently saying it had too much warehouse capacity. So, what effect has that had on the big box larger warehouse market that you’re not investing in, but what impact has it had there?

RSC: A shock is the answer. I’m not surprised that it was a shock because they did account for 25% of all new lettings in the market last year. That can’t be sustained ad infinitum. Unfortunately, some of our peer group funds who focus on that large format logistics space saw a 20% hit to their share price in a day on the back of that news. Now, maybe that was an overreaction, but I suppose, it demonstrates some of the fragility at the top-end, where pricing has become very rich, and forecasts of growth are underpinning people’s pricing aspirations.

GL: What effect has it had on the smaller industrial lots?

RSC: So far none. Will there be contagion? Maybe. Actually, I think that with construction costs rising, bringing forward new development has become more expensive. So, the vast majority of our industrial and logistics portfolio we hold at below replacement value. You couldn’t go out and build it for its current value and therefore, we’re not going to see an increase in supply. Rents are going to need to grow. So, it feels pretty robust.

GL: So, you referred to cost increases on building and construction. Of course, inflation is the big subject concern at the moment. I just want to ask you about inflation-linked leases. They’re obviously attractive to landlords and investors, but I wonder, do they contribute to the problem? Baking in inflationary increases that businesses have to deal with?

RSC: They are attractive to investors, but I would say this to investors. On the face of it, an inflation-linked lease sounds like the perfect solution to inflation. The problem is, normally, the index-linking is capped at 3%, sometimes as low as 2%, maybe 4% and inflation running well ahead of that is not really giving you the inflation linkage you want, but there’s a bigger problem. Because they are so attractive to investors, therefore, you’ve got investment companies buying these long-let properties in inflation-linked leases, they become a financial instrument and there’s less focus given on the underlying real estate. What we like to do-.

GL: Investors taking a tick-box approach. If it’s got the inflation link, don’t care too much about the details.

RSC: It’s because the value is in that lease. We want our value in the real estate, in the bricks and mortar and not in the lease because leases depreciate over time. Every year they get shorter. I suppose I’m stating the obvious, but if you have a ten-year lease with indexation, every year that lease is getting shorter, and the value of that lease is running down to nothing. If you haven’t paid attention to the fundamental attributes of the underlying real estate, then you’re going to catch a cold. So, what we like to do is buy good quality real estate and good quality real estate, I think you can take comfort from open-market rent reviews that you will see that growth. We’re often asked about inflation linking and is property a good hedge against inflation? The answer is yes, but don’t hold that against me in a year’s time. Ask me the question again in five years’ time because property is a long-term asset.

GL: Returns can’t match inflation step-by-step.

RSC: No, not least because we only have the opportunity to review our rents on a five-yearly basis and in the short-term, inflation could put a squeeze on real estate growth because it’s putting a squeeze on the economy. Then real estate will catch-up and over the long-term-, I think people are pretty comfortable with this concept. Well, people should be very comfortable with this concept when they consider their own lives and their own real estate investments in their houses. They know only too well that the value of that real estate-, it’s a hackney phrase, but they ain’t making any more of it when they talk about land, goes up over time. You can’t expect it to match year-on-year inflation.

GL: Just to clarify, do you have any index-linked leases?

RSC: We do, absolutely, but it’s not a key focus.

GL: It’s not the be-all and end-all of what you’re doing.

RSC: No.

GL: We’ve talked about industrials. From your presentation, it seems you’re seeing signs of rental growth in other sectors, it’s not all just about industrials, hot though that has been. Retail warehouses, office, high street retail all seem to be doing well in recent months. What’s going on?

RSC: We saw a turning point this year. In fact, in December last year, when rents on prime high street started to grow again. Now, of course, they’re growing from a low base because those rents have been hit hard over three to four years. It makes a really interesting entry point and in fact, we completed an acquisition yesterday, on two high street shops in central Winchester. Winchester is one of those prime cathedral city locations in an affluent part of the country that has always traded well and if you were to go down that high street on any day of the week and I know because the market is even open on a Sunday, it’s thronging with people and retailers want representation there. So, we are seeing a recovery there. So as a really interesting entry point into that market that has been going down for four years and should be able to kick up. Similarly with retail.

GL: Some high streets will survive.

RSC: Absolutely, but it’s by no means all high streets. Strong cathedral city locations, ideally with universities, good tourist footfall. General affluence in the surrounding areas. Those cities will do well. So, Winchester, Oxford, Cambridge, York.

GL: Those are prime. What about offices? What about the modern office? What’s happening there? Clearly, lots of us are working from home at least some of the time, what’s that doing to the office market?

RSC: Again, we saw growth in our office rents in our portfolio through the last 12 months and I think we’re going to have a two-speed market. I think the focus is going to be on strong regional city centres. Take a city like Bristol, where in fact, we don’t own. Prime rents in the centre of Bristol are £42 a square foot. Out of town, maybe £26 a square foot. So that’s the market telling you a very clear story. We want to be in town and with all the amenity that that gives, but the focus from a real estate perspective is going to-, from a landlord’s perspective is going to be providing a higher level of service and greater flexibility to office occupiers than we are used to giving them. No longer can you say, it’s a 25-year lease, the repairing responsibility is yours as the tenant. We’ll have four rent cheques a year, please and we’ll see you in 25 years.

It’s shorter leases, higher level of service and one of the things that’s often talked about is the hotelisation of offices. It’s not a very nice terminology, but I suppose, you get an idea of what it means. It’s providing that greater level of service, greater level of flexibility, but for that I think, occupiers are really paying and I suppose, our theory is if you don’t create offices that are nicer places to work than working from home, then people aren’t going to come back to the office.

GL: In the mix, is there lots of work going on to make the buildings environmentally friendly? Net carbon.

RSC: Yes, I think I could wax lyrical about how important we think it is and everything we’re doing, but actually, I think realistically, people should take that as a given because it’s become an imperative. You simply cannot consider real estate without considering ESG and every time we get a property back from a tenant, that’s exactly what we’re trying to do. In fact, we’re about to start an exercise with a tenant who occupies eight properties across our portfolio, to install solar PV. Put in electric vehicles charging points. Improve the environmental credentials of the building. We are the landlords. As the landlords we’ll make that investment and in return, the tenant, who still have eight years left on the leases will pay more rent. So, it’s something that’s just an imperative.

GL: There’s a lot going on, clearly. It’s quite hard work, it seems, investing in these smaller lots out in the regions, but there’s a lot of positive stories you’re talking about there. So, share prices of yourself, Custodian and other UK real estate investment trusts, why are they trading at quite steep discounts?

RSC: I think that people have been very theme focused. The property vernacular would say it’s beds, sheds and meds.

GL: Exactly, so funds specialising in those areas that have been trading on premium ratings. Although, we’ve seen the warehouse ones fall off.

RSC: Partly there are good fundamental reasons why they should have focused on those sectors through the last few years. Partly it’s a self-fulfilling prophecy. If enough people pursue it, then you see share price performance. You can’t get away from that and I would say that through the last two years, if you’re viewed as in any way a generalist Reit, then you have been out of fashion. I would say we’re not a generalist. We’re an absolute specialist in finding that marginal income for taking no extra risk by buying smaller regional properties and our focus on income, I think is going to become very fashionable quite quickly. At the discount we are today, which is as wide as we’ve seen it, save for a couple of months in the depths of Covid and whilst still narrower than some of our peers, entry point today, would give you a 5.5% dividend yield and I think that’s going to be really attractive.

GL: Clearly, a bit of a bargain going on there. Have you and the board given any consideration to buying back some of the shares to try and help that discount narrow, the gap to net asset value?

RSC: It’s constantly on the board agenda. We talk about it frequently. We haven’t felt the need to do it yet. We still see greater opportunity for deploying shareholders’ capital in new real estate investment, rather than buying back the shares. Of course, the only downside-, well, one of the downsides of a share buyback is you reduce liquid resources and that means you’re less able to react to opportunities in the market and we do see opportunities coming down the track.

GL: Because of so much uncertainty, economic.

RSC: Any change, any uncertainty creates opportunity and we just need to be alive to that.

GL: Richard, thanks very much for talk to me about what Custodian does and what you might be doing in the future. Thank you.

RSC: Thanks very much.