SEGRO PLC
LSE:SGRO
Earnings Call Analysis
Q2-2023 Analysis
SEGRO PLC
The company witnessed an adjusted profit before tax increase of 2.6% year-on-year, reaching £198 million, while adjusted earnings per share climbed up by 1.9% to 15.9 pence. Complementing this positive outcome, the half-year dividend saw an uplift of 7.4%, set at 8.7 pence, demonstrating a commitment to returning value to shareholders.
A critical component of the company's earnings growth is the net rental income, which expanded substantially by £31 million (12%) during the first half of the year. This growth is primarily fueled by a 5.1% like-for-like growth and the addition of £21 million from development completions.
The like-for-like growth contributing £12 million includes nearly £10 million from leasing up vacant units and £7 million from rent reviews and renewals, reflecting a 20% uplift on lease events. Indexation, influenced by annual CPI adjustments particularly on the continent, further bolstered income by £5.5 million, playing a significant role in the 6.4% like-for-like rental growth there.
The company managed costs effectively, maintaining bad debt levels in line with the previous year. It's worth noting the performance fee from the SELP joint venture is due in October and has not been booked in the first half, due to its sensitivity to valuation movements. A 5% valuation shift could swing this fee by €35 million. Despite these variables, the adjusted profit before tax has grown by 3% and earnings per share by 2%.
Financial stability is evidenced through a well-structured debt profile with an average maturity of seven and a half years, and spread-out maturities reaching up to 2042. No significant debt maturities occur at the SEGRO level until 2026, indicating a stable financial foundation supporting significant liquidity for investing in profitable development opportunities.
The company is poised to continue capitalizing on strong U.K rental growth, with significant rent reviews anticipated to conclude in the near term, bringing in an additional £57 million over the ensuing 18 months. This expected growth is in alignment with SEGRO's long-standing mid-term guidance of 2% to 6%. The average Estimated Rental Value (ERV) in Greater London provides ample room for increases given that top rents are over £30 per square foot while in-place rents average at just £16 per square foot.
Construction costs have stabilized in the first half of 2023, aiding in boosting the estimated yield on cost for the company's current program to 7.2% and 7% for the entire future pipeline. In addressing capital deployment, SEGRO emphasizes quality and returns over sheer volume, hinting at a disciplined strategy for utilizing its land bank in times of macroeconomic uncertainty and focusing on pre-leased deals. Moreover, the current projects in the pipeline are projected to contribute £76 million to rental income while requiring £365 million of capital, signifying earnings accretion.
The assembled growth potential includes plans to expand the current £605 million in cash passing rent by £316 million through harnessing the rental market's existing upside, vacancies, and imminent development projects. Moreover, the company has identified a potential £360 million opportunity in the land bank and an additional £150 million from lands under contract and optioned. SEGRO anticipates a structurally advantaged position moving forward, driven by a 52% rent roll increase and a vibrant development program, with continued belief in the sector from property investors.
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Okay. Good morning, everybody. And welcome to our First Half 2023 Results Presentation. Thanks for all of you who came this morning and indeed for others who are joining us online. As usual, I am going to make a few opening remarks and then we will go into the detail of the presentation.
But before I do any of that, I just want to say this moment to note, this is the first presentation for quite some time where we haven’t had Andy Gulliford up here presenting with us. Andy, as you know retired at the end of June after 18 years of incredible service to the company, the last 12 of which were as our Chief Operating Officer and the business has grown enormously since Andy joined us, and of course, has changed a lot. And I’d say much of our success over the years has been down to Andy’s leadership of our property teams, particularly over the last 12 years. So he’s left us with our very best wishes.
Andy’s retirement then gave us an opportunity to stand back and think about the best way to structure the business for the opportunities and the challenges that lie ahead. And this has resulted in the promotion of four talented individuals to join our executive committee alongside Margaret, our Group HR Director; Soumen and myself.
And they are Marco Simonetti and James Craddock who are running our Continental European and U.K. property teams, respectively. Paul Dunn who is leading our Central Customer and Operational Support teams and Paul’s here with us this morning; and Andrew Pilsworth, our new Chief of Staff, who will work with me in the executive team to drive a number of strategic initiatives and special projects.
And I have to say, I am delighted that we have been able to promote from within to fill these key roles in the company and I am very excited about working directly with James, Marco, Paul and Andrew as we write this new chapter in SEGRO story.
So on with the presentation, we continue to follow our consistent strategy, which has positioned SEGRO to perform through the cycle and deliver value for all our stakeholders. Today, against the backdrop of a tougher macroeconomic environment and much higher funding costs, you can see in this slide, top left, first of all, we have announced further growth in earnings and dividends and adjusted NAV is down a touch as values continue to settle following last year’s sharp correction.
Beneath those headlines, if we work around, first of all, top right, you can see on the right-hand side there, there’s been a 1.4% valuation deficit in the portfolio. That reflects 30 basis points of outward yield shift, which has largely been mitigated by ERV growth of 3.7% as occupier market conditions remained favorable. We are taking a very selective approach to capital allocation, which has remained predominantly focused on our development program with £551 million of net investment in the first half.
Moving down bottom right, continued occupier demand for our high quality portfolio has enabled us to secure £44 million of new rent, supported by good leasing activity and excellent work by our asset management teams in capturing rent reversion and that’s driven a 5.1% growth in like-for-like net rental income.
And then, finally, our balance sheet remains in good shape with modest leverage, very substantial liquidity, a long debt maturity profile, and a low and almost entirely fixed average cost of debt. Meanwhile, at the heart of everything, we continue to invest in the future of the business through our response of SEGRO commitments against which we are making good progress.
So a new era and a somewhat different market environment. So we decided to change the structure of the presentation, although you will see most of the content and the information we provide is very familiar.
And we thought we would start by standing back, taking a step back and looking at the numbers in the context of the bigger picture and to give you some of that market background, which still remains attractive.
So we will do that first, then I will go through the operating results, followed by Soumen, who will talk about the financials and then I will come back again and tell you about why we think the outlook for the business is positive.
So let’s start by looking at the market. Clearly, the macroeconomic environment is more challenging for most occupiers and this has undoubtedly created some headwinds. However, the long-term structural drivers of demand about which we have spoken of at length in the past remain intact and continue to drive demand.
Space is being taken up by retailers, both online and traditional and by consumer goods companies who are building out their distribution networks to provide an omnichannel or direct B2C service offering.
In the U.K., businesses linked to manufacturing accounted for the largest volume of take-up ever recorded according to data by Savills. With supply chain efficiency, cost reduction and resilience continuing to be hot topics frequently mentioned by manufacturers when discussing their investment plans.
And sustainability continues to be a key concern for many, something that we have noticed within our own portfolio with customers willing to pay a premium for a best-in-class space that helps them improve their carbon footprint and energy efficiency.
Urbanization remains a factor with European cities continuing to evolve and land remaining in very short supply, and meanwhile, the creation of data continues to increase exponentially with the rise of generative-AI likely to fuel even more demand for data centers.
So how are these structural tailwinds faring against the economic headwinds? Well, as you can see here, market wide -- and this is on the left, market wide take-up across Europe has undoubtedly moderated from its record levels during the pandemic, but it’s still pretty good.
In fact, it’s returned to something more in line with longer term averages. There continues to be healthy levels of inquiries, but demand is more discerning in terms of what it wants. And it’s fair to say that decision-making by occupiers is often taking longer than it did a couple of years ago. But many businesses are still taking a long-term view and are securing space today, whether for immediate occupation or to take delivery 12 months to 18 months from now.
And it’s at times like this, where quality counts and our portfolio focused on the most supply constrained markets and with the most modern sustainable space is outperforming the wider market as you will hopefully pick up shortly. But even with more normal levels of demand, market vacancy is well below the average of the past decade, reflecting the limited supply of modern fit-for-purpose space.
You can see from the chart on the right-hand side, there is still less than a year space available in all the countries we operate in and it is worth noting that the data here is at country level and focused on big box warehouses. The situation in most of our own chosen submarkets, particularly in urban locations is much tighter than this.
Overall then, the supply-demand balance for industrial and logistics space remains favorable, supporting decent volumes of development take-up and good rental growth and we think this is likely to remain the case.
Turning now to the investment market. Clearly, the second half of 2022 saw a significant correction on the back of inflationary pressures and interest rate hikes with both yields and investment volumes moving sharply, particularly in Q4.
When we reported results in February, we said values looked relatively attractive on a total return basis, that buyers and sellers were starting to become more active, but the direction of travel from there would be heavily influenced by the trajectory of inflation and interest rates.
Standing here in July, we can say that while the macro environment has remained volatile and the pool of active investors is clearly smaller than a year ago with few debt reliant buyers able to transact, there is definitely growing confidence from the deals already done or in the marketplace that current values make sense.
But I think more water needs to pass under the macroeconomic bridge before the volume of transactions picks up sufficiently for us to confirm whether or not we have reached the absolute bottom.
What is clear, despite the macroeconomic uncertainty is that real estate investors still have conviction over the industrial and logistics asset class, and in many cases, it’s simply a case of when rather than if they put their capital to work. When they do, we think high quality assets such as ours will be at the top of the list of investors preferences.
So in summary, we believe the fundamentals for our markets remain attractive. So let’s now look at what SEGRO has delivered in terms of operating results in the context of this market environment.
Actually, we have had an excellent first half in terms of securing new rent commitments. Not quite at the hikes we achieved in the second half of 2021 and the first half of 2022, but it’s been our best ever half outside of the pandemic era.
When take-up, as you know, was supercharged, particularly by the likes of Amazon. And beyond that, we have a very good pipeline of deals in the hopper right now, which I think bodes well for the full year.
Takers of our space continue to be very diverse as you look at it from my earlier comments and you can get a flavor of this from the logos showing on the right-hand side of the table. They range from manufacturers and consumer goods companies to retailers, logistics operators and postal parcel companies and many others not listed here.
The active management of our portfolio continues to deliver strong operating metrics. On average, we achieved a 20% uplift across all settled rent reviews and lease renewals. The U.K. was good at 26%, bearing in mind that the rent review structure here means we are capturing five years of accumulated rental growth in those settlements, but it does show that we are successfully capturing the significant reversion potential embedded in our portfolio.
We have also achieved a good 10% average gain in Continental Europe, but on a much smaller part of the portfolio, because this only includes lease renewals. Most of the Continental portfolio is covered by annual indexation linked uplift, which are in addition to these figures and which are coming through very well in this inflationary environment.
Now despite the strong rental growth seen over recent years, our high retention rate shows that the vast majority of customers are generally willing and able to pay these higher rents in order to stay in the most modern sustainable spaces that best matches their business requirements and supported by a landlord that provides class leading customer service.
Consequently, our occupancy also remains high at 96%, more or less where we want it to be. So we have some space available to lease and to set new rental levels, but not at a point where which significantly dilutes our income returns.
Given the scale of our portfolio, we have hundreds of lease events and transactions every year and I’d like to briefly just highlight some of the ways that our market-leading operating platform creates value from the portfolio, which we think is a significant part of our competitive advantage.
Our hands on tech-enabled teams on the ground build close relationships with our customers and offer them an excellent level of service. This allows us insights into customer’s future business plans and creates opportunities.
For example, top left, we have moved two customers out of existing buildings into our most recently developed sustainable and higher priced space in London, providing them with larger units and enhanced facilities that better match their requirements.
We can now upgrade the space that they have left, refurbish it to the highest sustainability standards and put it back on the market at higher rents, which is what we have done with the unit picture bottom left that we took back in one of our West London estates last year in Greenford, which recently achieved the highest ever BREEAM industrial certification in the world for a refurbished scheme and it’s now being marketed at rents, almost double the previous parting rent.
Using our insights into customer requirements, we constantly look for the right moment to unlock opportunities to re-gear or extend leases. So during the period, for example, we signed a new lease with ASICS, who have expanded their space in our logistics park near Dusseldorf and are investing large amounts of capital in automating their warehouse to make distribution more efficient.
It allowed us to lengthen the lease by 10 years and increased the rent by a double-digit percentage, whilst also removing indexation caps from the original lease. And we continue to retrofit solar panels onto our existing portfolio. For example, the installation of 2.6 megawatts at the scheme in Spain where we added over 6,000 solar panels and signed a power purchase agreement with a customer enabling them to reduce their energy costs and helping both of us to reduce our carbon footprint.
Moving now on to development, we completed almost 350,000 square meters of space in the first half and we are actually on track for a record level of development completions for the year as a whole, £28 million of rent was added in the first half alone and 83% of this has already been leased.
The yield on cost at 6.1% was slightly lower than in recent years and compared to what we expect going forward. But this reflects the particular mix of projects and indeed market conditions at the time.
Even at this slightly lower yield on cost and despite significant valuation yield expansion since they were commenced, the program of projects here remained profitable and delivered some fantastic assets with strong growth potential. And all of our projects were BREEAM very good or higher, and in fact, 85% of them were or will be certified BREEAM Excellent, which is the new minimum standard that we have adopted.
And then, finally, in this section, turning to capital allocation. We continue to take a disciplined approach. The majority of our investment is being focused into our development program, prioritizing construction on land we already own, favoring pre-let projects, which carry less risk and typically earning a 10% yield on the incremental capital.
Recognizing the environment we are in where capital is more expensive and less freely available, we are being particularly selective, and in fact, have been turning down opportunities which do not hit our required returns for the risks involved or indeed the quality of the land that we are offering. In the half, we invested £299 million in development including £37 million of infrastructure and we remain on track to invest about £600 million for the year.
Acquisitions have been focused on securing super prime land positions to feed the future development hopper. In the first half, that involved £326 million, the majority of which was on two deals. The first was the acquisition of the Bath Road Shopping Park in Slough providing significant opportunity for data center development using our sector expertise and our unique advantaged access to scarce power in London’s Western corridor.
And we also acquired the former Radlett Aerodrome adjacent to the M25 Motorway, which is an exceptionally rare opportunity to develop a big box logistics park in such close proximity to London, supported by a strategic rail freight interchange we will be building. We have been working on this site for 18 years, and once the infrastructure is built, we are confident that it will literally go like a train.
In terms of disposals, we sold a couple of non-core office assets, which had been parts of previous portfolio acquisitions and we also sold some smaller residual land plots, so generating just £74 million of proceeds in the half. Since the period end, we disposed of a sizable U.K. big box portfolio slightly ahead of both June and December book values.
With debt more expensive, selling selective assets at initial yields of around 5% and deploying the capital into development projects generating a yield on new money of 10% with stronger growth prospects makes good sense to us. So we will be increasingly looking to do this going forward, relying less on debt funding to finance the ongoing development program.
So that’s it for me for now. I am going to hand over to Soumen who’s going to take you through the financials.
Thanks, David, and good morning, everybody. It’s great to see there’s very strong operational metrics coming through across the portfolio. So I will take you through now how that’s translated into a very resilient financial performance in the first half of 2023.
So starting on slide 15 and you will be familiar with this slide, which gives you the highlights of our key financial metrics for the first half of 2023. Adjusted profit before tax is up 2.6% year-on-year to £198 million. Adjusted earnings per share is up 1.9% to 15.9 pence.
Now it’s just worth noting that we have changed the definition of adjusted profit to exclude the performance fee, which is due from the SELP joint venture and I will come on to talk about that in a moment.
The half year dividend has been set at 8.7 pence, that’s up 7.4% in line with our policy of setting at one-third of last year’s full year dividend. The portfolio is now valued at £18.1 billion, a small decrease only of 1.4% and that’s led to a fall in NAV of 3% to 937 pence. And the balance sheet continues to be strong and LTVs only ticked up to 34%.
I move to slide 16. We are looking at net rental income growth, which is a key driver of our earnings growth. It’s been another period of very strong growth, which net rent up £31 million during the first six months of 2023, an increase of 12%.
There’s two main contributors to that growth, which you can see the first two grey bars. Firstly, the rent from standing portfolio grew £12 million with like-for-like growth of 5.1%. And second, development completions added a further £21 million during the period. The investment activity was fairly material in terms of net rent with a net impact of only £2 million.
Turning to slide 17, which is the new slide. Given the increasing size and importance of like-for-like growth in driving rent, we thought we used to break down that increase of £12 million, which we experienced in the first half.
The box on the left, you can see that we added almost £10 million leasing up vacant units, offset by £7 million of takebacks to refurbish space to create new further opportunity.
Rent reviews and renewals added £7 million of second grey bar. That’s a 20% uplift or that’s the 20% uplift on lease events that David mentioned a moment ago.
Indexation added a further £5.5 million. Around half our leases, mostly on the continent have annual CPI ratchets. Now this has clearly been a big benefit during this higher inflationary period and that’s really been a big driver of the 6.4% like-for-like growth in rent on the continent.
Operating costs were up during the period, due to the investment in our platform, both people and systems. But know the cost ratio has stayed flat at about 20%.
Bad debts were in line with last year’s, only £1 million, reflecting the resilience of our customer base despite the broader macroeconomic challenges. We are seeing cash collection rates back to pre-pandemic levels. For example, for the June quarter day, in the U.K., we collected 96% of our rent within 10 days.
Turning now to the rest of the income statement. So slide 18 shows the key lines of the income statement. You can see on the table the growth in net rent at the top, feature the growing profitability at the bottom. Adjusted profitable tax grew 3% to £198 million and EPS by 2% to 15.9 pence.
Now a couple of things to note on this slide in the boxes on the right. Firstly, the SELP performance fee. You will recall that we have potentially due a fee from SELP at the 10-year anniversary, which falls this October.
We have not booked any fee in this half. The calculation is inherently uncertain. It’s very sensitive to valuation movement as it’s based on the excess return of rebase IRR. Now whatever we book in the second half will be excluded from adjusted earnings, both current and in comparatives going forward. In our view, the performance fee creates unhelpful volatility in the earnings metric, which should really be providing a view of the underlying business performance.
Our net receipt will be around €80 million, if calculated based on the June valuation. But to give you an idea of the sensitivity, a 5% valuation movement up or down would have a €35 million impact.
So frankly, whatever figure we come up with will be raw and given the market volatility right now, it could be very raw. We will only know for sure in October when the portfolio will be revalued for this purpose.
Moving on to the next box, which covers finance costs. Now that’s increased by -- from £32 million in the first half of last year to £52 million this half, mainly due to higher interest rates on new debt that we put in place over the past year.
The impact is offset by higher capitalized interest. Our new debt is mostly to fund our newest projects. So we capitalized interest for those at our marginal cost of debt, and given the increase in rates over the past 12 months to 18 months, that’s led to a big increase in the level of interest capitalized, which is up from £6 million a year ago to £27 million this period.
Turning now to the portfolio valuation. So on slide 19, it illustrates that we have seen relative stability in values during the first half of 2023, which is shown in the red bars, which in stark contrast, a very sharp correction we saw last year, which are the bars in the grey.
Investment activity remains low, but as values began to find a level, there were definitely signs of capital returning to the market and evidence there’s still appetite for high quality logistics assets.
The values reported just a 1.4% fall in asset values over the whole of the portfolio at 30 June to £18.1 billion. The U.K. was virtually flat with a fall of just 0.6%, and Europe, we saw less of a decline in 2022, so a fall of 2.7%.
On slide 20, in a little bit more detail in terms of the drivers behind those valuation moves. You see that yields were pushed out by 30 basis points across the portfolio, much less than 110 basis points that we saw last year. Yields in the U.K. moved down only 10 basis points and the continent between 20 basis points and 50 basis points.
Now the impact on this on the valuation was partly offset by that continued strong ERV growth, the rental growth that we have experienced of 3.7%. Rent moved up in every market due to our asset management initiatives benefiting from the supply and demand balance, which David talked about a moment ago.
The Continent saw quite a bit better rental growth in the U.K. although wouldn’t read too much into any single six-month period. The 5.1% property yield, together with that rental growth of 3.7%, offset an unlevered IRR of 8% to 10%, which we would suggest is very attractive in any long-term context.
Moving on now to the balance sheet, which is on page 21, which remains very strong and provides us with significant liquidity to invest in our profitable development opportunities. Leverage has ticked up slightly to 34%, but remains very reasonable, given the movement in valuations we have experienced over the past 12 months. We have significant headroom to our gearing covenants.
Values will have to fall by 45% before we hit covenant. Now you will be aware that our credit rating was downgraded by Fitch during the first half, but it remains at A- which is higher than the vast majority of companies within the real estate universe.
Now whilst they have us a negative outlook, we believe we will outperform their expectations in growing rent and delivering disposals, which would reduce our net debt EBITDA ratio to within their target levels.
Our average cost of debt has increased slightly to 2.9%, mainly due to interest rates on new debt. The interest cover remains very strong at 3.4 times.
And in terms of capital allocation, looking ahead in the box at the bottom right, we see full year CapEx at around £600 million. So that’s double the half one spend and we continue to target disposals of around 1% to 2% per annum of our asset base.
Now look, we have -- they are all good assets, but we think it is smart portfolio management to review and then bottom slice the portfolio every year, selling those assets, which we identify as offering us the lowest expected risk adjusted returns.
But as David highlighted earlier, this approach provides the capital to recycle into higher return opportunities. Now we hope to be at the higher end of the 1% to 2% disposal range this year, which will equate to around £350 million to £400 million of sales.
Slide 22 will again be familiar to most of you, but it’s still worth emphasizing that we have one of the longest and most diverse debt structures in the sector as a result of the funding activity, which we have been carrying out over the past few years.
This debt structure and the interest rate hedging, which goes with it, is designed like the rest of our business to perform through all parts of the cycle. Our average debt maturity is seven and a half years and the graph illustrates, we have debt stretching up to 2042 and maturities are well spread out over the next 20 years.
We have continued to top up liquidity with a couple of new bank facilities which we have put in place this year. There are no material debt maturities at the SEGRO level until 2026, so we have no refinancing needs.
91% of our debt is fixed or capped and two-thirds of our caps are in the money. These caps have long duration with the majority expiring in 2029. So we have very healthy protection against any further rise in short-term rates.
So turning to slide 23 and to sum up on the financial side. By continuing to invest in the business to capture occupier demand and despite significantly higher finance costs, we delivered earnings growth of 2% through the first half of 2023 driven by the reversion and indexation within the existing portfolio alongside development activity to add new rent and that’s allowed us to grow the first half dividend by 7%.
Valuations have been much more stable in the first half with a portfolio decline of only 1.4% due to strong rental growth almost offsetting the modest yield expansion. And our balance sheet remains strong with our long-term debt structure and high liquidity.
With that, I will hand you back to David to talk about the outlook.
Thanks so much, Soumen. So what I am going to do now is just give you an overview of why we still think the outlook for our business is still very positive and there are a number of factors. As I have said before, our portfolio is in great shape. In fact, the best it’s ever been in.
We spent the last decade carefully creating a super strong modern portfolio and with a well -- modern portfolio with well-located assets that we think will perform well through the cycle. Two-thirds of our assets are in the most supply constrained urban markets and the remaining third consists of high-quality logistics properties in prime locations.
We have an exceptional land bank providing with great optionality and significant future growth potential, and our market-leading operating platform, with people on the ground in all of our key markets, consistently drives capital light growth from our existing asset base, execute the development program well and gains access to new opportunities.
The vast majority of our buildings are extremely flexible and adaptable to many different uses. As a result, our customer base is highly diversified with no single name or industry segment dominating.
The diversity of occupier demand, particularly in our biggest urban markets provides a constant source of new or expanding businesses that need high quality, sustainable space in prime locations where land is exceptionally hard to acquire permitting incredibly difficult and choice is extremely limited. Supported by the structural tailwinds, we believe the diversity we have will provide us with resilience, ongoing high occupancy and further rental growth.
We already have significant reversion embedded in our portfolio, which, as you heard earlier, we are successfully capturing through rent reviews, indexation uplifts and leasing transactions. And thanks to the ERV growth recorded in the first half, this now stands at 147 million or 24% of the in-place rents.
As you can see in the red part of the bars, the vast majority of this sits in the U.K. where rental growth has been strongest in recent years and where the rent review structure means those ERV gains build up on a rolling five-year basis, and then unwind over the next five years.
There’s a significant volume of reviews in progress right now, which should be concluded in the near term with 57 million available over the next 18 months. These gains alongside annual indexation uplifts on the continent will drive our like-for-like rent growth in the years to come.
In addition, we believe the structural tailwinds and a favorable supply and demand dynamic will push ERVs higher still, not necessarily at the extraordinary levels seen in the pandemic years, but more in line with our long-held midterm guidance of 2% to 6%, which to us feels a lot more sustainable.
People do ask us about affordability of rents and the sustainability of rental growth, and what I’d say is this, rent remains a relatively small part of most occupiers cost base, labor, transportation costs and speed to market are generally more important factors and so location and quality of the building matter most. And I think that helps explain why the vast majority of our customers choose to stay with us when their leases expire.
And to give you a little context, the top rents in London, which is our most expensive market, for the best buildings are now over £30 per square foot. The average ERV across our entire Greater London portfolio is still only £22 a square foot and the in-place rents averaged just £16 per square foot. So there’s plenty of room for more growth.
So that’s the existing portfolio. Our development pipeline, which has increased in size, again, thanks to our recent land acquisitions, provides tremendous growth and considerable optionality. This slide gives you all usual data about their current program and our estimates for the land bank.
Construction costs have stabilized in the first half of 2023 and are, if anything, easing somewhat from the 2022 peaks. This, combined with higher rents, slightly lower land valuations has helped to increase the estimated yield on cost on our current program to 7.2% and 7% for the overall future pipeline.
We are conscious that macroeconomic conditions are less certain and occupier demand is therefore less predictable. We are also clear, as I said earlier, that we are going to be very disciplined about the use of our capital. For us, it’s about quality and returns, not about development and volume.
We can and we will flex the pace at which we utilize our land bank and will only push the button when it makes sense. The deals have to be right in terms of the returns that they can show us, they will mostly be pre-leased and we intend to fund a good chunk of that new CapEx through proceeds from disposals, thus keeping debt levels broadly constant. So, as I said, our future pipeline offers tremendous potential with great optionality to respond to occupier demand and capture growth in a profitable manner.
In the meantime, if you look at what’s in right -- what’s right in front of us and really the first two lines of the chart, the current list of projects on site or in our near-term approved program represents £76 million of rental income and requires just £365 million of capital to be spent to complete that program. So it will be very accretive to earnings.
Pulling all of that together, the growth potential embedded within our existing business at today’s market rents looks like this. You can see £605 million is the current cash passing rent. That will increase by £316 million as we capture the gap between the in-place rents and market rents, fill the vacancy and complete the current and near-term development projects. We then have another £360 million of opportunity on the remaining land bank that’s on the balance sheet and a further £150 million of potential rent on land that is under contract and optioned.
So let me summarize. Occupier markets remain solid. Available space across our chosen markets is low, which supports continued rental growth in line with our midterm guidance. We have a super prime portfolio exposed to the highest rental growth submarkets across Europe, supported by our market-leading operating platform, which unlocks value.
Our superb land bank gives us significant further opportunity with complete optionality and we will continue to invest in our business by prioritizing responsible SEGRO through our day-to-day activities and we will give you more details and a full update on progress against our commitments with our full year results.
In conclusion, then we are feeling positive. SEGRO is structurally advantaged to outperform. We are on track for another very strong year of rental growth. Future earnings will be driven by the 52% rent roll uplift from capturing that existing reversion and completing our development program current and near-term and property investors retain their conviction to the sector. Investment market activity is increasing and recent transactions give support to current levels of valuation.
So that concludes today’s presentation. Thank you for your attention. We are now going to move to questions. We will take questions in the room first of all and then we will open up the webcast and the conference line, and we would really appreciate it if everyone would initially let themselves to 1 question just to ensure that everybody else gets an opportunity to contribute. So who would like to kick us off first. Marc?
So only one question, so it’s going to be easy. So Marc Mozzi, Bank of America. The one from my side would be, what will be the cost to acquire the optioned land or optionized land that you have in your balance sheet? What is the total amount of investment that will represent, because if I understand well, the constant acquisition of land bank, we have seen over the last three years now has been essentially driven by this item and I would like to know how much we should forecast for the...
You are asking about the cost of the option land?
Well, I know the cost, which is £27 million, but…
Yeah.
… how much raising that option will cost you as an overall investment.
A few -- yeah. I mean, there’s a lot of detail behind that in terms of -- some of it is optioned land and some of it is land that we have acquired condition upon a building permit or a planning consent.
The best way to try and work out the overall cost is to reverse engineer it. If you take the rent we have given and assume somewhere between 7% and 7.5% development yields, you can back -- you can reverse engineer what the cost of the underlying land will be from that or the total investment at least from that.
So I need another items on that front is, how much does the land represent to the overall CapEx, is it 15%, 20%, 30%?
Well, it depends what it is and where it is, because a super prime site in London, which there’s some in there or data center site, it’s going to be a very large part of the total cost, whereas if it’s a logistics site in Poland, it will be a much smaller part. So we haven’t given that breakdown just yet.
I have done a guess, which is around £400 million.
£0.5 billion is about right.
Yeah. Okay. Thank you.
I mean, generally, yeah, I mean, you are right. I mean some of the sites I mentioned, Radlett. We have been working on that, I would say, last 18 years since we started on that side with an option, which is why it’s such a special opportunity. We are generally, I mean, look, we have got a fantastic land bank. We have got plenty of land now for our midterm development needs. It really is quite a unique asset.
We are going to be adding a bit less to the land bank going forward in terms of straight land purchases, but increasingly looking to do things in a capital light way where perhaps we get an option if it’s conditional on a zoning or a planning permission and the gap between spending the capital and turning into income producing is shorter. So we are very aware of that and within all of these, we still have optionality as to when we push the button, as I said earlier. Thank you. John?
Good morning. John Cahill from Stifel. I noted your comments about you will now look to sell some assets to fund the development opportunities that you have. Would you also consider third-party capital or joint ventures if the right potential partner came along?
Should we say -- yeah. I mean, look, the -- we -- I mean, potentially, yes, but we have always been very conscious that having a balance sheet and a business that is easy for people at least in the public markets to understand and interpret rather than having too many complex JVs make life more difficult is something that’s actually worth having.
We look at the whole portfolio, as Soumen said, we are scrubbing the portfolio constantly, where we are trying to bottom slice. Generally, we will -- we are looking to raise more disposal proceeds to fund development, because, frankly, the cost of debt is so expensive, and in an environment like this, equity is also quite expensive. Third-party capital is something we have done once in a big way with the SELP joint venture. I wouldn’t rule it out in the future. But it’s not something we are actively considering right now. Yes.
Calvin Maly [ph] from Kolytics. So just one question. So given the market outlook is a bit uncertain and that you are a net investor and given where the shares are trading today are a material discount to NAV, why not go completely the other way and a ramp-up sales even more than the 1% to 2% you have guided, even though you might have to take a small haircut on the valuation there and invest more?
Go ahead, Soumen.
Look, ultimately, we -- we are a long-term business and then I think we have said in the past, we -- as a long-term REIT, we have got to navigate through short-term economic cycles. And the reality is we -- for all the reasons David has outlined through the presentation, we still remain very, very confident around the outlook for occupier base, and therefore, the ability to really drive returns through that period.
We are going through a period of time right now where the cost of capital is resetting and we believe the right way to really think about how capital base of that at this time is to really between the three sources of equity, there are three sorts of capital that we have equity, debt and disposals to put a bit more emphasis on the disposal side and a little bit less emphasis on fresh, new capital.
So this is really about how best do we really take advantage of the opportunity we see in front of us in our customer base. We have got some great land in front of us to be able to develop it through and it’s really about how we fund it as well. Rather than taking any short-term big changes in strategy because that’s, frankly, what we believe will drive the value through the cycle.
Anymore in the room? Okay. We are going to go now to the conference line I think. I have got a couple of questions hopefully coming through. Operator, do you want to open the line up?
Absolutely. Yeah. Thank you. [Operator Instructions] Our first question comes from Frederic Renard from Kepler Cheuvreux. Your line is now open. Please go ahead.
Hello. Thank you for your presentation.
Hi.
Hi. Good morning. Just one question on my side. Can you comment on the occupancy rate in Greater London? I see that at the end of 2021 was still above 95%, today below 93% for us to know. I wanted to know a bit the rationale behind that?
Yeah. So the question, I think, about the relatively high vacancy rate in Greater London. It’s a good question, and you see in the property book, there’s a bit more detail on where the vacancy is. Basically, it’s mostly in that A40 Corridor, so Park Royal, Greenford and Perivale Park.
Just to explain that, so there are a few things going on here. One is -- and the context is worth noting, this is the market where we have the highest rents and have had the highest rental growth. It’s setting new rental levels in Greater London. So what we -- and it’s also where we have because it’s a very long-standing part of the portfolio.
We have some of the older sites, which we have been holding with the intention of redevelopment and in some cases, refurbishment. I gave the example of one of the assets in that Greenford market, where we have refurbished it to super high level and where we expect to be able to double the rents compared to where they were.
So what we are trying to do is progressively bring back assets on some of those estates. In some cases, they are individual holdings where we are just taking something back for a light reversion in some of them, what we now call SEGRO Park Greenford Central used to be called Northala Park [ph], those who know the market well. That is a much bigger estate where we want to redevelop the whole site.
So we are bringing back and we have been consciously trying to bring back a number of buildings onto short leases and indeed create vacancy or vacant possession so that we can undertake a redevelopment and that’s where we have been pushing quite hard.
There are a few examples where we have moved businesses out. I talked about Tottenham, created a new scheme there. We have moved some business out of the park rural market into higher priced space brand new in Tottenham. That’s again released some space for redevelopment and refurbishment. So it’s really about the kind of the asset management journey we are on in Park Royal.
And yeah, one or two vacations as well. One due to insolvency, and one, I can’t remember why the reason they left, but we have got good interest and a couple of those bigger units under offer at the half year. So, hopefully, that will make some progress as we go through the months ahead.
Thank you, David.
Thanks, Fred.
Thank you, Frederic. Our next question comes from Rob Jones from BNP Paribas. Your line is now open. Please go ahead when you are ready.
Great. Thank you. Yeah. Good morning, team. And I am looking at slide 30 of the presentation where it talks about the potential rent of £1.4 billion of rental income to come and I am wondering whether, given, obviously, as you talked about earlier, the higher cost of equity, higher cost of debt going forward and the right decision to be in top of the slide, let’s call it, you accepted the portfolio [ph] per annum. When we look at that total potential rental income, I wonder if it’s worth putting in a bar that shows income lost from disposals, because the way I interestingly think about it is you are selling two-third of the portfolio coming over a 10-year time horizon, that’s 20% portfolios. So you lose 20% of the passing rent roughly maybe 20% of the version and maybe 20% of the vacant space that could be filled, which could be $100-plus million. I was wondering what your thoughts are around that or if you have got any other comments? Thank you.
Thanks, Rob. No. It’s a fair point. I guess on the other side, what we have always tried to do with this graph is to map the current position as at the valuation date. And so there’s two boxes that we have got labeled there is, we very deliberately aren’t trying to kind of look into the future.
So we are not spooling forward for the rise in ERVs that we would expect, 2% to 6% guidance we have consistently given, we haven’t factored into these numbers. We also clearly not factored any further indexation in and nor do we take into account that redevelopment opportunity.
Dave just talked about some of those things in London, where we are taking assets out of circulation bit by bit to create future redevelopment opportunity. We have not put those numbers into here.
But it’s a fair point. There is a -- what you have on one side, you don’t have on the other. But ultimately, there is a cost to producing that, particularly that right hand two grey bars. Either we have got to pay the cost of finance or we have got to raise equity or there’s a loss of income from rent, because it’s not singular, we don’t try and map it on here, but it’s something to keep an eye on, because it drives overall…
I mean that’s…
…return.
…the point, isn’t it? I mean disposals is one of the funding options. We have been very clear that right now, we see an opportunity and we are attracted to the idea of accelerating disposals in order to fund more of the development program, but it might be something different in a year’s time, we will see how markets evolve.
I don’t think we would necessarily be confident to say we are going to fund all of this future development through disposals. As Soumen says, we have a range of funding options and we will adapt according to the market environment at the time. But…
Okay.
… it’s a fair challenge. We are only giving you one side of the equation and you are quite right, there’s a funding piece to think about, as well as the investment piece.
I guess one of the reasons why…
Thank you very much.
… we actually broke this chart into two a year or so ago, which is to make the point that actually the middle block here, that growth of red one from £605 million to £921 million is actually very, very capital light, because really to drive that, it’s about capturing the reversion, that big dark grey bar in the second block and actually to work our way through the current pipeline in the near-term is only £365 million of CapEx. So actually the return on capital and the drive in rents that we get through there is very high in terms of driving our overall group returns on capital.
Great. Thank you very much.
Thanks, Rob. Our next question comes from Max Nimmo from Numis. Your line is now open. Please go ahead.
Good morning, guys. Thanks for the presentation. Sorry, I couldn’t be there. And one quick question, you mentioned that two-third of the caps on your debt are in the money and what are the caps on that further third that they haven’t kicked in at this point? Thanks.
So our cap range from kind of 2.5% up to about 4% and most of the caps are in EURIBOR, and obviously, as we also see what ECB does later on today. I’d imagine virtual or then we will be in the money by the end -- by the turn of the year if ECB forecasts are correct.
Great. Thank you.
Thanks, Max. Our next question comes from Paul May from Barclays. Your line is now open. Please go ahead.
Thanks so much. Thanks for the presentation, guys. And I want to ask my first question, which was around sources of funding, seeing as you are quite adamant on where you see that at the moment. Just wondered on the SELP performance fee. I think in the past, you have generally taken it in the reporting period and then excluded it from comparators, so kind of getting the best of both worlds, why now have you decided that that’s no longer appropriate?
So, look, I think, given the level of market volatility, it’s becoming harder and harder for us to try and recognize a number before the value -- before the data becomes due and you can see it bouncing around a lot.
And look, sitting here today, the number is €160 million as at the June valuation. So you take a very big move to wipe that out in the second half. So sitting here today, I am hopeful that we will receive something. Can I give you a view as to what that number is? It’s tough.
The thing is it’s going to kind of therefore impact every kind of reporting period from now through to 2025, because it will be in this year’s actuals, it will be in next year’s comparatives. And an adjusted profit number that I think, as I said, should we really be trying to give you a sense to what the underlying business is doing. I think having that level of choppiness, we felt actually just isn’t ideal. So that’s why we have chosen to make the change.
Yeah. Thank you.
Thanks, Paul.
Thanks, Paul. [Operator Instructions] Our next question comes from Pieter Runneboom from Kempen. Your line is now open. Please go ahead.
Good morning, team. Thanks for taking my question. We have already had some discussions on whether to use the marginal or FFO [ph] cost of debt from the development CapEx. I was wondering what number you currently use for the land for new developments, of course, the capitalized interest moved up quite a bit and had a positive impact on FFO growth. So on the land cost, do you use the capitalized interest based here on the margin cost of debt or the average cost of debt and when do you start capitalizing interest costs on the land used for development? Thanks.
Sure. Soumen?
Yeah. So in terms of -- Pieter, if I understand the first part of your question correctly, it’s kind of what’s the rate of interest do we think about when we are looking at new projects and new opportunities, is that right?
Yeah. And it’s -- yeah, so and specifically on for the land, where you talked [Multiple Speaker]
So on the land that we have acquired in the first half, so when the investment committee receives that appraisal, the teams are worked up. Obviously, that will -- the whole premise of buying the land is the future development they will run through.
So there will be some interested in there in terms of the rate in which we work through that land, the construction costs and the finance cost, and the finance cost, we use as a spot rate. We update it every month based on what we think our marginal cost of borrowing is.
And as I said in my remarks, that number has ticked up a lot from kind of 1% to 2% 18 months ago to over 5% today, depending whether it’s sterling or euros. So we are incorporating when we are thinking about the future profitability of our -- of any new opportunity in front of us, whether it is land or development, their cost of funding is it at current spot rates. And…
Very sorry…
Go ahead.
Sorry, just…
Yeah.
… which, of course, if you think about it, it’s exactly what anybody would do who’s doing specific project finance.
Yeah.
You would charge the specific cost of that debt funding for that project to the project. The slight difference here is, because we have corporate level unsecured borrowings. We have got this huge pool of capital.
But we think when we look at our own appraisals, we are looking -- as Soumen says, we will allocate and charge interest to the project based upon the then marginal rate. So we don’t think there’s a question whether that’s the right thing or not to do, it’s what any developer would do.
That’s right because it’s the same as every project has a specific cost, whether it’s construction cost, the planning costs, the finance cost, it’s got to kind of stack up at the point at which we are pushing the button, and therefore, the cost against it are then charged on a specific basis.
In terms of when that happened? Look, we have -- the accounting standards essentially allow one to capitalize interest as long as that project is being taken forward, which is quite a wide definition. The way we have always done this is to say that actually, it’s only on the point at which we have work going on, on site, do we start to capitalize interest against it.
Now typically, on the volume of development CapEx, that’s buildings up here in production, that runs through in about a 12-month period. But there are a smaller number of larger, longer term sites, things like Coventry and Northampton, where the infrastructure has been going in for 18 months, but obviously, the full site will not be developed through for a number of years.
So those sites are also being capitalized as well. They say we don’t capitalize the entire land bank far from it. We capitalize the minority of it. But only those assets that are actually -- well, there’s actually something going on in terms of physical activity.
And it ceases -- I think there was a question about when it ceases.
So at the point at which PC or the practical completion is taken, whether or not there’s an occupier in situ or not. At that point, the capitalization will stop, and at the next revaluation, whatever costs have been booked to date, again, whether it’s planning costs, construction costs and finance costs will be netted against the next revaluation and the interest costs from that moment on will flow straight into the income statement as it does now. Does that help, Pieter?
Yeah. Yeah. This helps a lot. That’s very, very detailed answer to my question. That’s very helpful. Thank you.
Pleasure.
Thanks, Pieter. We now have a follow-up question from Paul May from Barclays. Your line is now open. Please go ahead.
Hi, guys. Sorry, I had just very quick one. The statement notes, I think, disposal post-period end balance book value. Just wondered if you can give us any color on the size and the profit versus book value, that would be great? Thanks.
Profit, so we can’t give you the number, because we are bound by a confidentiality agreement. But it is -- take it, it was a meaningful size, otherwise, we wouldn’t have mentioned it in there. We can’t give you any of the specific metrics. But as we said in the release and I think I covered it briefly, it was sold a little above June book value and indeed above December 2022 book value.
Okay. I presume the numbers will come out in the full year results.
I am sure they will come out in the Wall Street [ph] at some stage.
Okay. Thanks.
Thanks, Paul. We have no further questions registered on the phone lines. So I will now hand back to the management team.
So have we got any questions on the web? Yeah.
We have, yeah. Just one question on the web from Mike Prew, Jefferies. He’s asking about the valuation of land during the period and whether there are any changes in the values assumptions on this.
Sure. Of course. And so I think as we -- as the highlight, those land banks got a very, very wide spread of projects in it and the land has been accumulated over a number of years. Typically, the longer dated land has got -- probably has some higher levels of embedded profit.
The dates on the land has been marked for data centers and data centers of the land is held up extremely well, some of the land we bought a little bit more recently has been marked down a little bit more. So across the whole portfolio, it’s down just under 4%.
But no change in the approach. I mean the…
Yeah.
… values approach is consistent. They are just being a bit more conserved in terms of where it is. I mean, it’s fair to say notwithstanding a couple of our very unique purchases. There hasn’t been a vast volume of land transactions. So to be fair to the values, it’s very difficult to get that right, but they have adjusted down a little bit.
That’s everything from the web.
Great stuff. Right. Thank you very much everybody for all your calls and your questions this morning and have a great day.
Thanks all.