Break Clauses Becoming A Thing Of The Past
Renegotiation of lease terms with sovereign tenant DWP has led to break clauses being
removed from 108 leases, of which rents for 97 leases were maintained while rents for
11 leases were reduced. The properties have rent reviews every five years
benchmarked against UK CPI, and rental escalation of 15.4% is expected to kick in in
Apr 23. Exor NV is the largest shareholder with a 23% stake. ELITE is a recession-resistant counter-cyclical yield play. Maintain BUY. Target price: £0.87.
WHAT’S NEW
• Elite Commercial REIT (ELITE) has embarked on renegotiation of lease terms with
sovereign occupier Department for Work and Pensions (DWP) since Feb 22. DWP occupies
146 out of ELITE’s 155 commercial properties.
• Majority of 136 DWP leases have no break clauses (83.8% of total contractual rent).
27 of the DWP leases are straight leases without break clauses. Break clauses were
removed from 108 leases, of which rents for 97 leases were maintained while rents for 11
leases were reduced. The reduction in rents for the 11 commercial properties is estimated at
36% (before positive impact of rental escalation). DWP also signed a new five-year lease for
one commercial property at East Street, Epsom.
• Break options for 10 leases were exercised (7.2% of total contractual rent). DWP has
exercised break options for nine leases. It will vacate from one building in Mar 22 and
another eight buildings in Mar 23. HM Revenue & Customs has also exercised the break
option for Sidlaw House at Dundee and will vacate the building in Jun 22. ELITE will
consider three options for these 10 commercial properties: a) re-let to other potential new
tenants, b) divestment with vacant possession or following re-letting, or c) seek alternative
uses, such as conversion or redevelopment
• Only three leases with outstanding break options (3.9% of total contractual rent).
DWP has only one remaining lease with a break clause that occurs in Mar 23. DWP has not
decided on whether to exercise the break option for this building. Two other leases with
National Records of Scotland and Natural Resource Wales also have break options that
occur in Jan 23 and Aug 23 respectively.
• Mid-year valuation. ELITE plans to conduct a mid-year valuation exercise to update the
valuations of its properties post the renegotiation of lease terms.
• Rental rates are affordable for the UK government. The average rental rate for ELITE’s
155 commercial properties is low at £9.60psf per year in 2021. The average valuation of its
commercial properties is £130psf, which is below the current construction cost of £190-
250psf in the UK.
• Income stability with long WALE. ELITE has a long WALE of 5.5 years as of Mar 22 post
renegotiation of lease terms.
• Benefitting from higher inflation. The leases with the UK government are full repairing
and insuring triple net leases that provide high NPI margin of 97.1% in 2021. Thus, ELITE is
sheltered from the negative impact from higher cost of electricity. The leases have rent
reviews every five years benchmarked against the UK Consumer Price Index (CPI). The
built-in rental escalation is subject to an annual minimum increase of 1% and maximum of
5%. Based on consensus estimate of 7.5% for the UK’s CPI in 2022, we estimate the stepup in rents at 15.4% for Apr 23.
STOCK IMPACT
• Recession-resistant counter-cyclical yield play. ELITE benefits from recession-resistant
and counter-cyclical cash flows from its sovereign tenants. The UK government is rated AA
by S&P and Aa3 by Moody’s. Rent collection in advance for 2Q22 was 100% within seven
days of due date.
• Covea to become the largest shareholder. PartnerRE, the largest investor of Elite UK
Commercial Fund II, has increased its stake in ELITE from 1% to 23% post ELITE’s
acquisition of 58 commercial properties located across the UK for £212.5m in Mar 21.
PartnerRE is a top-5 reinsurer on a worldwide basis. Excor NV, the Dutch holding company
for Italy’s Agnelli family, has sold PartnerRE to French insurer Covea Cooperations for
US$9b in Oct 21.
EARNINGS REVISION/RISK
• Gradually deleveraging through DRP. ELITE’s aggregate leverage was 42.8% as of Mar 22. Its Distribution Reinvestment Plan (DRP) serves to allow ELITE to deleverage gradually.
Its average cost of debt is 2.1%. 63% of its total borrowings are hedged to fixed interest
rates. Assuming that Bank of England hikes Repo Rate to 1.25% by end-22, we estimate
that cost of debt would increase to 2.3% in 2023.
• We have trimmed our 2022 and 2023 DPU by 6% and 15% respectively due to the
renegotiation of lease terms and higher interest rates. We have conservatively assumed
that: a) break options for the remaining three leases with break options were exercised, and
b) a worst-case scenario that commercial properties with break options exercised are vacant
for nine months and rental income is halved after securing replacement tenants.
VALUATION/RECOMMENDATION
• Maintain BUY. Our target price for ELITE of £0.87 is based on DDM (COE: 6.75%, terminal
growth: 1.0%).
SHARE PRICE CATALYST
• Recession-resistant counter-cyclical yield play sheltered from uncertainties created by
heightened geopolitical tension and the Russia-Ukraine war.
• Accretive acquisitions of government offices and commercial buildings in the UK.