Land Securities Group PLC

LSE:LAND

Earnings Call Transcript 2023-Q4

[Mark Allan, Chief Executive Officer]

Well, good morning, everyone, and welcome to the presentation of Landsec's 2023 Full-Year Results. When we launched our strategy back in late 2020, it was based on two clear and simple principles: to focus our resources, where we have genuine competitive advantage, and to maintain a strong balance sheet. And since then, we've done exactly that. And as a result, we are in excellent shape, even though global economic and financial market conditions have deteriorated materially over the past year.

Inflation and interest rates are up sharply and credit conditions have tightened, which has put pressure on values across every asset class, including property. Now, on our half year results 6 months ago, we said we expected this pressure to continue, which it has. And whilst the political situation has stabilized somewhat since then, interest rates remain volatile, making it difficult to predict, where they will eventually settle, although we think it is unlikely that this will be back at the level seen for much of the past decade.

And this is important for two reasons. Firstly, our strategy was never based on the idea that this ultra-low rate environment would persist. And neither or our decisions now based on a hope that interest rates will fall back to those low levels if we wait long enough. And our resolve to sell £1.4 billion of mature offices over the past year underlines this. Secondly, and most importantly, this new reality plays directly to the strengths that we've been building since 2020.

At that time, it was difficult to find value in a world, where there was generally someone else, who is willing to borrow more at artificially low rates and so pay more, but that game is over. And as such, we should begin to see more interesting opportunities begin to emerge. Although as we said 6 months ago, we think it will take some time for the full impact of high interest rates to work its way through the system.

Now, in terms of capital allocation, we remain decisive and firmly focused on future returns. We have now sold £2.4 billion of assets, where our ability to add further value was limited. And we've been selective in our new investments, focusing only, where we see a clear opportunity to create value, principally in development, in major retail destinations and our mixed-use pipeline. And we've reduced financial leverage with net debt down, LTV down, and our net debt-to-EBITDA ratio down.

Our strategy remains the right one, and our three key competitive advantages remain our high-quality portfolio, the strength of our customer relationships and our ability to unlock complex opportunities. These have served us well over the past year and should continue to do so in the future. Our success in executing our strategy means we have the opportunity to look forward to growth, whilst part of the wider market is likely to be looking backwards to deal with leverage or refinancing issues.

Our portfolio is ideally positioned to benefit from the concentration of customer demand on best-in-class space, resulting in improving rental growth prospects. We've reduced our exposure to areas, where we see lower returns and created optionality to invest in higher return opportunities.

We continue to unlock complex situations that are accretive to returns, and we plan to explore options to further enhance growth by leveraging our clear platform value. And our strong capital base with an average debt maturity of more than 10 years, no need to refinance any debt until 2026 underpins the resilience of our returns, as we aim to deliver an 8% to 10% return on equity over time and to grow our attractive earnings and dividend yield.

So turning to our operational results. We continue to see a sharp divide between occupational demand and what is happening in capital markets. In London, we delivered another year of strong leasing, driving further ERV growth. We crystallized strong returns on assets, where future returns looked more modest. And our current development pipeline is now 60% pre-let or in solicitors' hands, with deals over the last 12 months, on average, 11% above ERV.

In retail, we delivered a marked pick-up in leasing with £38 million of lettings signed or in solicitors' hands on average 9% above ERV and occupancy up to 94.3%. We've expanded our portfolio at highly attractive returns, and retail sales have continued to grow. And in mixed-use, we received planning consent O2 Finchley Road for our 1,800 homes masterplan. So combined with further progress at Mayfield in Manchester, we can now potentially start works on site at both of those schemes later this financial year.

Financially, we delivered 4.4% growth in underlying EPRA EPS, and that's towards the upper end of our guidance for low to mid-single-digit growth. This was supported by our strong operational performance with 6% growth in like-for-like net rental income, whilst our dividend for the year is up 4.3%. Our return on equity and EPRA NTA have clearly been impacted by the rise in bond yields, which put upward pressure on valuation yields, but this was mitigated by our successful disposal program.

So, as a result, our LTV was down to 31.7% and net debt to EBITDA was 7x at the year-end. Now, irrespective of wider economic conditions, we remain convinced that delivering sustainably is key to our long-term success. And in that regard, we have made further progress with our ESG ambitions. Our energy intensity was virtually flat year-on-year, despite the increase in utilization of our portfolio, compared to the initial months post lockdown at the beginning of last year.

So, we remain on track to reduce energy intensity by 45% by 2030 versus our 2013/2014 baseline. We'll start the first retrofits of air source heat pumps, as part of our net zero investment plan later this year. And if we had not sold over £1 billion of mature offices, the share of EPC B or higher-rated offices in our portfolio would already be around 50%. But our debt would also have been £1 billion higher, which to us is more important.

As a result of those disposals, EPC A or B rated offices are down slightly to 38%, but this will increase back to 44% by the summer, as our current developments complete and to over 50% by 2025, as the first benefits from our net zero investment plan kick in before then moving up to 100% ahead of 2030.

We recently also announced our new Science Based Targets to reduce our emissions, aligned to the new Science Based Targets Initiative, Net-Zero Standard. And that's the world's only framework for corporate net zero target setting that's in-line with climate science. Now, this target significantly increases the scope of our carbon reduction ambitions, as it now includes all of our reported Scope 3 emissions and restates our target relative to a more up-to-date 2019/2020 baseline.

And finally, last month, we launched our Landsec Futures Fund, as part of which we will invest £20 million by 2030 to enhance social mobility in the real estate industry and power 30,000 people towards the world of work. All this and more ensures that Landsec remains at the forefront of driving change in our industry.

So, with that, I will now talk you through each of our key business areas in a little more detail. So, starting with Central London. Well, we sold £1.4 billion of offices during the year, all of which had been successful investments for us with an average 10% IRR over the time that we had held them. But given that these assets were fully let to single customers for an average of around 20 years, there was not much more we could do to add further value.

And as the look-forward return at the price we sold them was in the mid-single digits, we therefore decided to sell. And that means that we've now sold £2.2 billion of offices since late 2020, virtually all of which were in the City or Docklands. And this has significantly improved our future return prospects, as it has freed up capital to reinvest in our pipeline, but also because 74% of our portfolio is now located in the West End and Southwark. And that's where we believe rental growth prospects will be stronger there than in the City.

Now, we remain of the view that overall demand for conventional office space is going to reduce, as a result of more hybrid ways of working, but that the impact of this is not going to be uniform across every location. Now, we previously said that we expected large HQ type space or areas, which offer little reason to visit beyond simply work to see a more significant reduction in space requirements. Whilst we said we expected demand for attractive energizing well-connected places to be much more resilient.

Now, the chart on the top right of this slide illustrates how this is beginning to happen with around 75% of all space available for subletting in London located in the wider city and Canary Wharf submarkets, whilst in the areas, where most of our portfolio is focused, subletting availability is minimal.

Now, whilst we continue to see some customers upsizing, others taking less space, it is clear that for virtually all quality has become the most important decision driver. Our strong leasing performance following our record leasing last year shows we are well-positioned for this. We signed or in solicitors' hands on £48 million of annual rent on average 5% above valuers' assumptions. Our occupancy increased to 95.9%, which means our vacancy rate is half that of the overall London market. And our West End portfolio is essentially 100% occupied.

We continue to see strong demand for our Myo flexible offer, and occupancy there is now up to 92%. So, we're planning to open three new locations in the autumn. And underlying the appeal of our space to our customers, less than 1% of it is being marketed for subletting. And our development projects are similarly well placed. The well-timed sale of 21 Moorfields in September crystallized a very healthy 25% profit on cost, and we have continued to see strong leasing activity across our three other schemes.

These three projects are now 60% pre-let or in solicitors' hands, up from 38% 6 months ago, with deals over the past 12 months, on average, some 11% above ERV and even further above the expected ERV when we originally committed to those projects.

Now looking forward, we expect that the growing shortage of Grade A space will drive further growth in rental values for the best space. As such, we expect to see low to mid-single-digit growth in ERV across our London office portfolio this year, with growth in the West End towards the higher end, growth in the City more muted. We have already seen a reduction in new development starts across the market, and we expect that to continue. So new supply in 2 years' to 3 years' time is going to be down accordingly.

Our decision to commit in the autumn 55 million to early works at Portland House and Timber Square, means that we've managed to maintain program for delivery of those projects into a supply-constrained window in late 2025. So, as returns look attractive, demand remains strong and future supply is reducing, we will be committing to the full development of both of those schemes imminently.

Moving now to retail, where demand for the best destinations continues to grow. And this reflects the fact that for major brands, online and physical sales channels are increasingly seen as being interconnected. And an element of online sales continues to shift back to stores, as the pandemic impact on consumer behavior begins to wear off. Indeed, key retailers such as Next or Inditex have recently indicated that online sales are unlikely to be as big a share of their overall sales, as they had previously been anticipating, whereas online pure-play businesses such as Zalando have shifted their focus from growing market share to improving profitability.

As such, we continue to see brands invest in, refocusing on fewer, bigger, better stores, especially so as the profitability of operating that physical space has further improved, given the roughly 30% reduction in business rates that came into force last month. And this continues to drive a tangible increase in demand for space in our locations. The overview on the right of this slide illustrates this.

With 57 recent or current events, where brands are either upsizing their space, relocating to our centers from elsewhere in the city or where we're expanding our relationship by introducing those brands into new locations. Whilst we expect brands will continue to rationalize store numbers, many are seeing above-average sales growth in our centers, compared to the overall store portfolio. So with pressure on margins for both online and offline from inflation and a squeeze in consumer spending, we expect the flight to prime to continue, as secondary locations remain challenged.

Now, we continue to see the benefits of our investments in strengthening our retail team and changing the way we operate to focus on brand relationships rather than simply on assets, and we've seen continued growth in brand sales, and that supported strong growth in leasing. We signed £27 million of lettings during the course of the year, which is up 35% versus last year, on average, 8% above ERV.

As a result of that, occupancy increased 110 basis points, now stands at 94.3%. And we're not really seeing any sign of a slowdown in that trend despite ongoing concerns around cost of living. We currently have £11 million of lettings in solicitors' hands, that's 28% higher than this time last year, and they are on average 11% above ERV. And overall, we therefore expect to see low to mid-single-digit growth in retail ERVs in the year ahead.

Our growing brand relationships and the trading insights that we get from the growing amount of turnover data we collect increasingly provide a unique perspective on our prime retail destinations.

Now, we've previously highlighted that we saw value in this space, given that sales have largely recovered to pre-pandemic levels and leasing continues to build, while values remain down at peak pandemic distress or peak online penetration levels. And this disconnect has widened further in the last 6 months, as values were marked down further based largely on sentiment, even though operational performance continued to improve.

Now with subjectivity and valuations elevated, we believe the latter is a more relevant benchmark and continue to see an attractive opportunity in the future returns that are on offer. And we demonstrated this very recently when we bought the debt secured against the 50% stake of St. David's, which used to be [and buy into] [ph]. We did that via two separate transactions with two different lenders. And subsequently, we completed a loan-to-own restructure.

All of that allowed us to get 100% control of the center at a material discount to the latest book value and at an attractive income return of 9.7%. And that looks especially good given that occupancy has been growing, and we've been leasing space there 10% above ERV across the course of the past year.

So, now on to the third part of our strategy, mixed-use urban neighborhoods. Now, the structural trends underpinning our decision in 2020 to expand in this space still stand, be it demographic growth, driving demand for more homes, urbanization, or the fact that the lines between how people live, work, and spend their leisure time is increasingly blurred and will have an impact on the future of cities.

Now, our long-term pipeline remains significant, and we've made material progress during the year in bringing forward several key projects. At Mayfield in Manchester, we agreed a land drawdown with our joint venture partners, which effectively allows us to develop 100% of the first phase of this site ourselves, and that will cover around a third of the overall project.

At Finchley Road, we received resolution to grant planning consent for our 1,800 homes masterplan. And in Glasgow, we're on track to submit a major planning application shortly. Now, all of that means that this part of our business is now getting to a stage, where it is no longer simply about a pipeline, as we could actually start to deploy our first capital into development later this year.

Now all these projects are highly sustainable. They're located in some of the U.K.'s highest growth urban areas and they're all immediately adjacent to major transport infrastructure. So, given the mix of uses and the ability to face CapEx commitments, they continue to offer a balanced risk profile with attractive target IRRs in the low to mid-teens.

So, turning to our two most advanced projects. At Mayfield, we're preparing detailed plans that could allow us to start on site late this year with the first two office blocks, and they will offer 320,000 square feet of highly sustainable space in what is a very attractive location. The overall cost should be around £150 million, with an expected yield on cost of around 8%. And we expect to make a decision on timings this autumn.

At Finchley Road, we were delighted to receive a resolution to grant consent for our scheme in late March. So, we're now finalizing planning, progressing detailed designs. Subject to this and obtaining vacant possession, we could start enabling works on site towards the end of this financial year. We will, of course, make any decision to commit capital in view of wider economic and financial market conditions at that time, but ultimately, these schemes continue to offer significant long-term optionality and growth potential.

And with that, I will now hand you over to Vanessa to talk you through the financial results.

[Vanessa Simms, Chief Financial Officer]

Thank you, Mark, and good morning. Market conditions have changed considerably over the year and with growing disconnect between the strong occupier demand and the investment market, where the sharp reduction in transactions makes current property valuations more subjective. However, the strength of our business can be seen through the quality of our earnings and strong capital structure.

So, let me turn to our financial headlines. Our strong operational performance is reflected in a 10% increase in gross rental income and EPRA earnings. We benefited from a 22 million increase in surrender premiums and adjusting for this underlying EPRA EPS was up 4.4% to [50.1p] [ph]. I'm pleased to say this is towards the upper end of our guidance of low to mid-single-digit growth. And in-line with this, our dividend is up 4.3% to 38.6p, which reflects a dividend cover of 1.3x.

As a result of the interest rate rises, valuation yields increased, and the impact of this was partly mitigated by leasing, which drove 3.6% ERV growth. However, EPRA NTA per share was down 11.9% to 936p. We have further strengthened our balance sheet with asset disposals and financing activity. Our net debt is down almost 1 billion and LTV is down to 31.7%. Our net debt-to-EBITDA ratio has also reduced to 7x at the year-end.

Turning to EPRA earnings in more detail. Gross rental income was up 61 million, driven by three factors: the increased surrender premiums, which I referred to earlier, accretive acquisitions, and strong growth in like-for-like income, which I'll explain in more detail shortly. Direct property expenses were stable. Prior acquisitions increased direct costs by 7 million, which was offset by a 6 million decrease in like-for-like costs, as a result of increased occupancy and cost savings.

Last year, we initiated an organizational review to accelerate the execution of our strategy and to improve platform scalability and operating efficiency. This contributed to cost savings, which have offset inflation and our admin expenses have remained flat against last year, in-line with our guidance. Whilst inflation remains elevated, we expect admin costs to be down slightly in the year ahead, as a result of ongoing efficiency improvements. And interest expenses increased by 13 million, principally due to the acquisitions that we made in the prior year, plus a small increase in variable rates.

We expect interest costs to increase slightly this year, reflecting a small increase in the average cost of debt, which is now fully hedged at 2.7%. However, the cost ratio reduced to 25.2%, and we remain on track to reduce this towards the low 20s over time, principally driven by the efficiencies from investment in technology and operating model – our operating model review and procurement savings. And gross rental income was up 10% overall and 6% on a like-for-like basis with positive growth across all segments.

In Central London, we delivered 4.2% like-for-like growth from new lettings, strong growth in Myo income and Piccadilly Lights. Across major retail like-for-like income was up 1.9%, with growth in occupancy and turnover income, partly offset by some negative reversions of historical leases. And this year, we see the significant over renting in leasings in retail reset. So, we were expecting like-for-like growth to pick up the year after.

In subscale, the strong recovery in hotels and some leisure upside contributed – resulted in an 18.2% growth, and the net impact of our investment activity was 13 million. This was principally reflecting the full-year impact of prior acquisitions. The 22 million increase in surrender premiums reflects a lease surrender that we agreed in Southwark to create a new development opportunity next to the recent scheme at The Forge, and the lease restructure in Deloitte at New Street Square earlier in the year. The latter unlocked the opportunity for major lease regear with Taylor Wessing elsewhere in the estate and the successful disposal of One New Street Square in January.

And turning to portfolio valuation. The marked increase in interest rates meant that property transaction volumes slowed materially across the globe. In the U.K., you will reset quickly, as a result, and that was especially during the fourth quarter of calendar year 2022. Despite ERV growth across all key segments, this meant that the value of our property reduced by 7.7%.

Our Central London portfolio was down 7.3%, as the increase in yields was partly offset by a 4.7% increase in ERVs. And at the top – that was at the top end of our guidance of low to mid-single-digit ERV growth for the year. The ERV growth in the City was solely due to a major lease restructuring at New Street Square with the associated refurbishment CapEx taken as a cost in the valuation, and adjusting for this, the City ERVs were flat.

Following our recent disposals around 70% of our Central London portfolio is in the West End, which has proven more resilient than the City. And we expect the stronger outlook for rental growth in the West End to continue. Developments were down slightly with strong ERV growth from recent lettings, offset by softer valuation yields. And the reported value of our major retail assets was down 6.4%, where valuers moved yields out based on sentiment in the absence of comparable transactions.

However, in our view, the improvement in income and occupancy that we deliver is the most important factor than sentiment. And in mixed-use, the value of our completed assets at MediaCity proved relatively resilient. Future mixed-use developments were down, as these are valued based on their existing use. And we manage income on a short-term basis to create the flexibility for our development plans.

Across our subscale assets, hotels were resilient, but leisure was down 15% in the second half. This principally reflects the Chapter 11 of Cineworld, who continues to operate and pay rent and its recapitalization since the year-end is a clear positive.

So, looking forward, whilst property values have started to stabilize in recent months, investment activity remains low, and we are mindful of the wider market uncertainty, however, we expect prime assets to return to growth well before secondary property, where occupational demand is more questionable. And we expect major retail destinations to be more resilient than the lower-yielding sectors.

As a result of rising yield value – the rising valuation yields, EPRA NTA was down 11.9% for the year. This includes the impact of disposals, which completed 144 million below the March 2022 book value, but crystallized a 25% profit on cost and a 10% IRR. Including dividends, our total return was negative 8.3%, which again was highly impacted by yield movements. To illustrate this, our income return on EPRA NTA was 5%, whilst ERV growth added 2.5% and developments added 0.8%.

So, resulting in a positive return of just over 8% before the impact of ERV movements. While others in the market paused or they slowed down the activity last – since last summer, we have continued to progress our strategy to drive our future returns. This slide shows the impact of our capital decisions. We now have – we have now sold 2.4 billion of the 4 billion target that we set out in late 2020, including 1.4 billion over the past year.

And we continue to recycle capital further this year, and we're ready to act on opportunities that we expect to arise in the markets, as they adjust to the higher interest rates. But as we said in November, we believe that the full effect of the increase in interest costs will only work its way through the system over time. And our performance is underpinned by our sector-leading balance sheet, which we further reinforced during the year.

Our strong investment-grade credit rating provides good market access, and we have the lowest corporate bond spread in the sterling real estate market, which gives us a clear competitive advantage. During the year, we reduced net debt by 0.9 billion, and we issued a 400 million green bond, which increased our average debt maturity to over 10 years. And as a result, we are now 100% hedged.

We also have 2.4 billion of undrawn facilities, providing substantial flexibility, and we have no need to refinance until 2026. Our LTV reduced to 31.7%, although LTV is not a great measure to judge leverage when the approach to valuations varies widely in different markets.

More importantly, our net debt-to-EBITDA fell to 7x at the year-end and 8x on a weighted average basis over the year. This is one of the lowest in the sector, and it reflects the strength of our capital structure and our earnings profile. So the strength of our balance sheet puts us in a great position to take advantage of current market conditions.

Let me summarize with our performance outlook. Our sector-leading balance sheet and significant progress with the repositioning of our portfolio positions us well for future growth. We expect strong occupier demand from our high-quality retail and our Central London assets to result in low to mid-single-digit ERV growth in the year ahead. We have a consented pipeline of around 4 billion, which is expected to deliver double-digit returns. And combined with our attractive earnings yield, this underpins our aim to deliver an 8% to 10% annual return through the cycle.

Short-term movements in valuation yields are beyond our control. So, we're unlikely to be precisely in that range every single year, but this target is what we base our decisions on. This year, we expect EPRA earnings per share to be broadly stable with last year's underlying 50.1p. This includes around 10 million impact from the start-up cost of our Myo expansion, the investments in IT, and the final over renting in retail resetting.

We expect continued growth from operational performance to broadly offset this and the fact that we are likely to remain a net seller of assets in the near-term. And we expect EPS to return to growth the following year.

However, we expect dividend growth of a low single-digit percentage per annum, as our current payout is at the lower end of our policy range of 1.2x to 1.3x cover by earnings. There will undoubtedly be some interesting opportunities coming out of the current market dislocation, and given our strong position, we are well placed to benefit from this.

With that, I'll hand back to Mark.

[Mark Allan, Chief Executive Officer]

Thank you very much, Vanessa. So, I will now wrap-up with how we view the current environment, what you can expect to see from us in the year ahead, and then we'll open up for Q&A.

So, the past year has seen the most striking divergence between occupational markets and investment markets that I can remember. Interest rates, inflation have surged following a decade of unprecedented central bank stimulus and credit conditions have tightened, and that's resulted in a material slowdown in investment activity and downwards pressure on asset values, even though customer demand for the best assets, best locations remain strong and rents are continuing to grow.

Whilst it's impossible to predict, where interest rates will settle over time, we've positioned our business for a higher for longer scenario. As in a long-term context, the artificially low rates over the previous few years appears the aberration, not the adjustment that we've seen in the past 12 months.

Now unwinding a decade of excess liquidity was never going to be a smooth transition. And we're mindful that there may be further risk in the system, as the world continues to adjust to a new higher rate reality. We said 6 months ago that this adjustment would have a negative impact on return on equity in the short term, which, of course, it has. And whilst the recent stabilization in property values, there lies a low level, the investment market activity, we do expect prime values to return to growth well before secondary.

And this reflects the increasing recognition amongst customers, be it in offices or in retail, that the quality of space is pivotal to attracting key talent or customers, more so than ever, the key ingredients for growth are portfolio quality, balance sheet strength, and an ability to unlock opportunities, all areas, where Landsec scores highly.

So, to sum up, markets continue to adjust to a new reality, which means the short-term outlook remains unsettled, but we have built positive momentum in executing our strategy despite these headwinds. As a result, we have a high-quality portfolio that's well positioned for growth, a strong balance sheet that is ready for growth, and a skilled team delivering value through our existing assets, but also ready to seize new opportunities, meaning that over the longer-term, we will be able to deliver better returns for our shareholders.

Our strategy remains the right one, and we will continue to build on the strong momentum in each part of our business. We'll remain decisive in monetizing assets, where we can't add further value, and we expect the balance of disposals from here to shift more from London, towards our subscale sectors. In the near-term, we will probably sell more than we buy initially, and that's reflected in our earnings guidance. And we will progress our two near-term developments in London, whilst continuing to maximize optionality in our future pipeline, which could see us start first works on site at two major mixed-use schemes, as well in the next 12 months.

Our balance sheet is strong, preserving that strength remains a key priority. Although, we have significant headroom to invest, the size of accretive opportunities in our existing pipeline and across the wider market is such that it would likely exceed our own balance sheet capacity over time. So, we also intend to explore opportunities to access other sources of capital to accelerate our overall growth and enhance our returns.

The successful execution of our strategy means we have a high-quality portfolio, which is well placed to cater for the future demands of our customers, resulting in improving prospects for growth. Whilst our strong capital base puts us in a great position to capitalize on the opportunities that will no doubt arise, as the market continues to reset. The outlook for the next few years is ideally suited to the competitive advantages of the new Landsec. As a result, we're excited about the future.

Thank you very much, ladies and gentlemen. With that, I will now open for Q&A. We've got three potential sources of questions here in the room, and I'll start there. Hopefully, we've got a roving mic on its way. And I will then move to questions from the conference call. And then lastly, with any questions coming from the webcast. So, please feel free to raise your hand if you've got a question. The microphones are in the chairs, I'm sorry, forgive me, technology. Miranda, why don't you start?

[Miranda Cockburn, Panmure]

Yes. Miranda Cockburn from Panmure. Just in terms of valuation, just interested, your portfolio fell in value by around about 5% in the second half of the year. That was obviously a very significant outperformance of the MSCI IPD, which even if you take out industrials fell by, sort of 10% to 12%. Can you just sort of talk through the rationale behind that? Is it – are we starting to see the differential between the sort of the good and the bad in terms of offices, et cetera, retail? How do you see that?

[Mark Allan, Chief Executive Officer]

I mean, I think it is very much that. I mean, I think that was the outage in property historically has just been how important, in particular, the location of assets have been and well located prime assets have always significantly outperformed inferior assets. I think we're now adding to that a much more acute sense of importance of the quality of assets, be that the sustainability credentials, be that the amenity that's offered around offices, whether they are attracting a big enough share of catchment in retail assets.

So, I think this divergence is just going to become more and more acute. So, at the wrong end of the market, if you like, we've already got 20% to 25% of excess retail property across the U.K. We could well see not probably to that extent, but we've said our view is there's probably a 20% reduction in demand for conventional office space, but it's going to be at that same end of the market. So I think this divergence is going to continue.

I think MSCI is very helpful from a sort of trend and directional perspective, but actually what in MSCI relative to what you've got in our portfolio, and I guess some of the other listed REITs. It's a very, very loose proxy, I think, in terms of – I wouldn't read too much into direct performance of the two, but very helpful directionally.

[Miranda Cockburn, Panmure]

And then just a couple of other small questions. One, just in terms of what's the valuation yield of St. David's, as in your – that the current valuation obviously versus the 9.7% implied yield?

[Mark Allan, Chief Executive Officer]

I would...

[Vanessa Simms, Chief Financial Officer]

So, yes – the transaction was close to the year-end. So, it's in a similar position to the acquisition.

[Mark Allan, Chief Executive Officer]

So, the 9.7% would be at a bit of a discount to what it's, but it's not going to be a material discount at this stage.

[Miranda Cockburn, Panmure]

And then lastly, just in terms of your subscale portfolio, which is about 1.3 billion, obviously, that's been subscale for a while now, and it's – you're looking to sell. Over what time period do you think we could see that or you exiting out of that?

[Mark Allan, Chief Executive Officer]

So, I think [we certainly] [ph] expect, as you indicated to see disposals during the course of the year ahead. As a reminder, we've got a hotel portfolio, retail parks and leisure parks within that subscale portfolio in roughly equal thirds. Now, I think the – from there, that the hotel portfolio has seen the strongest recovery post-COVID, I think that's also, where the investment market is most liquid. So that's probably going to be one of the nearer-term disposals from there.

Retail park market, I think, you're starting to see capital return, debts return in modest quantity. So, I think you could see us sell retail parks on a -- more like on a piecemeal basis and a portfolio basis. Leisure parks, I think, more challenged in terms of immediate disposal prospects, concerns over consumer spending. Most of those leisure assets are cinema anchored, and whilst we expect cinema performance to pick up quite materially later this year and into next year, as the production slate – there was a sort of impact on films not being produced back in COVID, this led to a bit of a dearth of releases in the last 6 months to 12 months. That changes from later this year.

So, I think that would probably – we'd want to see that come through before looking to exit from any of the leisure assets. So, broadly of that order, but it's going to be over the next 3 or so years in total.

I think another question here, and then, we'll go to Paul behind.

[Sam Knott, Kolytics]

Sam Knott, Kolytics. Thanks for the presentation. I got a couple of questions, if I can. On your retail destinations, you've got a 4.4% like-for-like sales above pre-COVID levels. Is that inflation adjusted given the loss of a few years now? And if not, are you sort of expecting further growth back to those levels on a real terms basis or is this more of a new normal?

[Mark Allan, Chief Executive Officer]

Actually the 4.4% will be a nominal number. So, it will include inflation. So, certainly, you'll see price inflation is in that number. It's not a sort of like-for-like pure volume. I do certainly feel for the reasons we've outlined that we're going to see a couple of trends continuing in our sector or in our centers, I should say. So, we are going to see more retailers upsizing and locating into our centers.

So from a total sales point of view, there's room for occupancy still to grow a little bit further. But then for those strong retailers that are in those locations, the mix of online, offline has started to change because of the profitability pressures on doing online business. So that is going to continue to drive in-store sales. So, I firmly expect us to see growth.

From a rent point of view, we've got ERVs – sorry, rents resetting this year that Vanessa talked through in the presentation. Once we're through those, I think, from next year, we'll then start to see that sales growth translate more naturally through to rental growth.

[Sam Knott, Kolytics]

Thanks. And on sort of the future capital allocation, you indicated that you expect there to be some opportunities for investment, as of the impact of rates comes through the system. [Indiscernible] what sectors you're expecting those opportunities to be in under what sort of pricing you'd expect it would – that sort of settle at the best opportunities? And would that be funded purely from disposals or what's your, sort of headroom on LTV that you feel comfortable with in the near future, if there's some economic uncertainty?

[Mark Allan, Chief Executive Officer]

So, let me talk about the sectors, and then I'll ask Vanessa to comment on balance sheet headroom. So, when we launched our [strategy] [ph] back in 2020, it was very important that we focused our resources and capital and people, where we have genuine competitive advantage, and I think that's a really important principle to run any business by. So, it will still be the sectors that we have expertise in today, where we'll be looking to deploy capital.

So, we obviously have a London development program, which is a very attractive program that's going to be delivering into a supply starved window in late 2025. But I think we will see other opportunities emerge in London over time. Mixed-use, I have talked about the projects that are ready to deploy capital into. I think we've got a pretty substantial mixed-use pipeline that we'll be able to deploy capital into pretty consistently in the years ahead.

So, unlikely to be adding material new mixed-use projects in the near-term given the scale of what we've got. But retail, I think we indicated back with our strategy that we wanted 20% to 25% of the portfolio to be in major retail destinations. It's sort of high teens at the moment. So, there's certainly room to invest more from a portfolio allocation point of view in retail. And as, we've done that with St. David's, we'll continue to look for opportunities within that overall sector.

As to pricing, I think we made quite an important point in the presentation that prime values are going to turn a corner and return to growth well ahead of secondary. It is really challenging to judge when occupier demand is going to provide any, sort of underpinned secondary. I think as a result of that, you are going to see capital concentrating at the prime end of the market. So, I'm not expecting to see sort of super distressed pricing, but I think we will see very high-quality assets available at sensible prices. Vanessa, [so balance sheet] [ph] headroom.

[Vanessa Simms, Chief Financial Officer]

Yes. So, I've mentioned in the presentation I suppose 2.4 billion of headwind that we've got available at the moment. And in terms of LTV, when we launched the strategy in late 2020, we talked about a target range for LTV to operate between 25% and 40%. So, that's where we've got our, sort of capital operating guideline, and that was through the cycle. And probably about 18 months ago, we said in the current climate, we expect it to be operating in the range of 30% to 35% at this stage. So, we're at the lower-end of that range. So, I think that combined with the headroom puts us in a strong position.

[Mark Allan, Chief Executive Officer]

Paul?

[Paul May, Barclays]

Thanks very much. Paul May from Barclays. I just want to focus on this 8% to 10% long-term return that you are targeting, which is in excess of, say, real estate, 6% to 8% long-term returns. Just wondered at what time you're expecting to deliver that and whether you can break that down between income and growth and given your rolling cost of debt is, say, 5%, give or take, at the moment, which is higher than probably when you set up your financial targets, you're probably looking to have less debt on that, I assume, just moving forward, I think you mentioned alternative sources of financing earlier. And then finally, to hit those returns, assuming or I assume you're not expecting a material increase in long-term rental growth from the, say, 1 to 3 that real estate has delivered over the historic long term. So, you'd be assuming a material fall in yields or increase in yield, sorry, particularly, say, on offices, if you're looking at offices from the current levels? Thank you.

[Mark Allan, Chief Executive Officer]

Sure. Thank you, Paul. So, let me explain what that 8% to 10% is because the reason I think it was important that we referred to that within our statement is that we're making – we have to make in our business long-term decisions about, where we allocate our capital. And in doing that, we've got to judge what's the right return that we should be making for the risks that we're taking.

And so, with the 1.4 billion of assets that we sold sort of mid-single-digit return that we were expecting on our assumptions meant that wasn't a good place to keep capital, low double-digit. These are all unlevered returns, by the way. Low double-digit returns on development, I think, low double-digit returns, it will be available unlevered on prime retail in the current market. Those look to us much more interesting.

So, when we put all of that together, we think that leads us back to a world, where ungeared returns for property are going to be high-single-digits, which is where they probably were pre-financial crisis, they were pulled down by cheap money. They've got to gravitate back upwards. When we put that, sort of through our model of how much we're going to be able to recycle capital and maintain the balance sheet strength, et cetera, of the business, it leads us to feel that, that 8% to 10% is about right.

Now, how does that break down? Historically, we've been targeting, I think on our previous returns of roughly 50/50 income versus growth. I think we're probably pointing to slightly more growth, as a proportion of those returns. And interesting point you make on the 1% to 3% growth that real estate has historically delivered. The point I've made a moment ago, I think, in response to Miranda's question about actually this bifurcation of demand, I really think that's going to deliver much stronger growth at the prime end of the market and there's probably never been a more dangerous time to look at averages than the market we're in at the moment.

[Paul May, Barclays]

And then just one, sort of the difference between retail and offices, as you say, obviously, retail has been through a structural change, yields have moved out a lot. They were sort of almost arbitrarily moved out in the final quarter last year on – just a view of the valuers', offices have been much more resilient on the yield side. But operationally, you're probably getting to a point, where there's not a massive difference between the two in terms of like the better retail and the better offices. Is there an argument to be made that you see far more attraction in U.K. retail than you do in U.K. offices or at least in London offices at the current stage?

[Mark Allan, Chief Executive Officer]

It's an interesting relative call. I mean, I think what we're looking at is delivering best-in-class office product in well-connected locations, all of the amenity and the tickle of the sustainability credentials is going to deliver really strong returns. Obviously, there's more risk involved in the development aspect of that. I think on a risk-adjusted basis, therefore, the prime catchment dominant retail looks to offer a better return. But in terms of how much capital we could deploy over what sort of period of time, I think it's really important that we continue to grow and develop that platform in London development. But there is opportunities if we can unlock them within prime retail space.

And of course, you're buying at a 7.5%, 8% yield. Rents are substantially reset or will have done this year within that sector. And if that returns to growth, as we expect, then 7.5%, 8% cap rate is not the right cap rate for that sort of investment.

[Paul May, Barclays]

Thank you.

[Mark Allan, Chief Executive Officer]

Max, at the front here.

[Max Nimmo, Numis]

Hi. Yes. Max Nimmo at Numis. Just a quick follow-up question on the leverage side of things for Vanessa. As you begin to sell down some of the higher-yielding subsectors – subscale sectors, should we expect that, that net debt-to-EBITDA to kind of go back up a little bit or you – will you try and keep it around that sort of 7x because it's obviously come down quite a lot this year from [everything you sold] [ph]?

[Vanessa Simms, Chief Financial Officer]

Yes. So, we have capital operated – stated sort of capital operating guideline to target to operate with a net debt to EBITDA below 9x. I would expect us to be within the 7x to mid-7x going forward. But it will obviously depend upon the timing of our reinvestment into the development pipeline, as well as other assets. So, I think, broadly speaking, we would be below 8x, a bit below, where we've got that operating guideline at the moment.

[Max Nimmo, Numis]

Yeah, thanks.

[Mark Allan, Chief Executive Officer]

I don't think I have any more questions in the room. I've got a couple on the webcast. I'll go to momentary, but let me just check on the conference call line first if we've got anyone dialed in that has a question.

[Operator]

There are currently no questions on the line.

[Mark Allan, Chief Executive Officer]

Great. Thank you very much. So two questions from the webcast. So firstly, from [indiscernible] asking, can we elaborate on other sources of capital for future growth? What are we exploring and what kind of structures?

So, I suppose the basis of making reference to that within our results this year is that if we look at the scale of opportunities from Central London, we look at what we've got in our mixed-use pipeline over multiple years, we look about the attractions that we see in retail. They certainly in totality exceed any balance sheet capacity that we would have, whilst maintaining the strength of financial structure that is such an important part of the Landsec story.

So, of course, we've got choices, as a business. We can scale back the level of opportunities that we pursue. We could choose to take leverage up, which is, as I've indicated, is not something we would be prepared to do. We could move at a slower pace over a longer period of time. But when we look at the opportunities that are out there, we do think there is significant benefits to having scale across these and then a real opportunity to leverage value from the platforms that we have in each of those three businesses.

Hence why we will be looking at how we might partner with third-party capital to pursue some of those strategies, some of those opportunities. Now, it's too soon to talk about what those structures may or may not look like. But I think it is very clearly signaling the scale of opportunity that we believe we can capitalize on, as a business is ahead of what we would be able to sort of fund independently.

And then a technical question on Argonaut, the security structure is 9.6 billion of assets in the Security Group of constraints on asset management. What are the sector [waiting requirements] [ph] in the pool, please, that's from [Mike Prew] [ph], Vanessa?

[Vanessa Simms, Chief Financial Officer]

So, we do use the Argonaut structure to fund the Group primarily. That's our main funding facility. So, we have a pretty broad balance of assets that aligns to our main portfolio. The exceptions of what probably wouldn't be in there would be with MediaCity, where that's in a joint venture, and it's got its own security pool. But other than that, most of our assets would be in there.

[Mark Allan, Chief Executive Officer]

And Mike, I think if you've got some more specific questions on the asset pool in that structure, then, please do reach out to us directly, and we'll do our best to help answer. I'm told that we've got no further questions on either the conference call or the webcast. Hopefully, we've covered everything that people wanted to ask in the room. So, let me wrap up there just by saying thank you very much for your time this morning, and have a good day. Thank you.