Land Securities Group Plc – Half-Year Report 2021

Chief Executive's statement

Positive business performance. Building strategic momentum

The mid-point of our 2021-22 financial year affords a good opportunity to reflect not only on year to date performance as we emerge from the pandemic, but also progress against our new strategy a little over a year after we launched it. In both cases the picture is encouraging; the economic recovery following the pandemic has generally been at the stronger and more sustained end of our expectations range and our strategic clarity is allowing us to be more decisive in our capital allocation.

Our total return for the six months was 36 pence per share, equating to a 3.7% total business return. EPRA earnings were 24.3 pence per share while portfolio valuation movements contributed 10.9 pence meaning that, after dividends, EPRA NTA per share increased 27 pence to 1,012 pence at 30 September. We are proposing a second interim dividend of 8.5 pence, which together with the first interim dividend of 7 pence equates to a total of 15.5 pence per share for the first six months of the financial year.

When we launched our strategy in October 2020 we were clear in our intent to focus on three key areas – central London offices, major retail destinations and mixed-use urban neighbourhoods; areas where we believe we have a sustainable or attainable competitive advantage that will help us create long-term value for all our stakeholders. We were also clear that this would require meaningful asset recycling, with around £4bn of asset sales planned over the short to medium-term in order to fund investment into these key focus areas.

Initially, and in the midst of the pandemic, our priority was disposals and we made good progress in the last financial year. However, with the economy recovering strongly during 2021, we have been able to balance that with more focus on capital reinvestment. We now have a healthy pipeline of potential opportunities across each area of our business and this is affording us excellent visibility of the potential returns achievable in each area together with the associated risks. Adding this perspective to opportunities across our own portfolio means that we can be more decisive in our capital allocation, confident that we are enhancing prospective returns through the decisions we make.

Our recent £426m investment in MediaCity and our £190m recommended all cash offer for U and I Group PLC are clear evidence of the steps we are taking in this regard. In both cases, progress against our strategy is accelerated materially. The first phase of MediaCity is an established, high quality mixed-use location that offers attractive income-based returns while the acquisition also gives us the option of investing over £500m into the next phases of development with effect from early 2023. The proposed acquisition of U+I gives us the option of investing a further £600-800m into a significant, high quality pipeline of projects over the short to medium-term, starting in 2022. Anticipated returns from the investments are in line with or ahead of our target levels and, importantly, the projects offer development optionality rather than obligation, meaning that we preserve balance sheet flexibility.

Our positive business performance and delivery against strategic objectives reflects the capability and commitment of our teams, despite the challenging environment that everyone has been operating in. It also demonstrates the progress we are making with the cultural changes we are seeking to effect and which are critical to the successful delivery of our strategy in the long-term. While there is plenty more to be done, Landsec is now a more agile business, closer to its customers and better able to assess and respond to changing market conditions in a considered and effective way.

Prime London rents proving resilient. Investor demand driving prime yields down. Landsec portfolio well placed to benefit

At the time of our full year results announcement in May 2021 we said that we expected rents for prime, grade A London offices to be resilient, reflective of trends in occupier demand, while there was also the prospect of yields tightening as a result of the weight of capital looking to invest in London given its value relative to other global cities.

So far, this has proven to be the case with ERVs across our central London offices up 1.2% and average yields tightening by c.2bps. Values for central London retail are weaker, reflecting the slow return to cities over the period but, taken together with the uplift in value for our central London development portfolio, values for this part of the portfolio were up 0.8% over the six months.

We expect customer demand to remain resilient for the remainder of the financial year. Office utilisation has increased markedly over the past couple of months as confidence in the safety of workplaces and public transport has improved and government guidance has become clearer. Utilisation is now approximately 55% of pre-Covid levels and leasing activity, both with existing and new occupiers, continues to improve. During the period 26 lease events covering £27m of rent were either completed or agreed at levels supportive of ERV. Sustainability and flexibility are the key demands of customers and, in both cases, Landsec is well placed to respond.

The weight of investor demand for prime London office assets shows no signs of abating and yields could compress further from current levels as a result. There is also increasing evidence of investors pursuing a 'build to core' strategy, meaning that more capital is targeting prime development projects with the potential to push down development margins on new opportunities. Against this backdrop, we expect to continue targeting disposals of high quality core assets with little further value add potential and to remain disciplined in deploying capital into new development opportunities only where we have a clear competitive edge. In the medium-term the proportion of our portfolio invested in central London is likely to fall from the current level of approximately 70% as disposal proceeds exceed the amount reinvested in central London acquisition and development activity. It will, however, continue to represent the significant majority of our portfolio.

Prime retail rents and values stabilising. Catchment dominant destinations set to be long-term winners

The pandemic materially accelerated structural changes that were already underway in the retail sector, most notably the shift to online retail. Prime retail rents are currently close to 40% lower than their peak and values are down by approximately 65%. While the financial impact of this has unquestionably been painful, it does mean that the opportunity for a reset has also accelerated. As a result we have an increasingly positive view of the prospects for prime retail destinations.

At the time of our full year results announcement in May we said that prime retail rents appeared to be approaching sustainable levels and our experience over the past six months supports this view. Across all regional retail elements of our portfolio we have completed or agreed terms on 181 lettings, with rents agreed on average 3.3% above ERV, and portfolio vacancy has fallen from 8.8% to 7.5% over the same period. Lease terms are generally shorter and turnover-linked provisions are more common but incentives are also generally lower meaning that the impact on yields is not particularly pronounced.

We continue to expect prime retail destinations to be long-term beneficiaries of structural shifts in retail, provided that they offer experiences that cannot easily be replicated online. We estimate that approximately 17% of all retail floorspace in the UK is currently surplus to requirements, which we expect to rise to 25% by 2025. However, with rents for the prime locations most popular with shoppers now at affordable levels for retailers, vacancy is increasingly likely to be concentrated in secondary locations. In the past six months we have seen established retailers relocate into our centres from other nearby locations, others take the opportunity to upsize their existing space and digital native brands take physical space to complement their online offer.

It will, of course, take time for these trends to take hold across the market in a meaningful way but the outlook is increasingly encouraging. Our outlets portfolio saw like-for-like sales increase 7.9% versus 2019 for the 25 weeks after 12 April with values up 1.0% over the six months as a result. Shopping centre sales also benefited from the strong post pandemic recovery with brand partner sales now within approximately 3% of 2019 levels for this same period.

Equivalent yields across our shopping centres and outlets range from 6.8% to 7.5%, averaging 7.2%. With leasing evidence providing support for rent levels and investor demand beginning to return, these yields appear increasingly attractive on a relative basis and we expect to see interesting prime retail investment opportunities emerge. With our retail parks planned for sale in the short to medium-term, the overall proportion of our portfolio invested in core retail is likely to remain broadly flat at around 20%, but with greater focus on major retail destinations.

Thoughtful mixed-use development an increasingly critical ingredient in the fabric of cities. Momentum building in the Landsec portfolio

The lines between where people live, where they work and where they spend their leisure time are becoming increasingly blurred. With many parts of today's built environment already in need of remodelling and sustainability such an important focus for everyone, there is a clear opportunity to reshape neighbourhoods and cities in a thoughtful way over time to meet these changing needs in a sustainable way.

At the start of the year we had a number of projects within our portfolio, mainly suburban London shopping centres, that had significant mixed-use development potential. Since then, we have added a further major project through our £426m acquisition of a 75% stake in MediaCity and have made continued progress with planning applications at O2 Finchley Road and Lewisham. With the next phase of MediaCity already benefitting from planning consent and giving us the option to invest over £500m into the next phases of development from 2023, a planning application at O2 Finchley Road on track for submission this financial year and an application at Lewisham targeted for late 2022, we are building momentum in this part of our business.

Our recommended all cash offer to acquire U+I, if completed, would add to this momentum. Not only would it bring in highly regarded, complementary mixed-use development skills, it also offers access to a significant pipeline of high quality urban regeneration projects that give us the option to invest between £600m and £800m in the short to medium-term.

The returns available from mixed-use development assets are attractive – development phases offer low double digit ungeared IRRs and investment phases mid-single digit yields – with rental growth prospects supported by successful placemaking. Furthermore, the phased nature of the projects allows us to manage capital commitments carefully and to adapt our strategy as we progress. Over the next few years we plan to increase the proportion of our portfolio invested in mixed-use assets to between 20% and 25%. The progress we have made with our existing projects, together with our recently completed or planned new investments, means that we now have real clarity on how this can be achieved.

A continued focus on capital discipline is crucial

Although there has been a strong and sustained recovery over the past few months, uncertainty remains elevated. It is still difficult to distinguish between short-term factors in the recovery and longer-term trends, making accurate forecasting of demand difficult, while supply chain challenges, both global and localised, risk slowing the recovery from here and driving inflation.

Capital discipline is at the heart of our new strategy in three clear ways:

• At the time we announced our strategy in October 2020 we reduced our financial leverage tolerance levels to between 25% and 40% LTV. We continue to operate firmly within this range despite significant valuation declines in the year to March 2021, and our clear asset recycling plans mean that new investment will generally be funded through asset disposals.
• We have been clear that capital investment will be focused only on areas where we have a sustainable or attainable competitive advantage, which informed our decision to exit £1.3bn invested in subscale sectors (retail parks, leisure and hotels) over time. We are on track, with £52m of proceeds from retail park disposals in the period and, with investor demand strengthening across all three subscale sectors, we could choose to accelerate this as reinvestment options become clearer.
• We are focused on increasing optionality in our development programme, meaning that we can respond more quickly to market conditions, adapt accordingly and become a more agile business as a result. We have preserved optionality over two consented London developments – Timber Square and Portland House – as we progress our committed projects first; and our MediaCity investment boosts this further with future development phases capable of commencing on site from early 2023.

Sustainability is more important than ever. Our 2030 science-based carbon reduction pledge is now supported by a fully costed net zero transition plan

In 2016 we became the first commercial real estate business in the world to set a science-based carbon reduction target and in 2019 we increased our ambition to align with a 1.5 degree global warming scenario.

We have today announced a new net zero transition investment plan across our entire estate which will ensure that we remain at the forefront of everything that the property sector is doing to tackle the climate crisis.

This is a really important step to ensure we achieve the climate commitments we have made to reduce our carbon emissions by 70% by 2030 (versus a 2013/14 baseline) and to ensure that we stay ahead of the Minimum Energy Efficiency Standards Regulations (MEES), which require an EPC 'B' certification by 2030, as well as other regulatory requirements.

We have already reduced our carbon emissions by 55%. Over the next nine years we will invest approximately £135m across the portfolio to deliver further reductions. The investment programme will reduce operational energy use by optimising our building management systems through the use of AI; decarbonise our heating by replacing gas-fired boilers with electric alternatives such as air source heat pumps; and increase our onsite renewable capacity. We will also continue to engage and partner with customers to work collaboratively to drive down energy consumption.

Alongside this, we remain committed to designing and building net zero buildings with The Forge, our first net zero building, on track to complete in October 2022 having achieved a 25% reduction to date in embodied carbon from the initial design stage.

This investment equates to approximately 1% of portfolio value and, with increasingly clear evidence of stronger sustainability credentials underpinning stronger operational performance, is not only essential from an environmental perspective but an economic one too.

Outlook

As a result of the success of its vaccination programme, the UK appears reasonably well placed to navigate autumn and winter without needing to revert to lockdowns or other excessively restrictive measures. However, it is by no means certain that this will be the case. In addition, people's behaviour patterns are still difficult to predict; it is challenging to discern short-term 'pent up' demand driven factors from long-term trends; and supply chain disruption is likely to remain an issue for a number of months, raising inflation concerns.

We remain alert to all these risks but, overall, our outlook is one of cautious optimism. We are providing high quality, sustainable office space that is very well aligned to today's customer demands; in our retail portfolio we are generally seeing leasing activity supportive of ERVs for the first time in quite a while and increasing evidence of a 'flight to prime' for which our portfolio is well placed; and we are building real momentum with our mixed-use development activity. With a strong balance sheet, a portfolio suited to changing customer needs and a clear strategy that positions the business for long-term growth, Landsec is well placed for the future.

Mark Allan

Chief Executive