Land Securities Group plc (OTCPK:LSGOF) Q2 2023 Earnings Conference Call November 15, 2022 4:00 AM ET
Company Participants
Mark Allan – Chief Executive Officer
Vanessa Simms – Chief Financial Officer
Conference Call Participants
Hemant Kotak – Kolytics
Osmaan Malik – UBS
John Cahill – Stifel
Kieran Lee – Berenberg
Paul May – Barclays
Mark Allan
Very good. Ladies and gentlemen, good morning. Welcome to the Presentation of Landsec’s 2022 Half Year Results. As usual, in terms of agenda, I am going to start with a brief overview of how we are positioned as a business and the key highlights from the half year before taking you through each of the three pillars of our strategy in more detail in the operational review. Vanessa will then take you through the financials. And after a quick summary, we will then open the floor for questions.
Now since our full year results in May, our global economic and financial market conditions have of course changed materially. Rising inflation and bond yields have started to put pressure on values across every asset class, including property. And we believe that this value adjustment will likely continue. Now the exact extent of this repricing will of course depend where interest rates settle over time, which is difficult to assess. But what is clear is that we are unlikely to go back to the ultra-low interest rate environment of the past decade.
Now importantly, the new strategy that we launched in late 2020 was never based on the idea that that low rate environment would persist as we deliberately built our strategy around two key principles of sustainable value creation. Firstly, to focus our resources on areas where we have a genuine competitive advantage and secondly, to preserve balance sheet strength and our actions since then have been firmly concentrated on those two principles. Now in late 2020, yields in many sectors were very low, contributing to our view that asset values in those sectors looked full. And as such, we focus instead on selling mature London offices where our ability to add further value is limited. And we’ve now sold nearly £2 billion of these assets on average, just 1% below book value.
And we focused our investments solely on opportunities where we saw clear value or that we felt offered long-term optionality. And that’s reflected in the attractive income returns on our investments at Bluewater and MediaCity and in the acquisition of U+I, which added significant urban development optionality at a low cost. Whilst we deliberately chose to stay clear of venturing into new sectors, which happened to be in vogue at the time where we didn’t have competitive advantage and where record low yields are now correcting rapidly.
In terms of our balance sheet, we said we would reduce financial leverage. And since then, our net debt is lower, our LTV is lower and our net debt-to-EBITDA ratio is lower. Our strategy has been well executed, remains the right one and it provides us with significant resilience, underpinned by our three key competitive advantages: our high-quality portfolio; the strength of our customer relationships; and our ability to unlock complex opportunities through our extensive development and asset management expertise.
As a result of the successful execution of our strategy, we are now well positioned for this new market reality. Our portfolio quality is high, which is an increasingly fundamental decision drivers for customers, be that in office or retail. We have been decisive in allocating our capital to where we can add genuine value and reducing our investment in those assets where we believe we can’t. We have unlocked new valuable long-term development optionality that can drive future growth through several innovative deals either via major lease restructurings within our existing portfolio or via our acquisitions of U+I and MediaCity, although importantly, we retain full flexibility on the timing of any future capital commitments. And we have further strengthened our balance sheet with a low 31% LTV, net debt-to-EBITDA of around 8x by the year end, taking into account the full year effect of our recent disposals and average debt maturity of nearly 10 years and no need to refinance any debt until 2026. And all of this means we are in good shape to take advantage of the potential opportunities that will no doubt arise over the coming 12 to 18 months as the market continues to adjust to a new reality.
So turning to our performance over the half year, the strength of our customer relationships and quality of our portfolio clearly continue to underpin our positive operational momentum. In London, we delivered another period of strong leasing, driving further ERV growth. We crystallized significant valuation and development gains, and we made further progress on leasing our current pipeline with deals across the portfolio over the last 6 months on average 3% above ERV.
In retail, we signed or are in solicitor’s hands on £27 million of lettings on average, a marked 12% above ERV. Retail sales have continued to grow with like-for-like sales ahead of pre-COVID levels now. And we have delivered an increase in occupancy of 1.2 percentage points since March to 94.4%. And finally, in mixed use, we have made good progress in terms of planning and preparing our pipeline. So whilst we maintain full optionality, we could potentially start the first phases of Mayfield, MediaCity and Finchley Road as soon as next year.
Turning now to our financial results, we have delivered 9% growth in EPRA EPS, supported by our strong operational performance, which drove 8.3% growth in like-for-like rental income, whilst our dividend for the half year is up 13.5%. Unsurprisingly, our total accounting return and EPRA NTA have been impacted by rising bond yields, starting to put upward pressure on property yields for us, principally in London offices. But this impact has been mitigated by strategic actions already taken, principally around disposals. As a result of which, our LTV was down to 31%.
Now notwithstanding the changes in economic conditions, we remain convinced that in order to set ourselves up for long-term success, we need to continue to deliver sustainably, and we have made further progress on our long-term ESG ambitions. Our energy intensity was stable year-on-year despite the increase in utilization of our portfolio compared to the initial months post lockdown last year, which means we are still on track to reduce energy intensity by 45% by 2030 versus the 2013, ‘14 baseline.
We are now progressing detailed preparations for the £135 million net zero transition investment plan that we announced a year ago and are on track to start the first retrofit of air source heat pumps next year. 43% of our office portfolio is already rated EPC ‘‘B’’ or higher. That’s the required 2030 benchmark, and that compares to 15% for the overall market. And we expect this to increase to over 50% by 2025, after which the real impact of our net zero investments will start to come through. And this plan, of course, moves us to 100% by 2030. Earlier this year, we also announced the next leg of our net zero plans, our target to reduce embodied carbon by 50% to less than 500 kilograms per square meter. And several of our near-term projects already show the benefit of our focus on designing buildings in a smarter, less carbon-intensive way.
Now the presentation that many of you saw in our recent Capital Markets Day, which is available on our website, contains more details. And finally, we also announced the launch of our realizing potential fund, which will see us invest £20 million to enhance social mobility in our industry and empower 30,000 people towards the world of work by 2030. These targets are ambitious, but they will make sure that Landsec remains at the forefront of driving change in our industry.
So with that, I will now talk you through each of our three business areas in more detail. And starting with Central London, where we have continued to see strong leasing momentum following our year of record leasing last year. Overall, we expect more flexible ways of working will reduce demand for conventional office space across the UK, but the impact of this will not be uniform across every asset and location. We expect large headquarter type space or areas which offer little reason to visit besides doing a job to see a more significant reduction in space requirements. Whilst demand for attractive energizing places which offer people a genuine reason to want to spend time there will be much more resilient. So whilst we continue to see some customers downsize, others take more space. The one trend in terms of demand, which is really clear, is that for virtually all customers, quality has become the most important decision driver. And this is where Landsec is well positioned as nearly half of our portfolio has been built or substantially redeveloped within the last 10 years. And its sustainability credentials are already materially ahead of the wider market.
Combined with our strong customer relationships, the impact of this is reflected in our strong leasing performance. As we signed or in solictor’s hands on £41 million of annual rent at levels on average 3% above valuers’ assumptions. Vacancy in our portfolio remains around half that of the overall London market as the small reduction in occupancy during the period fully recovered since the period end. So, overall occupancy remains at 95.1%, in line with March. The value of the high quality of our product offer also comes through in our current developments. We significantly derisked our pipeline with the disposal of 21 Moorfields in September which crystallized a healthy 25% profit on cost. So we now only have £110 million committed CapEx left to spend on our remaining three schemes. And once complete, these are expected to generate an ERV of some £38 million. And these therefore, provide significant upside to income at a low incremental investment here. And 38% of this is already pre-let or in solicitors’ hands with active negotiations on further lettings ongoing, including the first floors at The Forge in Southwark. And deals over the past 6 months have been, on average, 11% above ERV, which highlights the continued demand of modern sustainable space in locations with attractive amenities.
Now looking forward from here, our focus is on maintaining optionality in the face of ongoing macro uncertainty, but doing so without sacrificing momentum. Grade A availability remains very low. And if previous cycles are any indication, new construction starts are set to fall sharply, meaning that completions in 2 to 3 years’ time will be similarly constrained. We have three projects totaling 900,000 square feet, which could deliver by late 2025, and therefore, into that window of low supply.
With a gross yield on cost of over 7% and yield on incremental CapEx of over 10%, the potential returns on these projects look attractive. However, to avoid material capital commitments in times of elevated uncertainty, we intend to commit to £55 million of early works at the 2 projects ready to proceed, that’s Timber Square and Portland House, rather than sign full design and build contracts at this point. And this buys us 6 to 9 months before we need to decide on committing to the residual £400 million or so CapEx whilst maintaining a delivery program for 2025.
And now moving on to retail, where we have continued to see demand for prime locations grow. Now we’ve talked previously about online and physical sales increasingly being seen as interconnected by key brands. And these trends continue to build since then as the pandemic impact on consumer behavior has waned and an element of online trade has shifted back to stores. Indeed, over the last few months, the likes of Shopify, Next and Zalando have all acknowledged that the surge in online sales during the pandemic, which everyone took to be a permanent 5-year leap forward in online sales penetration, turned out to be more temporary as online sales have effectively fallen back to their pre-COVID trend.
As such, we continue to see brands invest in refocusing their efforts on fewer, bigger, better stores, which is driving a tangible increase in demand for spaces in our shopping centers, as you can see on the right. This shows almost 50 recent or current events where brands are upsizing and effectively doubling their space. Relocating into our centers from elsewhere in the city, or where we are growing our relationship by introducing them into new locations. Given the challenging economic outlook and pressure on margins, both offline and especially online, we expect this focus on rationalizing the tail end of store portfolios and flight to prime to further accelerate from here. So while the squeeze on consumer spending is, of course, something that we watch closely, we do not expect it to be the primary driver of occupier demand.
In terms of our operational performance, it is clear that our investments last year in strengthening our retail team and changing the way we operate to focus on brand relationships and guest experience is paying off. We have seen continued growth in brand sales, which has supported a 70% increase in leasing activity. We signed £12 million of lettings on average 20% ahead of ERV, which partly reflects a small number of new outlet deals at material premiums. But even adjusting for those, lettings on average were 15% ahead of ERV. And momentum has remained positive since with a further £15 million of leases in solicitor’s hands on average 7% above ERV. As a result, occupancy increased 120 basis points since March to 94.4%.
And based on our strong leasing pipeline, we expect this to increase further in the second half of the year. Our differentiated platform, strong customer relationships and growing insights into trading through turnover data increasingly provide us with a unique perspective on value in prime retail. Now as you can see on the right here, our brand sales have recovered significantly over the past 18 months, but rents remain much lower, which highlights the improved affordability of physical retail space, especially in comparison to distribution space, where occupational costs have grown materially and which, when combined with significantly higher online customer acquisition costs and transport costs demonstrates how the economics of online versus offline have shifted dramatically.
We have now let or relet a quarter of our retail rent over the past 18 months on average, 7% above ERV, which unquestionably underlines the sustainability of rents at these levels. However, the chart on the right also shows that valuations nonetheless remain at peak COVID distress and peak online penetration levels despite the reversal of the latter since then, and strong operational recovery in our performance over the past 18 months. Now the near-term macro challenges and limited availability of debt financing means this gap may well persist for some time yet. But in our view, this continues to suggest potential for attractive value opportunities.
And now on to the third part of our strategy, mixed-use urban neighborhoods, which, of course, we identified as an opportunity when we launched our strategy in late 2020. Now the structural growth trends underpinning this view remain unchanged and be that through demographic growth, driving demand for residential through urbanization, all the way the cities are changing with the lines between how people live, work and play, increasingly blurred and a growing focus on sustainable space that really delivers for its local communities.
Now our ability to unlock complex opportunities has added significantly to the optionality in this part of our business through last year’s acquisition of MediaCity and in particular, of U+I. Now the U+I and Landsec teams are now fully integrated into a single regeneration business, a business that preserves the best of both. And since acquisition, we have already sold or exchanged to sell around half of U+I’s noncore assets for £85 million and that’s on average 22% above book value. As such, our overall pipeline of mixed-use urban projects continues to offer an attractive blend of income returns, development outside and medium-term growth, especially in residential, with a balanced risk profile given our ability to phase CapEx commitments, the diversity of uses and the mix of locations.
Our progress on our mixed-use pipeline remains on track, while we maintain full flexibility about any future capital commitments. Since May, we have obtained detailed planning consent for the first phase development at MediaCity. And we’ve agreed terms with our JV partners at Mayfield for Landsec to have the option to fund 100% of the first phase of development, approximately one-third of the total project. We also expect a decision on planning at Finchley Road in the second half of this financial year. So this could allow us to start works on sites on all three projects as soon as next year.
Now we are obviously mindful of the potential impact of the changes in economic and financial market conditions, especially in the regions where returns can be more sensitive to changing conditions as a result of lower land values. But nevertheless, our pipeline provides significant optionality given the opportunity to deliver some 9 million square feet of mixed-use, sustainable, well-connected urban space relative to a current book value of around only £350 million. And with a current income yield of 6%, the cost of holding these sites is relatively immaterial.
And with that, I will now hand you over to Vanessa to talk you through our financial results.
Vanessa Simms
Thank you, Mark. Good morning, everyone. Our half year results reflect a period of divergence between a strong occupier market and a more challenging investment market. So let me start with our financial headlines. Our earnings performance has been strong with gross rental income up 15% and we have delivered a 9% increase in EPRA EPS to 26.6p driven by strategic acquisitions and a positive leasing performance.
Today, we declared our second quarterly dividend of 9p, which brings our dividend for the first half to 17.6p per share. This is up 14% on the same period last year, partly reflecting the lower payouts last year as we emerged from the lockdown. We expect the full year dividend to grow in line with the growth in underlying earnings. The material increase in interest rates since March has clearly put upward pressure on our property yields, which has partly been mitigated by strong leasing activity and disposals. But still, our EPRA NTA per share was down 5% to 1,010p. And our proactive capital allocation has further strengthened our balance sheet with LTV down to 31.1%.
Turning to EPRA earnings in more detail, which were up 9% to £197 million. Gross rental income was up £43 million. as a result of our acquisitions last year and strong like-for-like income growth, which I’ll explain in more detail shortly. We also had a £10 million increase in surrender premium, driven by a lease regear, which added 1.3p to EPS in this period. Direct property expenditure increased by £13 million, almost half of which was driven by acquisitions. The remainder of the increase was due to three factors: first, the higher letting fees as a result of the strong letting activity; second, the higher asset utilization as we were still in lockdown for part of the prior period; and thirdly, a small element of cost inflation, which has largely been offset by cost savings. Whilst in solvency activity in the period has been limited, we have retained a prudent debt provision, and we stay in active dialogue with our customers which is supporting our cash collections. Admin costs were flat in line with our guidance.
And next year, we expect admin costs to reduce despite inflationary pressure as our plans to reduce our cost base remain on track. Net interest costs increased by £7 million to £40 million principally due to our acquisitions last year, which resulted in an increase in average borrowings in the period. Disposals have reduced our net debt and our variable rate exposure. We, therefore, expect net interest costs for the full year to be only slightly higher than the prior period.
Our upper cost ratio at 26.2% is in line with the prior full year. This is up slightly compared to the prior first half and that’s due to the post-COVID normalization of trading and movement in bad debt provisions. Our target remains to reduce our EPRA cost ratio towards low 20%. The current high levels of inflation will likely extend the time frame in which we can achieve this. However, I am pleased with our progress with our cost efficiency initiatives, which we began over 12 months ago. Three of the most significant are centralized procurement, a more efficient operating model and our investment in technology and automation. And we have visibility on the benefits these programs will deliver in the coming years.
Moving on to gross rental income, which was up 15% overall and 8.3% on a like-for-like basis with positive growth across all segments. In Central London, we have delivered a 5.5% growth in like-for-like income as demand for high-quality assets is strong and London retail is recovering. Across major retail assets, our strong leasing performance has increased occupancy and growth in variable rent, and has delivered a 4.8% increase in like-for-like rental income.
In subscale, the impact was even more mild with a 23.3% increase largely driven by a strong recovery in hotel performance. The net impact of our investment activity added £16 million, principally driven by the acquisition of MediaCity and our share of Bluewater. The £10 million increase in surrender premium that I referred to earlier, relates to the Deloitte regear at New Street Square. The restructuring of their lease has opened up room for asset management initiatives across the estate in the short term whilst we work up medium-term redevelopment plans at Hill House. Our committed London office developments will complete over the next 8 months and will, therefore, increase income in the next financial year.
So turning now to the property valuation, where you can see the benefits of our strategic decisions. When we launched our strategy 2 years ago, we said we would focus solely on sectors where we had a competitive advantage. We also said we would reduce our exposure to mature London offices where yields were low, which has been timely as these yields are now correcting as seen in our half year results. Conversely, values in the two sectors that we have been investing in shopping centers and mixed-use opportunities have been resilient. So overall, our portfolio was down 2.9%, with strong leasing evidence driving 1.8% growth in ERVs.
Our Central London portfolio was down 4.4% as the increase in yields was partly offset by ERV growth of 2.6%. West End office valuations were more resilient than the city given the strength of the occupier demand in this location, and we expect this to continue. As you can see, our city offices had a decline of almost 10% in the period. Developments were broadly stable as our pre-letting activity drove an increase in ERVs, but this was offset by softening in yields. Shopping center valuations are up 1.1% with ERVs up 2.4%, reflecting the growing positive leasing evidence. Outlet values were down fractionally. That’s reflecting a marginal reduction in turnover income following last year’s strong lockdown inventory clearance. And our mixed-use portfolio was down just 1%, with a small increase in yields at MediaCity, offsetting the valuation upside at Mayfield.
Finally, our portfolio of subscale assets remained resilient as well, with hotels, in particular, benefiting from strong operational performance. We plan to trade out of the subscale assets over time, but we have deliberately focused our disposal activity on mature London offices over the past 2 years. Looking forward, we expect property yields will continue to soften in those sectors where they are the lowest. For us, this is principally London offices, although we expect part of this to continue to be offset by ERV growth, as the availability of Grade A space remains scarce.
We expect the impact on other parts of our portfolio to be less with shopping servers, in particular, likely to be more resilient given their recent value correction and high yield. So as a result of the reduction in property valuations, our EPRA NTA per share was down 5%. Virtually all of this was driven by London offices, which made up 95% of the £323 million valuation deficit. The £92 million loss on disposal principally related to the sale of 21 Moorfields, where we sold this asset at a discount to its March book value, and the sale crystallized a healthy 25% profit on cost and derisked £800 million of capital. As a result, our total accounting return for the half year was negative 2.9%.The strong earnings performance over the period has supported the strong growth in dividend.
Over the last 2 years, we have consistently said that we would be more decisive on capital allocation, and this slide illustrates that. Since late 2020, we have sold £2 billion of assets including £1.8 billion of London offices, on average, 1% below their book value. We have invested £1.5 billion, which has added resilience to the portfolio and created significant opportunities for future growth. We still intend to sell the remaining £2 billion of assets that we earmarked for sale over time. And we expect to be a net seller in the near-term. Whilst we’re pragmatic about value, our strong financial position means that we can be selective when it comes to disposals.
Turning to our balance sheet, which is in excellent shape, as a result of our strategic actions. Our LTV reduced from 34.4% in March to 31.1%, which is comfortably within our target range and provides a lot of flexibility. And we have significant headroom with our debt covenants. We expect our weighted average net debt-to-EBITDA ratio to reduce to around 8x by the year-end, which puts us in a very strong position. Our average debt maturity increased to nearly 10 years, 84% of which is hedged or fixed and we have no need to refinance any debt until 2026. That’s taking into account a £1.8 billion of undrawn credit facilities. So overall, our financial position remains very strong.
Let me summarize. Despite the more uncertain economic environment, our strategic focus over the last 2 years means we’re in good shape. Our long-dated debt profile provides visibility on earnings and our low leverage provides optionality. We maintained the earnings guidance that we gave in May. We expect underlying EPRA EPS growth of low to mid-single digits this financial year. That’s excluding the positive impact of higher surrender premiums, which are currently £10 million ahead of the prior year, as I mentioned earlier.
Next year, our committed pipeline will support income with £38 million ERV and just £110 million investment remaining to complete our three schemes under construction. The exact shape of EPS progression beyond the current year will, of course, depend on the timing of future disposals and new investments. There will undoubtedly be interesting opportunities coming out of the current market dislocation. So given our strong position, we are well placed to benefit from this.
With that, I’ll now hand back to Mark.
Mark Allan
Thank you very much, Vanessa. So I will now wrap up with a summary of how we see the current environment and what you can expect to see from us before we then move to Q&A.
Now as I said in my opening remarks, it is clear that economic and capital market conditions have changed materially since the start of this year. And indeed, volatility in the 6 weeks since this balance sheet date have been particularly high. Interest rates across the globe have surged in response to rising inflation with the central bank support that artificially depressed bond yields for most of the past decade now clearly into reverse. It’s difficult to assess where interest rates will settle over time but in a long-term context, it seems clear to us that the ultra low rate environment for the past decade was the aberration, not the rates that we see today.
We expect the adjustment to this new reality will likely have a lasting impact on asset values, be that in equities, bonds or real estate. Now as always, in listed markets, this price adjustment is well ahead of direct markets. But in real estate, this adjustment is now well underway, too, even if it’s not fully reflected in September valuations. Whilst investment markets continue to function, we expect this pricing adjustment will continue. But it’s unlikely to be an efficient process as markets, as we know, always over and undershoot rather than move smoothly to a new fair value. But in our view, those sectors most at risk of continued repricing remain the ones where yield has compressed most before the start of this year, while sectors which had already repriced and arguably overshot in doing so, such as prime retail look to us to be much more resilient.
When it comes to occupational demand, there is an increasing recognition amongst customers be it in London or in retail, that the quality of space is pivotal in attracting key talent and attracting customers. As this space remains in short supply, we therefore expect that demand for the right places in both sectors will remain more resilient than it might have done in previous economic downturns. And that, in turn, will offset some of the pressure from rising yields in the form of continued rental growth. This means that the two most critical attributes in this current market are portfolio quality and balance sheet strength, both areas where Landsec scores highly.
So in summary, asset values are repricing to reflect a higher rate environment with the keenest yields likely to move the most. This will clearly impact total returns negatively in the short-term but in the medium term, should present compelling opportunities and mean that over the longer-term, we can deliver better returns for our shareholders. Our primary focus over the next 12 to 18 months must therefore be to position Landsec for this recovery.
Our strategy remains the right one, and we have built strong operational momentum over the past 2 years across every part of our business. And we will build further on that, whilst making sure that we stay close to our customers, that our cost base is appropriate and that we continue to foster a more agile, outward-focused culture that makes the most of the substantial talent in our business. The pace of our portfolio repositioning is likely to change a bit but we will continue to look to monetize mature assets where our ability to add further value is limited or assets that are in sectors, which for us are subscale. And we see less urgency to reinvest proceeds given the near-term outlook. As a result, we expect disposals to exceed net investment or new investment, I should say, over the next 12 months.
We will continue to maximize optionality in our development pipeline without sacrificing momentum and make sure that we maintain our strong balance sheet. Combined with our high-quality portfolio and ability to unlock complex situation, it is this strength and flexibility of our capital base that can put us into a great position to capitalize on the opportunities that will no doubt arise as the market continues to reset. The market outlook we see for the next few years is ideally suited to the competitive advantages of the new Landsec.
And with that, I would now like to open the floor to Q&A. I will ask for questions first from those in the room here. If I could ask you just to wait for a microphone before asking the question. I will then go to the conference call line before then any questions that come through on the webcast facility.
Question-and-Answer Session
A – Mark Allan
So first question down here, Hemant.
Hemant Kotak
Hi, good morning. Hemant Kotak from Kolytics. Good set of results in what’s a difficult environment. A couple of questions around valuation and what you’ll see in the market in terms of pricing because you’ve alluded to what you think is going to be softer pricing going forward potentially, especially in terms of valuations. Just on valuations first. If you look at the yield curve for financing rates, that’s probably moved about 200, 250 basis points since your margin valuation to September valuation clearly, that’s eased off a little bit in since then. But given that 200, 250 basis point movement in funding rates, I guess, the equivalent yield movement was only 20 basis points. So is – what was it that the valuers were looking at? Was it a lack of transactions? Why were they slow to move on valuations? And what made you think there is more coming?
Mark Allan
Right. Thanks, Hemant. So I mean we made the comment in the presentation and it’s a discussion we’ve had internally that kind of given where everything has happened in the 6 weeks or so since the end of September, you’re looking at valuations today, dated September, there is a lot that’s happened in between that arguably isn’t fully reflected. What I would say is that if I take the most significant part of our portfolio and where we saw the most significant valuation move, 21 Moorfields completed as a transaction just before the end of September. That was a live transaction in the market. It was given the bond-like nature of the income stream, it was very much linked to gilt rates and that completed successfully at that time. So I think we’ve got very robust valuation evidence for that part of the portfolio.
Now in between, I think we’ve seen gilt rates increase by over 100 basis points and come broadly back down to that same level. So I think things have been more stable over the last couple of weeks. I think that is starting to manifest itself in the market in more people who have perhaps been on the sidelines for a few weeks, hold back. I do think credit terms will have shifted. I think credit spreads would have shifted availability of debt finance will have shifted and some of the transactions, including 21 Moorfields that happened in September were based on credit terms that were agreed 6 months prior. So I think credit conditions is probably one of the things that will sort of impact a little bit.
I think the other thing that for us is going to have a bearing going forward, we sort of bear in mind, our transactions that have happened in sectors where debt has been put in place at rates that are materially below where they could be refinanced now and where they will be refinanced in the future. That will have time – of course, take time to come through the market, but it’s something that we expect to be reflected in values. And of course, that will vary from sector to sector. No one has been putting debt into shopping center acquisitions for a while.
So I don’t see a particularly negative impact, but debt that’s gone into low-yielding sectors, pricing and growth placed on – based on a structural shift in societal behavior or the economy that isn’t coming through at the same pace. That’s where I would expect to see some exposure. So I do think valuation movements going forward, they are not going to be uniform across the real estate sector as a whole, but we do need to position ourselves for a higher rate environment.
Hemant Kotak
Thank you, that’s clear. That’s clear. So if you look at your subscale sectors and you look at the equivalent yield, that’s 6.3%, that’s higher than – if you look at your average and Central London, that’s 4.7%. So given you’re trying to sell some of these subscale sectors and there is a potential for softer pricing ahead? How much do you do what you did with Moorfields and sort of bite the bullet and sort of press on as quickly as you can, especially because they have held up well?
Mark Allan
Yes. I mean, I think when you’re selling assets, particularly in this type of market, the worst thing you can do is compare the offers available in the market to a historic valuation. I think doing that leads you to not make decisions and leaves you to be, I think, rather flat-footed as an organization. We’ve shown through 21 Moorfields. That’s not how we want to view things. What we will look at is what returns do we believe we can achieve elsewhere by leveraging our competitive advantage based on what we see in the wider market. So that would be the comparison for us.
I do think with respect to our disposals the fact that we are selling into a number of different markets over the next couple of years, be that retail parks, hotels, more London office. We are selling into different pools of capital. So that will give us, I think, a couple of things. I think it gives us resilience in terms of being able to progress disposals because we’re not reliant on a deep pool of investor demand for a single type of asset, but I think it also gives us live valuable information on how investment markets more widely are looking at the different sectors in terms of pricing.
Hemant Kotak
Okay. And one last question, please. So you’ve obviously already alluded to the fact that the lower-yielding assets. So Central London in this case, for your portfolio, they are potentially a risk of further valuation declines. And you’ve also talked about the fact that in terms of your development, when you’re looking at it, you’re going to trade carefully with regards to the three main schemes that you have, the £400 million of CapEx that you have. Under what circumstances would you decide not to press ahead with those?
Mark Allan
Yes. So just as a reminder, we’ve got three London office projects with the benefit of planning consent, all of which are capable of delivering into a 2025 delivery window. Our view of 2025 from a demand point of view is that we’re going to see other construction starts slow. Demand for the best quality space remain very resilient. And therefore, we think that is going to be a very attractive window into which to be delivering in some of the best quality products in the market. So we want to keep our momentum, but we look at everything around us and particularly when we were looking at making these decisions around progressing projects 3 to 4 weeks ago. There is a huge amount of macro uncertainty. And it felt to us unnecessary to commit £500 million of future CapEx, we wanted to maintain maximum flexibility.
So what would it need to look like? I think it would need to look very volatile and that the better thing for us to do for our shareholders is to preserve balance sheet strength and preserve flexibility. We’ve been able to do that on these projects by taking the two that are ready to go, Timber Square, which you will have seen many of you on our Capital Markets Day in Portland House in Victoria.
We can progress early works packages. We’ve got good relationships into that part of the supply chain ourselves. We can price that risk very well. We can maintain program and then we have the opportunity in the spring to look at market conditions. If the recent weeks of being anything to go by, I think that will be a period where we will have seen, hopefully, some sustained stability. But in this market, it just felt the right thing to do.
And next question in the room? In the front here.
Osmaan Malik
Hi, good morning. Osmaan Malik, UBS. Hopefully, just a quick one. The development pipeline is 38% pre-let. You also give earnings guidance where you say if we fully let that pipeline, we will get £38 million of income. Can you just give us a bit of detail on the confidence on leasing the unlet development pipeline space? What gives you confidence and over what kind of time frame, please? Thank you.
Mark Allan
Yes, we will do our best. I mean, when we underwrite London office developments in terms of our IRR assumptions and the underlying leasing assumptions, we would assume that we will be about 25% pre-let at PC, so we’re really ahead of that. And as I mentioned in the presentation, we’ve got active dialogue, active negotiations in place across all of the assets completing over the next few months. My sense is that within the first half of the next financial year, we will see a material overall increase in our occupancy. So I think a meaningful amount of that £38 million is going to start accruing to the P&L during the next financial year.
In Victoria, which completes around the end of the financial year, we’re about 60% pre-let from the top of the building coming down. I think we’ve got to acknowledge that sometimes low floors can be a little bit slower to let, but a substantial portion of that building already pre-let. Lucent in the West End. We announced a couple of days ago, pre-letting at the top of that building as well, and I think demand there is very strong, the Forge as the third building, which is in Southwark that’s smaller floor plates. We’ve just sort of got into the window for letting there. The best example of that one is the adjacent office building Triptych, which, again, you’ll see on the Capital Markets Day, that was launched in March and has got half of one floor remaining as of November. So I would expect The Forge to follow a similar sort of time horizon with active negotiations in place on some of the upper floors there already. So I think really good momentum. So I would expect by the middle part of next year that we would be in a move that on quite materially.
Osmaan Malik
Thank you. Very helpful. And then just a broad question. Correct me if I’m wrong. I think when you – previously, when you thought about your total return to shareholders in terms of return on NAV, you were talking about, I think, mid to high single-digit return. Now given the environment has changed and you said we’re settling at a higher rate of – higher background rates. Could you give us your thoughts on where that number might be if you were to redo the excise day and forgive me if I’ve missed that in the statement?
Mark Allan
Sure. I mean, in the old days, if I can call it that, so probably going back pre-financial crisis and a few years after that, the general rule of thumb that we used to look at was that the total property returns, generally speaking, we’re in the 8% to 10% range for most sectors. And then you put a bit of leverage on that, adjust for your cost base to be delivering low double-digit total returns on NAV and doing that consistently was the sort of thing that was needed to justify an NAV type valuation. What we saw with moving to the rate environment is that 8% to 10% became more like 6% to 8% and then probably more like 5% to 7% over the last few years. So if things normalize back to a long run trend, I’d expect that return requirements for total property return to get back to those high single digits. I think we will see interesting opportunities of that sort of range. And that means, I think, rather when we’ve been talking mid to high single-digit total returns in a low rate environment, we should be targeting. And I think we will have more opportunities to find opportunities that will mean we can be delivering in the low double digits.
Osmaan Malik
That makes sense. But just to be really clear, and I appreciate this might be a hard one to answer. If – are we looking at that double-digit return based on where valuations might eventually fall to or based on the September valuation?
Mark Allan
It’s a difficult one to answer, but as we’ve indicated, we’re expecting to see not uniform across different sectors, but further weakness in valuation, which I think will probably be shorter and sharper than it might have been in sort of previous cycles given how quickly rates have reflected. So the ability to deliver double-digit total returns will be on deploying new capital as and when we start to see the opportunities emerge. So, that’s going to be probably somewhere between the two that you’ve mentioned.
Osmaan Malik
Thank you.
Mark Allan
Thanks, Os. Another question. Let’s pass the mic along, if you don’t mind.
John Cahill
Thanks, good morning. John Cahill from Stifel. One thing that you’ve built within the business is this capacity to develop office schemes and not other asset types that are going to be highly energy-efficient and will go towards your net zero ambitions. And part of the driver, of course, is this legislation that we’re expecting for 2030 and 2027 regarding energy efficiency requirements. If that legislation were to be watered down or got rid off completely, would it actually change anything in terms of your development prospects? So in other words, is it the perspective tenants are saying to you, well, actually, irrespective of what the government says, our stakeholders are demanding these – that were in these kind of buildings. Is that really the driving force behind this rather than the government’s take, if you like?
Mark Allan
100%. So, if you talk to agents and particularly, this is – I mean net zero is primarily in our business about the Central London offices. That’s where the energy intensity is highest. If you talk to leasing agents representing occupiers with requirements, there are a whole range of sustainability driven requirements, whether that’s around BREEAM ratings, NABERS ratings, embodied carbon targets, all of these things. It is all about the importance that those occupiers attached with respect to their brand, their reputation, their relationship with their customers, with their staff. That’s what’s driving the requirements. So, we could take the – and that’s been frank EPCs are a very blunt instrument. There are theoretical designed energy efficiency of a building that never is then really ever measured in use. I think what we will end up with is rather than the EPCs, we will end up with energy and new certification, which is the actual energy usage of the building. It’s what we are measuring through our energy intensity. I think that’s what will ultimately be where the regulatory input will be, but the market is way ahead the regulation on that. So, I don’t think any changes to regulation, watering down or otherwise, we will have the slightest bit of difference on occupier demand.
John Cahill
Very clear. Thanks.
Kieran Lee
Hey. Good morning. Kieran Lee at Berenberg. You have talked a bit towards valuations and what you are expecting there. But on the rental rate side, the last period was obviously very high employment. We have seen a number of those sort of layoffs across a number of sectors and that potentially changing. You have got a big pipeline of developments upcoming to let and a natural portfolio churn. How are you looking to prioritize sort of occupancy rates and rental rates and balance those two factors in? And where do you expect that trajectory of rental rates and tenant support measures to go?
Mark Allan
Well, I think we have as we are not the only people, of course, to comment on this, but I think we have what is very much a two-speed market. And the strongest businesses and the ones that are most focused on their employer brand, attracting and retaining the best quality talent, getting them in, in terms of collaboration, productivity, culture, all the things that you can’t deliver in an online world. That’s what’s driving the demand for the highest quality space vacancy at the Grade A end of the market materially lower than for the market as an average. So, whilst I think of course, historically, you might look at office demand perhaps on a more average basis, and there would be a closer correlation to GDP growth and unemployment numbers. I think that connection is going to be much weaker over the next few years because what we are seeing are people looking at how do I position my business for the long-term. And they are still focusing much more on attracting and retaining the best talent rather than saying, how do I cut cost base. I think it would be interesting to see how the tech sector responds. I think obviously, they have been a big driver of office space demand. They have been a big driver of behavior, I suppose, on how the office has been used. And clearly, they are quite big takers of space. And one of the things that we mentioned in our comments is that large headquarter type space. We think that the requirement for that type of space is going to be lower going forward. And we certainly, ourselves when we are underwriting demand, we are putting quite a big haircut on take-up of that type of space just to factor in an assumption that there will be reductions. We don’t model it in an overly sophisticated way, but we do just feel that there is going to be a reduction in demand for conventional space. And therefore, we are focusing on space that offers us good flexibility and diversity in terms of the types of occupiers be that sector or space requirements that we can target. So, I couldn’t be more confident about the demand, say, for that 2025 window into which we are going to be aiming to deliver our current development pipeline.
Kieran Lee
Thank you.
Mark Allan
Any more questions in the room? So, I am going to – I think we have got a question on a conference call line. So, if we could open the line on the conference call and just move to the question we have there, please.
Operator
The question we have is from Paul May from Barclays.
Paul May
Hello everyone. Apologies, I couldn’t be there. Just a few questions for me. Firstly, what’s the current all-in marginal finance cost at the moment for the company?
Vanessa Simms
So, on the variable cost of finance on drawing down on our RCF is the margin on that runs at around 60 basis points, 70 basis points over the cost – the interest cost and rate.
Paul May
Okay. And if you were to go more fixed because I assume you wouldn’t do everything variable?
Vanessa Simms
Yes. So, we are – 84% of our debt currently is fixed or hedged. As we intend to be a net seller over the next 12 months to 18 months, we have retained some flexibility there so that we are not in an over-hedged position. So, I am expecting cost of debt to remain below the 3%. So, we usually run around 2.5% to 2.7%.
Paul May
Okay. But sorry, if you were to go into the market to get new financing, are we talking 6% on a use for fixed financing, or would it be higher? Just trying to understand if you could say about?
Vanessa Simms
It’s actually – so we have the organic structure in place at the moment. So, if I use the bonds that are in the trading in the secondary market. Currently, those bonds are trading – well, I say currently, over the past couple of weeks, they have been trading around 5.5% to 6% as an all-in equivalent cost if you then assume a sort of normal new issue premium on that. So, we are a bit less than that. That’s a reflection on the strength of our credit rating within that structure.
Paul May
Perfect. Thank you. Just on that, you mentioned obviously asset sales over the next 12 months, 18 months, 24 months. Obviously, at asset values for typically liquidity dries up entirely. We are just starting to see asset values declining as you mentioned, asset values are likely to fall further. Do you think in that environment of falling asset values, lower liquidity in the assets the 30% LTV, which is in a very good position on a relative sense compared to Europe, actually does give you the capacity to invest in the market should opportunities arise or do you think that you would need additional equity to be able to do that efficiently?
Mark Allan
Yes. So, as you say, that LTV, I think we have a – we are very comfortable with the strength and resilience of our balance sheet. What we have sought to flag within the presentation today is that we do think they are going to be quite significant opportunities in this type of market on a 12-month to 18-month view. And we would intend to be a net seller over the next 12 months. So, we would like to create more headroom than we have today. I think we certainly have headroom, but I think the opportunities will exceed where we would be in terms of balance sheet today. So, asset sales remain a priority. I mentioned earlier that having the diversity of portfolio. I mean the assets we are looking to sell are exactly the same assets that we said we would be looking to sell 2 years ago. So, our subscale sectors and mature London office assets, so whether that’s retail parks, which are smaller lot sizes, reasonably liquid market, whether that’s multi-let London offices with asset management angles or single-let assets with longer term income streams or indeed hotels, those are all selling into different pools of capital. So, you are absolutely right that liquidity inevitably reduces in this market. I do think it’s really interesting at the moment. There is still a significant amount of international capital that I think sat on the sidelines for a six-week period where UK gilt rates were moving by unprecedented amounts from one day to the next. I do think the UK is still in relative stability, looking like an attractive place for international capital. So, I do think we are going to see a better underpin for the best quality assets. But clearly, any assets that the market feels is going to need to re-price is where liquidity is going to be thinnest. I think the markets we are generally selling into I would expect liquidity, although to be lower to still be at the level that we can progress disposals on a sensible time scale to give ourselves the capacity we want to pursue the different types of opportunities that we would look at where we can add value through our development and asset management expertise.
Paul May
Thank you. And then sorry, just the last one on the developments, either the mixed-use or the other office developments that you haven’t yet kicked off. What’s the targeted sort of yield on cost, or what was the yield on cost, if you were look at this six months ago, obviously, finance rates have changed and exit yields have changed. So, sort of profit on cost I assume has come down. I just wanted to get a sense as to what sort of profit on cost you are looking at, or are the potential developments much more income-focused than capital growth focused? Thank you.
Mark Allan
Yes. What we have always tried to put together in our mixed-use pipeline is a pipeline offers optionality for us to press buttons when we see the return environment over the next sort of 2 years to 3 years that these phases take to deliver looks favorable. Now, clearly things are moving around a lot at the moment. We need to form a view as markets settle on where the right exit yields are. We need to look, for example, in the residential component of our pipeline, how does residential rental growth respond in this current environment. We have got office opportunities to develop in Manchester, which is – has been a very strong market in terms of rental growth in the face of relatively limited Grade A deliveries. I think we have got to look at how that market looks. So, it’s difficult for me to say today exactly what do the returns look like on that mixed-use pipeline. The great thing with that pipeline is we can accelerate or decelerate and switch things in and out to be able to deliver a return across the whole portfolio over time. We have got about a 6% income yield on that. We have got in the MediaCity second phase of development. I think we ascribed something like a £20 million value to that. We probably got Mayfield in the books at less than that. So, it’s not as though we have to press ahead within a particular window. And we have tried to bring that similar type of approach to how we think about development in London, where there is obviously a longer development time horizon, and you have seen that through the approach we are taking with Timber Square and with Portland House. So, development by its very nature, is longer cycle, there is more risk involved. What we are doing is using our expertise to be able to shorten the window from commitment through to certainty as far as we can. So, I think you should look at our mixed-use pipeline as something that offers optionality to progress phases of projects at the right time rather than try and look at a particular return at a point in time and assume that’s fixed. I think the other thing I would say about something like Mayfield in Manchester, for example, with an outline consent is depending on how conditions vary across the different uses we have there, you have the opportunity to re-phase, accelerate, revisit planning, if that’s appropriate to deliver something that’s viable. So, we are not locked in to a fixed long-term plan on any of our mixed-use projects, and that optionality we think is incredibly valuable.
Paul May
So, just to – just a follow-up on that. So, is it – I mean can you say today that do you still make money with a higher rate environment and a higher exit yield, or is it something you are looking to sort of adjust the schemes in order to make them fit for purpose given the outlook, as you mentioned, of a higher sort of background rates?
Mark Allan
I think it will be a combination of both. There will be phases of the projects we have that we would be still very comfortable. It hit our required returns now. There will be others that we would look at thinking at sequencing or tweaking design. And that’s the nature of mixed-use multiphase development. It’s very different to a London office where you lock in a development, you lock in a specification and then you are committed to delivering that. There is inevitably a lot more flexibility mixed use. And that’s one of the reasons we have sought to bring in the skill set for approaching and adapting our mixed-use projects through the acquisition of U&I. But the important thing, as we mentioned on a couple of occasions through the presentation is we have full flexibility, full optionality. So, it’s not as though we have committed a bunch of CapEx today to projects that we now can’t influence, and that will continue to be a feature of mixed-use in the long-term. Are there any other questions from the conference line? There are a couple of questions on the webcast. So, I will just move to – I think we have two questions from the webcast. So, the first, which I think Vanessa will be able to talk to with respect to retail is, has the structure of leases changed, shorter terms? What does the retail leasing pipeline look like in light of strains on consumer spending and economic contraction?
Vanessa Simms
So, I think Mark told actually in the presentation that there has been real evidence that brands are really migrating to the best-in-class assets. So, there is a real flight to prime in both an asset and a location perspective. With that, we are seeing our core retailers are looking really for fewer but larger and much better quality of stores. So, what we are actually seeing in our – what we are seeing in our ground probably more reflects that flight to prime than maybe what the broader market is seeing because the inferior locations are probably suffering on the back of a lot of our key brands moving into the prime locations. What we are seeing in terms of turnover leasing, is probably the one trend that we saw on the back of the pandemic, which has continued is that we are looking – a lot more of our leasing structures have a turnover top-up element to them. So, I think there was around – it’s just under 80% of the leases that we signed in the last six months have reflected to some degree, a turnover element of this. And typically, in the new leases, that would equate to around 15% of what we would forecast to be the overall rent on those particular leases. So, I think it’s fair to – it’s pretty clear that turnover elements is increasing. We pre, sort of in 2019, I think overall, that would have equated to around 7% of retail income would have had a variable element to it. We have seen that now around 11%. And I would expect that trend to continue somewhere towards 15%. That of course, does also reflects the balance or the mix of outlets versus shopping centers because generally speaking, in outlets, you would see – and this was pre-pandemic anyway, would see a much higher proportion of turnover elements in leases than in shopping centers. So, I think that, that would be the main trend that we have really seen coming through. And in terms of our pipeline, I think the question was around the strength of the pipeline. And are we seeing anything different in the recent months, the position we were in is obviously you had a lot of leasing activity in the first six months of this financial year, and we see that continuing. We have a very strong pipeline ahead of us, which we are either going through negotiations or in legals with, which gives us confidence that, that trend will continue. In terms of what we are seeing on since – probably since around the mini budget time, if I was looking at any leases that may have fallen over since that period, and we have only had less than 1% of that pipeline step away from the negotiations since that period. And they were really more the independent F&B retailers. So, that’s probably the area that we are primarily focused on from a consumer impact would be around leisure and the F&B and the impact in that area. I think probably the only other point to mention would be around the approach of the main retailers. There were some probably retailers that – or the key brands that we are looking at their rationalization strategies over the last recent months where they were moving to larger but fewer stores. We are seeing those retailers continue with that. That trend is continuing with the rationalization and probably some of the retailers that were then on a growth strategy, we are seeing them paying back and focusing now on a more of a consolidation strategy. So, I think there is probably in the current market, those are intending to maybe launch new brands we saw one or two brands that we are looking to expand or launch new brands, maybe thinking twice about that opportunity. But for the core brands that are here today, they continue with their strategy.
Mark Allan
Thanks Vanessa. And a couple more questions from webcast. Can we talk through the around 10% decline in value of city offices in the period given the benchmark saw values down 2.5%? So, a couple of general comments, and then I will ask Vanessa to comment on some specifics within the valuation movements. But I think larger lot sizes, larger floor plates, more bond-like income stream, where there is a closer link to bond yields and less ability to factor in rental growth in the market, I think saw the more acute shift in values, and that was closer to our city assets such as the 21 Moorfields were based. But I think there were a couple of specifics around CapEx and other elements to individual assets within the valuation.
Vanessa Simms
Yes. We did see – in the city offices, we have increased some of the CapEx on a couple of our city office – city assets, and that was really where we had capital plans around both the ESG component. So, where we are looking to replace air sourced heat pumps or air sourced heat pumps in, should I say. And these are predominantly were One New Change and in New Street Square as well, where we are looking to move one of our existing customers, give them the option to move into one of the buildings that have been freed up by Deloitte. And that enables us to refurbish quite a substantial refurbishment for them on another property and that also enables us to put air sourced heat pumps in and bring the ESG credentials. So, that program has probably been accelerated from where the original valuation assumes that works to take place.
Mark Allan
So, there will be some CapEx spend assumed without necessarily reflecting the ultimate benefit we would expect to see in terms of stronger leasing demand and rents going forward, so an element of timing. And then a question on the cost base, what proportion of the admin cost base is the development team? You mentioned a 6% income yield from meanwhile use, what is that after allocating central costs? I don’t know how specific we are going to be able to be in answering that. But is there anything you can add, Vanessa?
Vanessa Simms
Well, I think the – probably the point to note at the moment that, that might be a question that’s a bit more relevant as we go through. We acquired U&I at the beginning of this year, which really provided a great resource team for us to expand our capabilities in the mixed-use regeneration. And then we have some – the development capabilities as well from a Landsec perspective, which support the development side. So, we will capitalize some of the development team, got direct development team into costs. But I would say that the general cost that sits in our admin cost is fairly light in terms of specific development. So, it really flexes up and down in line with development activity that we undertake.
Mark Allan
And I think with respect to the costs and development costs associated with the mixed-use pipeline, I think generally speaking, I think we would assume development costs would equate to somewhere in the order of 6% to 8% of installed CapEx over the period of the project. So, you obviously got to pare that back for the number of years that the project would be there, but that’s typically the sort of level, I think we would look to benchmark to.
There are no further questions on either the webcast or the conference call. Hopefully, we answered all of the questions in the room. So, thank you very much, ladies and gentlemen, for your time and attendance this morning, and wish you a very good day. Thank you.
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