Good afternoon and welcome to the Custodian Property Income REIT plc investor presentation. Throughout this presentation, investors will be in listen-only mode. Before we begin, I'd like to submit the following poll, and I'd now like to hand it over to Richard Shepherd-Cross, Managing Director. Good afternoon, Giselle.
Hello and welcome to this short webinar, restating the rationale behind the recommended all-share merger between Custodian Property Income REIT and abrdn Property Income Trust, which I'll refer to as Custodian and API during this webinar. I'm Richard Shepherd-Cross, the investment manager to Custodian, which we launched 10 years ago and have grown through issuance and acquisition to gross assets of over GBP 600 million. Due to the restrictions of the takeover panel code, I won't be answering questions at the end of this webinar, but if you do have questions, please direct them through the Q&A tab on the right-hand side of the screen, and they will be picked up by Frostrow. Custodian approached the board of API last year to propose an all-share merger of the two companies.
Following a reciprocal due diligence process and the announcement of the recommended merger in January, I'm delighted to be discussing the recommended merger, which is a further step in pursuing Custodian's ambition to be the REIT of choice for private and institutional investors seeking high and stable dividends from well-diversified U.K. real estate. Since the announcement of the recommended merger, there have been some, albeit limited, calls for the board of API to consider a managed wind-down of their company and the announced indicative offer made by Urban Logistics REIT, or I'll call them ULR. And I will pick up on these developments over the next few minutes.
As you may be aware, the recommended merger is expected to bring together two complementary portfolios to create a differentiated REIT with gross asset value of over GBP 1 billion, made up of approximately 200 regional properties diversified by asset, geography, and tenant, to champion an income-focused strategy secured against below-institutional-sized assets. In line with Custodian's strategy since inception, post-merger, the combined group's average asset size will be under GBP 10 million with low gearing, which should deliver a marginal income advantage and continue to support a fully covered and sustainable dividend from the combined group's shareholders.
The strategic alignment between Custodian and API is striking, and shareholders in the combined group are expected to benefit from a balance between the main commercial property sectors in keeping with each of Custodian and API's existing policies, including significant exposure to the industrial sector representing 44% of the combined group's estimated rental value as of December 23. This sector continues to benefit from low vacancy levels, limited new supply, strong occupier demand, leading to rental growth. We also expect the combined group to benefit from a meaningful reversion, with the combined estimated rental value of GBP 84.3 million exceeding the combined passing rent of GBP 68.1 million by some 24% as of December 23, and a shared commitment to sustainability underpinning the shared asset management strategy with 81% of the combined portfolio holding an EPC rating of C or above.
Custodian's investment manager, Custodian Capital, will be mandated to manage the combined group following completion of the recommended merger. Expected cost savings come from a proposed reduction in management fees paid to Custodian Capital due to its tiered fee structure and the removal of duplicated corporate expenses and other potential operational efficiencies, which total GBP 1 million per annum, as well as Custodian Capital offering a reduction in management fee during the two-year transition period following completion, and a nine-month fee waiver on the management of the API portfolio, which is expected to save the combined group costs of GBP 2.1 million and GBP 1.5 million, respectively. And finally, and perhaps most importantly, the continued commitment to paying a fully covered dividend remains a key focus of the enlarged business. This slide looks at the investment strategy that underpins the strategy of the property portfolio post-merger.
The combined portfolio is expected to have an average lot size of GBP 5.1 million, benefiting from the yield advantage that's available for below-institutional lot sizes, the threshold for which is widely regarded to be approximately GBP 10 million. A fundamental element of Custodian's strategy is to target these smaller-sized properties, principally characterized by, as I said, individual values of less than GBP 10 million at acquisition, to capture the yield advantage available relative to larger-sized properties. This chart, which is central to the strategy, shows the average difference between the net initial yield of properties traded in the market with lot sizes of over GBP 10 million that's represented by the light blue line versus lot sizes of under GBP 10 million represented by the dark blue line.
As you can see from the data sourced from property data from 2010 to 2023, there has been a transaction yield advantage of approximately 150 basis points for pursuing the smaller lot strategy compared to a narrower margin pre-2010 of approximately 60 basis points. The Custodian board believes that this yield advantage since 2010 is not reflective of a rise in risk associated with smaller properties, but instead due to a change in the supply and demand dynamics in the market. The Custodian board believes these dynamics are principally caused by an increase in investor strategies that pursue larger-sized properties, but with a restricted supply, demand has resulted in pricing pressures and a reduction in transaction yields. This has coincided with those same investors reducing their exposure to smaller-sized properties, lessening demand while increasing supply, easing pricing pressures and yields.
These market dynamics underpin the strategy, which is consistent across the combined portfolio and will remain a central plank of investment policy as it delivers a higher income return from a low-risk portfolio. So why do we believe the recommended merger represents a superior offer for shareholders when compared to the terms of ULR's indicative offer or, indeed, a managed wind-down of API? Based on the undisturbed share price, that is, before the announcement of the recommended merger and before the ULR indicative offer, and based on the current share price of Custodian, the recommended merger represents a premium to the ULR indicative offer of 5% and 6%, respectively. Custodian also has a history of a stronger rating to net asset value, which over the past year has shown an average discount of only 11% versus ULR at 27%. Balance sheet strength and refinance risks should be a key consideration.
The Custodian portfolio delivered an EPRA topped-up net initial yield of 6.4% as of September 23, which is comfortably in excess of the weighted average cost of debt of 4.2%, thereby enhancing earnings. The near-term expiry of fixed-rate debt at Custodian is limited to a GBP 20 million fixed-rate loan that expires in 2025. But the board believes that based on current gilt rates, it would be possible to refinance this quantum at a rate below the EPRA net initial yield of the portfolio, which would maintain the accretion to earnings. By contrast, the ULR portfolio delivered an EPRA topped-up net initial yield of only 5% as of September 23, which is currently in excess of its weighted average cost of debt of 4.1%, thereby enhancing earnings, albeit insufficiently, to cover their prevailing rate of dividend.
Their near-term finance cost risk also occurs in 2025 when its GBP 151 million term loan facility and the associated interest rate swaps expire. This is a significantly greater amount of borrowing that needs to be refinanced and potentially hedged. And the Custodian board believes that based on current refinancing rates, this would present a risk to the earnings of ULR, given that it is unlikely that a market hedge for this portion of ULR's debt would be at a higher rate than the EPRA topped-up net initial yield of 5%. The board of Custodian believes that the current share price materially undervalues the company and is confident in the potential restoration of the superior rating relative to valuation at which Custodian shares have historically traded. In terms of the recommended merger, keep diversification central to the strategy of the combined group.
Going forward, as these charts show, the two portfolios are highly complementary in this regard, with a combined weighting by estimated rental value to the industrial and logistics sector of 44%, retail warehousing 18%, and offices, high street, and retail sectors at 26% and 12%, respectively. One of the strengths of a diversified strategy is that it acknowledges the cyclicality of both occupier and investor demand. It allows the portfolio to perform in a variety of market conditions and to find those mispriced assets and make counter-cyclical adjustments to secure both future rental and capital growth while also being supportive of long-term sustainable dividends. One of the strengths of the smaller lot strategy is that it necessarily delivers greater diversification. This pie chart demonstrates graphically and clearly the real benefits of diversification when no one tenant in any single property accounts for more than 2% of the rent roll.
The largest tenant, B&Q, represents only 3.6% of the rent roll. Yet this is spread across three separate and geographically diverse locations. As you can see, many of the top 20 tenants listed on the right are well known as good quality businesses. In the view of the Custodian board, Custodian and API share an income-focused investment strategy with an emphasis on regional, below-institutional-sized assets that are well positioned to capture the rental growth and yield advantage available in order to generate higher income returns and capital growth for shareholders. Custodian currently pays a quarterly dividend at an aggregate annualized level of 5.5 pence per share, representing a 5.9% yield against net asset value. This is fully covered by recurring earnings, with cover of approximately 102% for the year to March 2023.
Following the recommended merger, Custodian is expected to continue paying a fully covered quarterly dividend in line with its existing policies and practices since IPO. And this would result in a 7.3% uplift in annual dividends payable to API shareholders. ULR currently pays a semi-annual dividend at an aggregate annualized level of GBP 0.076 per share, representing a lower yield against net asset value of only 4.7%, which is not covered by recurring earnings, with cover at approximately 91% for the year to March 2023. The Custodian board believes that the continuation of the existing ULR dividend policy following completion and of the ULR indicative offer would imply a 10.9% reduction in annual dividends payable to API shareholders, which would continue to be paid on an uncovered basis.
This would represent a 20.4% reduction compared to the annual dividends expected to be paid to API shareholders following the recommended merger. Furthermore, the ULR indicative offer includes a GBP 0.0245 per share special dividend payable only to ULR shareholders. This payment reflects a greater than pro-rated dividend expected for the relevant period, which API shareholders would not benefit from as it is payable, as I said, only to the ULR shareholders. As I mentioned earlier, we are seeing strong occupier demand and rental growth across both the recommended merger portfolios. This portfolio, this chart shows the rental reversion of some 24%, with approximately half coming from rental growth and the balance from the letting of vacant space. It's this rental growth that will continue to support both capital value growth and ongoing dividends, the two principal components of total return.
A low-institutional lot-sized strategy does not mean that you must forgo the quality of income. This chart shows the combined portfolio following the recommended merger, which will be consistent with existing credit risk metrics of both portfolios, with over 80% of tenants in the combined portfolio being considered lower than average risk by Experian. All this needs to be considered against a managed wind-down of the portfolio with the aim of returning cash to shareholders. The Custodian board believes that the API shareholder returns potentially available from a managed wind-down of the API portfolio are inferior to those from the recommended merger, not least because a managed wind-down is rarely as orderly as the term suggests. A managed wind-down potentially involves value erosion, loss of future rental reversion, negative impact on share price, and liquidity. A wind-down needs to be considered in the light of market timing.
The board of Custodian believes it may be suboptimal timing for a wind-down. The Custodian board believes that the current and anticipated market conditions are not conducive to wholesale program of disposals, with the office sector being of particular concern. While the Custodian board acknowledges that the property market is cyclical and a market recovery could lead to a managed wind-down being seen as a route to fair value, it would take time. It believes that the below-institutional-sized property segment in which API's portfolio is invested does not tend to benefit from the early stages of a cyclical recovery. Typically, that target segment of the market is dominated by debt-funded buyers. The Custodian board would not consider it an optimal time to dispose of properties until interest rates have fallen and commercial property debt costs look more attractive.
Additionally, it may be particularly challenging for a public company given its transparency to the market and the likelihood of opportunistic buyers seeking to extract value. Furthermore, the Custodian board notes the estimated rental value of the API portfolio is currently GBP 7 million above the current contracted rent, representing significant reversionary potential in the portfolio. The Custodian board expects a sector-led disposal program of API assets by ULR will restrict the extent to which the API shareholders would be able to capture this potential latent value. The Custodian board anticipates that a prolonged period would be required for a wind-down to deliver material distributions to API shareholders. Factors in this assessment include the practical processes to realize assets, even where such assets are deemed saleable, including preparation of property for sale, appointment of agents, coordination of the sale process, completion conditions, and financing.
Other factors include the requirement for a market recovery in respect of certain sectors, which API portfolio is significantly exposed to, and the fact that distributions to API shareholders are unlikely to be forthcoming until bank lending is settled. Additionally, the Custodian board anticipates that API would, through a wind-down process, be exposed to increasing portfolio concentration, with a growing focus over time on a rump of residual assets, which often, regardless of their ability to produce income, have proven unsaleable for fair value. There is the potential for income to reduce in the medium term. The Custodian board anticipates that this could occur, for example, due to an increasing expense ratio as the costs of administering a public company are to a significant extent fixed.
The Custodian board believes that the challenges we have discussed are factors which influence the relatively wide discounts to NAV and declining secondary market liquidity that are often experienced by companies opting for a managed wind-down. Market timing will, in large part, be influenced by debt markets, as already discussed. Market expectations of interest rates suggest that at current levels, it is a suboptimal time for disposals. The final point to consider with a recommended merger is the impact on the balance sheet. As discussed in a wind-down, outstanding debt will need to be settled from the sale proceeds before distributions can be made to shareholders.
However, following the recommended merger, the balance sheet strength of the combined group will have a diversified debt portfolio with an aggregate GBP 225 million of fixed-rate debt expiring in 2025, as we've mentioned, 2026, 2028, and 2032, thereby creating no cliff edges in the ongoing financing of the company. The GBP 125 million of drawn revolving credit facility provides short-term financing flexibility. We expect this to be paid down in part following the completion of currently agreed sales drawn from both sides of the combined company. This will support earnings. As disclosed in the recommended merger announcement, the combined group would deliver an EPRA topped-up net initial yield of some 6.2%. Based on current gilt rates, it would be possible to refinance the first fixed-rate loan expiry in 2025 at a rate below the net initial yield, maintaining an accretion to earnings.
So, in summary, the board believes that the enlarged Custodian Property Income REIT will remain true to its core principles of income-focused returns, paying fully covered dividends with greater diversification, increased reversionary potential, and a robust balance sheet. We believe that all shareholders will benefit from the increased scale, aligned strategy, rental reversion, liquidity, balance sheet strength, and the market presence of the larger merged entity. The Custodian board believes that this is a superior proposition to the ULR proposal for the reasons discussed and preferable to a wind-down, which faces a challenging market and gives away rental reversion built up in a well-managed and carefully curated portfolio and could lead to a protracted period of share price weakness and illiquidity, two of the key challenges the recommended merger hopes to fix. Many thanks.
Perfect, Richard. Thank you for updating investors today. Could I please ask investors not to close the session as you now be automatically redirected to provide your feedback in order that the management team can better understand your views and expectations? This will only take a few moments to complete. Some shall be greatly valued by the company. On behalf of the management team of Custodian Property Income REIT plc, we'd like to thank you for attending today's presentation. Good afternoon to you all.