Derwent London PLC
LSE:DLN
Earnings Call Analysis
Q3-2023 Analysis
Derwent London PLC
Derwent London's third-quarter update provided reassurance to investors, emphasizing a resilient letting performance in a market experiencing shifts in demand and supply dynamics. They have completed GBP 27.8 million in new lettings, which is over 8% above the estimated rental value (ERV), and have impressive pre-lets at their Baker Street development. This activity underlines the increased demand for high-quality office spaces, with Derwent achieving rents on average 10% ahead of ERV for half-year activity. The company also showcased a reduced vacancy rate from 4.5% in June to 3.7%, signaling a tightening of available space and potentially higher future rental rates.
In the face of rising interest rates, which are now expected to remain high, Derwent's strong financials afford it ample resilience and continues to push the narrative of financial prudence and strength. Net debt is marginally up to GBP 1.3 billion due to continued investment in projects, yet loan-to-value remains at a conservative 25.2%. With only one small refinancing due over the next year and a robust balance sheet with substantial liquidity, Derwent London is positioned to tackle near-term challenges effectively and has the capital to invest in valuable opportunities as they arise.
Despite potential discounts in the market, Derwent London is focused on investing in its existing portfolio with an open mind towards buybacks or special dividends as opportunities present themselves. This strategic approach indicates a commitment to enhancing shareholder value while maintaining the quality of their property offerings.
Construction costs have stabilized with inflation around 3% to 4%, a decrease from the double-digit figures experienced in the previous year. Derwent has locked in costs for significant developments, such as their Network and Baker Street schemes, emphasizing their focus on keeping projects on schedule to ensure a timely inflow of income, which is integral for meeting pre-let commitments and maintaining investor confidence.
The outcome of the PIMCO option on additional floors at their 25 Baker Street project is pending and will be determined by the end of the month. This could leave either 1 or 2 floors remaining, presenting a potential increase in rental income if let out to new tenants at potentially higher rates. Additionally, refinancing plans for the next year are poised to leverage a favorable lending environment, with the anticipation of margins between 220 and 240, ensuring the company can manage its liabilities effectively amidst variable interest rates.
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Ladies and gentlemen, welcome to the Derwent London Q3 2023 Business. My name is Rocco, and I will be the operator for your call this morning. [Operator Instructions]
I will now hand you over to Paul Williams, Chief Executive.
Good morning, everybody, and welcome to the Derwent London Q3 2023 Business Update. Turning first to our strong letting activity, which reinforce our view that the flight to quality continues and there is good active demand for London offices.
In the year-to-date, we have completed GBP 27.8 million in new lettings, over 8% above ERV, with H2 activity so far of GBP 8.5 million on average 10% ahead. This includes the second pre-let at our on-site 25 Baker Street development to Moelis, which was signed in Q3. Together with the pre-let of PIMCO agreed in the first half, the project is now 76% pre-let at rents averaging 13% above ERV.
We're seeing a really good rise in viewing activity across the portfolio and are delighted with the latest lettings at Featherstone to Tide and Avalere Health. The building is now 80% let.
Our EPRA vacancy rate reduced over the quarter to 3.7% from 4.5% in June and 6.4% at December '22. We have also agreed GBP 12.5 million of asset management activity in H2. The highlight was Paymentsense taking an additional 50,000 square feet in Brunel through an assignment to now occupy 83,000 square feet over 5 floors.
As part of the transaction, we removed the 2029 lease breaks on the existing leases and extended the expiry from 2034 to 2036. On new space, the leases were extended by 5 years to 2036. Consequently, the term of certain of these 5 floors were extended by nearly 6 years to 12.7%.
Now as to the wider market. We are encouraged by the great number of businesses putting offices first. [ Savile ] has highlighted the take-up in Q3 increased quarter-on-quarter as more occupiers increase their space needs.
This is supported by a Cushman & Wakefield report, which showed that in 8 of the 13 largest recent pre-lets, the tenant increased its space rather than decreased. Pre-let levels across London are high and are expected to go higher. The pipeline for on-site newbuild projects is constrained with the equivalent of less than 9 months of speculative space completing by the end of '26 based on average take-up. This is leading to strong rental growth for the right product. While available space in London is elevated at 8.8%, a large part of this is secondary with weak leasing prospects and not in our locations.
In the West End, where we have over 70% of our portfolio, the market vacancy rate is below the long-term average at [ 4.2 cent ]. Interest rates now appear to be approaching their peak. In the investment market, volumes remain subdued. Our yields have been under pressure, but the West End is more robust than the city given its lower dependence on debt and smaller lot sizes. Our new developments have performed well as highlighted at the interims.
At 25 Baker Street, we have now also exchanged on 4 of the 41 private residential units for GBP 22 million, reflecting an average capital value of over GBP 3,200 per square foot, which is ahead of our appraisal. A further 2 units are under offer. The development has now reached the top level and works are proceeding at a rapid pace.
At Network, early construction work is progressing well, following the signing of a fixed-price build contract with Kier in Q2. In both the Marylebone and Fitzrovia submarkets, there is little competition from either existing space or buildings under development. We are delivering best-in-class space in well-connected locations with really high-quality amenities and outstanding green potentials. This gives us significant confidence that we will lease the remaining available space at attractive rents ahead of ERV.
Having a strong balance sheet has rarely been more important with interest rates now expected to remain higher for longer, and we are well positioned. We have only one relatively small refinancing due over the next 12 months and have already had positive engagement with a variety of lenders including the existing one.
Net debt increased slightly through the quarter to GBP 1.3 billion as we invested GBP 52 million in our projects. As a result, loan-to-value remains very comfortable at 25.2%. After the steep increases last year, utility prices reduced further in Q3, and our average vacancy has also come down. For the full year, we expect a marginally higher level of irrecoverable cost than in 2022.
So to conclude, we have delivered a further strong letting performance. Occupiers are prepared to pay a premium to secure the right space in the right location and our lettings are consistently ahead of ERV.
Our distinctive buildings are on demand. We have a strong balance sheet with limited near-term refinancing and substantial liquidity. Thank you, and I look forward to seeing many of you at the launch of our new member lounge at the Featherstone Building in Old Street on the 15th of November. I will now pass back to Rocco for any questions.
[Operator Instructions] Today's first question comes from Paul May with Barclays.
Just a couple of quick ones for me. I appreciate obviously prime space is leasing well. I think we've spoken in the past anything sort of below that prime space is a struggle -- just wondered what you're seeing in leasing on space and conversations on the leasing on space that's not sort of Uber prime? And secondly, transaction market remains subdued. It's the most prolonged subdued transaction market, I think ever. And I just wondered what you believe would unlock that transaction market and are you seeing signs of that transaction market unlocking?
Paul, super prime. Well, we're getting good letting activity across all our portfolio. And we'd question whether T building is super prime, but we've got good demand there and letting good rent. So I think you've got to be careful what you think is super prime because I think it's got to be the right building in the right position with the right sort of amenities. So we're seeing good demand across our portfolio. And what's been interesting for us, we've seen a real uptake in viewings and inspections in the Old Street and White Chapel area, which is really good and encouraging.
So I think occupiers want to be in a good building with a good landlord. Obviously, I think we're also seeing this recentralization continuing with occupiers deciding to come more into town. Luckily for us, we don't have an awful lot of poorer quality buildings. I think for the smaller end, we're continuing to do our fix -- our flex and furnished space, and that's seen some good demand. I think for some of the poorer height buildings maybe in the city and in Docklands, I think that you're going to have to think about what you do. And I think, therefore, on the vacancy rate, you think what is the true competition to that sort space. So as I say, we're seeing good level of inspections across our portfolio for a range of our product.
Obviously, we've been upgrading the portfolio going along. You're aware that we announced a few years ago that we keep the better greener buildings for longer. I think that proved to be right because I think the lettings are continuing. In respect to your question about transactions, you mean letting transactions or investments?
Investment transactions which I say are very subdued.
They are all very subdued. I think, again, probably a sort of a picture of where those buildings are. I think the West End is much more robust than the city. I think the bigger the buildings they are, the more tricky it is in respect to financing and stuff. We have seen a few buildings coming to the market recently in the West End and they've been reasonably well bid. So I think that's a little bit more encouraging. I think the fact that, hopefully, the interest rates are sort of are now setting, I think you'll see it a little bit more be coming around. I'm doubting this year numbers will be down. But I think we're in a position. We've got, what, maybe GBP 600 million of cash available.
We've got a balance sheet. If we saw some value, then we could look at those opportunities. But I think this year will be, as I say, will be down, but I think we're beginning to see a few things coming out and reasonably well bid if it's an interesting build in the right location. So that's where I see it.
And our next question comes from Alex Kolsteren with Kempen.
Two from my side. First up, do you see any interesting acquisition opportunities as a result of this [indiscernible] at the moment?
Okay. Well, we've seen a few things come around. I'd say we're investing a lot of money within the portfolio. We're upgrading doing some refurbishment post sort of our Baker Street building and our network building. We have 2 really exciting projects to follow on. So I think focus is continuing to invest in that and plus also do some refurbishment But we are beginning to see a little bit more interesting buildings coming around. We just want to make sure that we can see some value on those. There's some added value properties where you can actually see land prices being the right price for those opportunities where we can add our distinctive touch.
So it's early days. No news on any future acquisitions for us, but we're in a position to -- we're in a position to move if we want to. I think we're also seeing now probably the banks taking action on those, loans may be struggling. And I think the sort of moving on to sort of lender pretend to actually, we could do something about that. So we see a few of those recently. So I think you might see -- now I suspect it's more a story for 2024 than for 2023.
All right. That's very clear answer. And then secondly, what's the current trend in the construction sector? Do you see prices coming down or stabilizing at least?
Well, they are stabilized. I mean, first of all, we would be delighted to have fixed all -- for both our Network and our Baker Street scheme. So they are fixed. We're seeing inflation coming down probably to about 3% or 4% from a sort of probably double digit last year. But don't forget, prices were stagnant for quite a long time, so that -- we have seen it down. And as I always say, for us, the most important thing is program, make sure that we're on program especially we've done such strong pre-lets. Obviously, we want to make sure that income comes in as quickly as possible. So our focus is less on the end price more on the program because we fixed the end price. So yes, we're seeing a little bit more stabilization of that -- and as I say, probably 3% or 4%. The houses will probably tell a little less, but I think our view is it's a bit more.
Our next question today comes from [ Colin Morley ] with [ Codex ].
Thank you for the update. Could you just refresh us on how you're thinking about capital allocation in this current environment maybe given where developing yields are in the low 60s and acquisitions in the sub-5s.
Well, I think our focus is obviously investing in the portfolio. We don't rule anything out, obviously, with the discount. So we'd have to consider options, whether it's special or buyback. I think our focus, as I say, is investing. If we were to do some setting, nothing necessarily immediately planned, we will consider what we do with that. I say limited refinancing next year as well. So obviously, we have some -- we've got some thought on that. I'm obviously focusing on, as I say, on the portfolio, but we will give some good thought to about that.
Obviously, debt is expensive. So one of those things we're thinking about is to whether or not we refinance or pay it off, as I say, with the balance sheet as strong it is, then we do have that option.
And our next question comes from Adam Shapton with Green Street.
Two quick ones. One, maybe just on 25 Baker Street. Just for the avoidance of doubt, the PIMCO option on the vacant space, has that reached a conclusion? Or is that still live? And then just the second one on the refinancing for which you're in discussion today, GBP 3 million, any details you can give us on where the market seems to be on spreads either in absolute terms or maybe compared to 6 or 12 months ago? Any color around that would be helpful.
Well, Emily is with me. Emily on the PIMCO option.
Yes. And the PIMCO option, we will have certainty on they have to exercise by the end of this month. So that will leave us with either 1 or 2 floors remaining in the building. So no certainty yet.
I mean, the positive thing for me if they decide not to take their option up, are rent letting to owners who will take the space will move them up will be higher. So actually, if they don't take the option, it's good news for us. It's one of those heads we win, tails we win. So that's good, quite good. Your other question is about financing and I'll pass it a bit to Damian.
Good question. And I'd say that if we refinanced with a similar product to the last one, we're looking at margins in the low 200s. So something between probably 220 and 240 at current levels. We're not looking to do it yet. This is something for next year. It will be interesting to see if those spreads come in at all. But they're looking pretty sticky at the moment.
But interestingly, in the bank market, margins haven't moved out anything like as much. So if we were to refinance that with one of our lending banks, and that's one of the things we are considering. Margins would be considerably lower, but that would probably be a shorter-term piece of refinancing. So there's quite a lot of variety out there. What's interesting is there's no shortage of willing lenders, particularly these sorts of prices. So it's quite an interesting time for us at the moment.
Thank you. And ladies and gentlemen, this concludes today's question-and-answer session. I'd like to turn the conference back over to Paul Williams for closing remarks.
Thank you, everyone, for listening in. We're all around later today. If you want any further questions, picking the phone to Robbie. We look forward to seeing as many of you as you possibly can on the 15th of November to see our fantastic new lounge, to see anything else of the portfolio. Anyway, thank you for your time today and all have a good day. Keep safe. Keep well. Thank you.
Ladies and gentlemen, this concludes today's conference. Thank you for joining. You may now disconnect your lines, and have a great day.