Sky-rocketing house prices make it more difficult for young buyers to get their first step on the housing ladder and that clearly plays to the strengths of Grainger (GRI) as the UK’s largest quoted landlord. But I challenge the company’s chief executive officer (CEO) Andrew Cunningham that he is operating in a tough industry where competitive pressures are intense.

Threats are posed by large property managers and to buy-to-let individuals alike so I venture that the rental market is a little crowded. Rather than deny this, the CEO acknowledges the challenge, before methodically setting out how the FTSE 250 firm differentiates itself from the crowd.

‘We are all faced with the same restrictions in that Britain is a relatively small island, with a small supply of land and getting planning permission is difficult,’ responds Cunningham. ‘So given those constraints you tend to have a lot of people chasing after very little.’

Build your own

This is why Cunningham expects Grainger’s short-to-medium-term growth to come from building properties to rent rather than buying existing assets. Some 60% of its UK portfolio is located in the high-demand areas of London and the South East, where residential asking prices are going up and rental yields thus depressed. These trends are unlikely to abate anytime soon with the Royal Institution of Chartered Surveyors last week (18 Dec) forecasting an 8% rise in UK house prices in 2014. The East of England and London are seen as leading the pack with respective capital growth rate projections of 10% and 11%. These conditions make it difficult to build up an institutional-sized portfolio unless a firm is prepared to construct its own sites.

My subject highlights £150 million of building projects over the next 18 months, all part of his ambitious plan to keep driving net asset value (NAV) northwards. Numis forecasts NAV per share will increase by another 12% in 2014 to 219p from 2013’s 195p outcome, itself an impressive 23.4% higher than the prior year. The new-build pipeline includes 100 flats in Barking, expected to yield more than 8%, 84 homes in Clapham, almost 200 in Hammersmith, 84 in Kensington and Chelsea and a 2,550-unit project in Waterlooville, Hampshire. ‘That is the sort of thing we are looking at, how we can develop our own proposition for rental.’

Cunningham stresses the firm is not in competition with the owner-occupied market where the properties do not tend to be best-suited for rental. A two-bedroom flat built for the owner-occupier market, for example, will tend to have different sized bedrooms which can become a potential source of conflict between tenants. Grainger’s properties have similar-sized bedrooms equipped with en-suite bathrooms and the corridors tend to be wider and served by additional lifts so people can move their furniture without disrupting the other residents.

Sign of the times

‘It is a simple case of arithmetic,’ Cunningham elaborates. ‘If people are renting for longer before buying you will have more renters. They are looking for a better quality, more professionally-managed product. The financial consequence of that is that there is a demand element building up for rental property and we are satisfying that demand.’

This change has not been driven by financial reasons alone, social factors also come into play. Some people choose to rent, partly due to the changing jobs market. People like an element of flexibility in terms of type of job and location, but mobility and flexibility doesn’t sit easily with a big mortgage. ‘So people are choosing to be renters for longer, choosing it as a lifestyle,’ Cunningham says.

Grainger targets 25 to 35-years-olds who are in reasonable jobs and want to live somewhere decent, managed by a professional landlord who fixes things when they go wrong. According to Cunningham, one million additional rental households have been created in the UK’s private sector during the past decade. ‘Social or affordable housing is dropping and the only sector that is growing is privately rented. Whereas that wasn’t the case ten years ago when we were looking to grow that part of the business it is now and so there are more opportunities for people like us, who can do it to scale and a high level.’

He is clearly hoping to repeat the company’s success in Germany where more than 6,000 properties account for the greater part of the firm’s £1.8 billion owned portfolio. The move back then into the private rental market was crucial in order to replace the group’s declining revenues from its legacy regulated tenant market (see 'Rich Heritage' below). But Grainger is not placing all its eggs in this basket either and has other development interests which involve buying land, securing planning and then selling it on to housebuilders. It also manages £2.8 billion of rental property on behalf of third parties and owns an equity-release business targeting retired householders.

Money, money, money

The robust nature of the core business is very clear to see when you consider the firm remained cash generative throughout the financial crisis.

Cunningham explains he actively manages the group’s capital position with a particular focus on reducing its dependence on bank lending. This drive began shortly after he stepped up from finance director to CEO in October 2009 when he immediately launched a £250 million rights issue.

Net debt has come down below the £1 billion mark, due to internally generated cashflow and the sale of properties into the recovering UK market. Disposals generated a £77.7 million of profit last year, 7.9% more than in 2012. Here, Cunningham prefers a joint-venture structure to a straight sale. This involves selling a percentage of selected assets but the retention of an interest so the firm can still run the properties and generate ongoing management fees.

Recalling the dark days of the financial crisis, when his predecessor had to stand aside due to ill health, Cunningham says: ‘If you are an asset-backed business with leverage you would not be able to come out of a situation where asset values fall by 15% to 20% almost overnight without a few bruises and certainly we had a few bruises.’ His was certainly a baptism of fire as hedge fund managers shorted the stock in the run up to the 2009 rights issue.

Cunningham, who has been at Grainger since 1996, displayed some steel back then and instead of using the entire placing proceeds to pay down debt, he put part of them into a 1,600-strong portfolio of London residential properties, snapping up prime real estate at beaten-down valuations.

Further measures to reduce reliance on the banks have included borrowing from insurance companies, such as Prudential (PRU), while last month (21 Nov) the firm tapped the bond market for the first time raising £200 million when it issued seven-year paper with a 5% coupon. Cunningham explains the bond issue gives the firm enough cash to repay early its debts that are due to mature in 2014. The next maturity to prepare for is in 2016 and he will start looking at that towards the end of 2015.

Rich heritage

Grainger was established in Newcastle 101 years ago to manage assets in the regulated tenant market. This is a sector where companies buy a residential property at a discount and then receive below-market levels of rent from the tenant, who usually lives in the property for the rest of their life. Once the property is returned to the company it is sold at market prices unlocking the capital value. But the last regulated tenancies were created in the late 1980s and with the average age of Grainger’s regulated tenants 72 the firm does not expect this revenue stream to exist in 30 years’ time.

Biography: Andrew Cunningham became Grainger’s chief executive officer (CEO) in 2009, 13 years after joining the company as finance director. An accountant by trade, he cut his teeth as a partner in one of PwC’s predecessor firms.

Grainger
(GRI) 204.1p BUY

SUMMARY

Grainger’s expanding portfolio of residential properties offers the prospect of cash-generative growth. Dividend payouts are likely to remain low but this looks to be the right strategy given the scale of the opportunity.

Bull case

• Cash generative

• Self-build model

• Diversified revenues

Bear case

• Planning permission risks

• Trades at premium to NAV

• Crowded market

Market value: £839.4 million

Prospective PE Sep 2014: 21.6

Prospective dividend yield: 1.1%