Despite the headwinds, real estate continues to be in demand by occupiers and as an investment class. The Asset management report looks more closely at occupier demand and paints a rosier picture than a year of pandemic headlines might suggest, and although occupancy has decreased from 95.9% to 91.6%, more than half of our vacant properties are currently under offer to let. The outlook feels more positive and predictable than 12 months ago and we expect that the Company's property portfolio will continue to support the policy of stable dividends in a post-pandemic world. As discussed in the Financial review, dividends per share of 5.0p have been approved for the year and the Board has announced a minimum dividend of 5.0p for the year in prospect.

In a long-term low interest rate environment the marginal income return from real estate investment over risk-free investment, represented by UK 10 year gilts, and the low cost of debt are both likely to support property pricing.

The combination of resilient capital values and a return to stabilised dividends should lend support to Custodian REIT's objective to be the REIT of choice for private and institutional investors seeking high and well supported dividends from diversified UK commercial property.

David Hunter

Chairman

15 June 2021

Investment Manager's report

The UK property market

In common with the wider economy, the commercial property investment market has experienced a year unlike any other with office workers deserting their offices, shoppers going online as retailers were forced to close and pubs and restaurants unable to serve customers for a large part of the year. The government's moratorium on the eviction of tenants for non-payment of rent has left landlords unable to compel tenants to pay rent but, despite these challenges, I believe real estate investment has been remarkably resilient.

As a diversified property investment company, Custodian REIT's resilience in the face of the pandemic is representative of the resilience of the real estate market more broadly. Custodian REIT's NAV decreased by 4.0p over the year which was exceeded by dividends paid to deliver a marginal, but positive NAV total return of 0.9% for the year. We go into the year ending 31 March 2022 with the estimated rental value ("ERV") of the property portfolio, adjusted for acquisitions and disposals, only 1.4% diminished, albeit with an increased vacancy rate.

These positive total returns and limited rental reductions, when compared to significant share price volatility, particularly in Q1, suggest that real estate outperformed market expectations of earlier in the year. A share price recovery began in Q4 in line with greater certainty of rent collection rates which were much better than forecast and had been improving through the year.

The clear winner in real estate investment has been the industrial and logistics sector which has benefited from the shift from the High Street to 'E-tailing' and from the onshoring of the national supply chain post Brexit. Investment demand and pricing are both at record levels which has been strongly positive for Custodian REIT as this sector makes up 49% by value of the portfolio and its valuation increased by 4.6% during the year.

The high street retail sector's future is uncertain, but, I believe, as part of a combined retail and leisure-based city centre there will still be active demand from occupiers. The trend for fewer shops was well established prior to the pandemic but in core locations we still expect to see high occupancy levels albeit at rental levels 25-50% below the peak. High Street retail makes up only 8% by value of the property portfolio and we have sold four small shops in the last six months, with another under offer, which we did not feel had medium-term potential for a return to rental growth.

By contrast the out of town retail sector which makes up 18% of the Custodian REIT portfolio by value, is witnessing investors openly competing for assets. This is a sector where there is confidence that the combination of convenience, lower costs per square foot and the complementary offer to online retail will keep these assets relevant. Through the last year we have seen DIY and discounters (B&Q and B&M for example) trading strongly.

After a year of working from home many workers are looking forward to returning to the office. Without doubt the way we use offices and how frequently we visit them has changed, following the largely successful national experiment of remote working. As always, when considering real estate investment, the location of offices will be key. Having withdrawn from an office acquisition in Oxford, to preserve cash, at the start of the first lockdown Custodian REIT completed on the same office building one year later in a city which is benefiting from the growth in Biotech, driven in part by the university and the focus of this growing sector in the Oxford-Cambridge arc. We have already agreed terms to lease the last remaining space in the building at a new headline rent demonstrating the positive future prospects for the property.

The sustainability credentials of both the building and the location will be evermore important for occupiers and investors. As investment manager we are absolutely committed to the Company's ambitious goals in relation to ESG and believe the real estate sector should be a leader in this field.

ESG has become an imperative for many investors. Commercial real estate is a significant contributor to national emissions, so we believe an emphasis on how we can improve the "E" is particularly relevant for real estate. In this regard we are striving to beat the Company's target to improve the Energy Performance Certificates ("EPC") of the portfolio. We expect to eradicate all EPC's of "F" and "G" ahead of the target set of end of 2022 and all EPC's of "E" before 2025. We are well advanced with this project with plans in place for all the "F" and "G" EPCs and 30% of the "E" EPCs.

Energy performance and emissions are important considerations across all redevelopments and refurbishments in the portfolio as is the importance of "S" (Social) in creating an engaging, appropriate and sustainable (in all senses of the word) built environment. These commitments are demonstrated in the refurbishment of a property in West Bromwich, the details of which are set out in the ESG Committee report. Investing in real estate that meets the ESG requirements of occupiers and legislation will lead to shorter periods of vacancy, higher rents and enhanced values. We have policies, embedded in our strategy, to keep Custodian REIT on target to meet the required standards but we remain focused on delivering returns at the same time. The KPIs the Company has set itself are set out in the ESG Committee report.

Before considering rent collection, which has been a key focus through the year, it is worth reflecting on the continued use of CVAs by tenants to reduce their operating costs. As discussed in the Asset management report CVAs have been the cause of an 1.3% reduction in annual passing rent during the year. While, on the face of it, CVAs are disadvantageous for landlords this is not always the case over a medium-term time horizon. An example of how this can be positive for investors is the CVA of Pizza Hut. The Custodian REIT portfolio contains three Pizza Hut restaurants operating an arguably outdated model. The CVA enabled the Company to gain vacant possession of each property with increasingly competitive bids received to secure the assets from new drive-through operators including fast food and coffee shops and Pizza Hut itself. All three units now have 21st century tenants lined up to take occupation.

Rent collection

As Investment Manager, Custodian Capital invoices and collects rent directly, importantly allowing it to hold conversations promptly with most tenants regarding the payment of rent. This direct contact has proved invaluable, through the COVID-19 pandemic disruption, enabling better outcomes for the Company. Many of these conversations have led to positive asset management outcomes, some of which are discussed in the Asset management report. The financial resilience of the Company and the pragmatic approach of the Manager has enabled the Company to take a longer-term view of rent collection. It was better to acknowledge the challenges faced by certain occupiers and balance their contractual requirement to pay rent and the ability of the Company to fund short-term rent deferrals. If quarterly rent payments could not be secured consensually the Manager sought to allow tenants to pay monthly and, only if this was not achievable, to allow for an element of rent to be deferred. Where possible longer lease commitments were sought in return as part of a lease re-gear. Rent concessions were offered, as a last resort, but amounted to less than 1% of the total contractual rent roll.

91% of rent relating to the year has been collected, net of contractual rent deferrals, or 89% before contractual deferrals, as set out below: 


 
                                                     31 Mar    Net of contractual rent      Before contractual rent 
                                                     2021      deferrals                    deferrals 
                                                     GBPm 
 
 
Rental income from investment property (IFRS basis)  38.7 
Lease incentives                                     (1.9) 
Cash rental income expected, before contractual rent 36.8                                   100% 
deferrals 
 
Contractual rent deferred until subsequent financial (0.9)                                  (3%) 
years 
Cash rental income expected, net of contractual rent 35.9      100% 
deferrals 
 
Outstanding rental income                            (3.1)     (9%)                         (8%) 
 
Rental income collected                              32.8      91%                          89%

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June 16, 2021 02:16 ET (06:16 GMT)