This is an exclusive and detailed interview with Graham Barnet, founder and CEO of Sigma Capital (SGM).
We start by discussing Graham’s career and the origins of Sigma, before moving on to discuss the investment attractions of rental property in the UK today, the Sigma approach, and the company’s ambitious plans for the future.
Sigma Capital (LON:SGM)
- Share price: 131p
- Market cap: £117 million
- Forecast 2018 EPS: 13.2p
Q. My first question is about you and your career. How did your experience lead you to your current position?
Graham Barnet: I started as a lawyer, went into merchant banking for four or five years in Scotland, and, at the age of 27 set up my own business. It was designed to do two things. One, property – residential development and letting – and also acting for companies controlled by families in Scotland, who also had outside institutional investors. There were a lot of those back in the early nineties.
I represented the family’s interests in interfacing with institutional investors. I began to be involved in a number of fundraisings, and also became involved with stock market flotations.
That led to the formation of Sigma, in December 1996, which was essentially acting as an access to capital and a bridge to the capital markets. Then we floated Sigma in April 2000.
Q. So it originally started out as venture capital?
Very much so and, at that stage, we acted for businesses across all sectors.
We focused on businesses with weak trading records but that were rich in property assets, which could be leveraged to bring capital into the business, allowing families to grow the business, without diluting the family holdings. That, together with the residential ventures I was doing myself, was the backbone of what we are doing today.
Q. Sigma has moved into the private rental sector now. Before we get into the particulars of Sigma and what it is doing, I thought we might talk about the Private Rented Sector (“PRS”) in general, and why investors would want to choose PRS rather than other segments in the property market.
Everyone thinks that the Private Rented Sector is a relatively new phenomenon in the UK, but, of course, up until before World War II, 60% of the population of the UK rented. After the Second World War, there was a huge drive to build new homes. In reality the pendulum of home ownership and rental has swung back and forward over the last 100 years.
The Private Rented Sector is a very well established model in other countries in the world – Germany, France, America and Japan for instance, where there is large scale, managed rental stock. There is risk mitigation by having thousands of tenants across thousands of units over sites in multiple geographies.
So, for investors, not only is the quality of the yield very strong, but the granular nature of underlying assets gives them an awful lot of risk mitigation. The problem in the UK is that there has not been a collective asset base, in scale, for the big institutions and pension funds to buy into. And the reason for that is that the private rented market was essentially a “mamas and papas” industry. There were one or two quite large private portfolios, but, broadly speaking, it was a mixed bag of secondary stock.
Even at the peak of the market before the crash of 2007/8, we weren’t building enough houses in the UK, and it seemed that if we could put a large scale model together in the UK, then the capital markets, the big pension funds etc., would definitely want to invest capital. The issue was getting to the point where we could get the scale for them to take that risk. We entered into a dialogue with a number of the big pension funds about six or seven years ago to ask, ‘if we could pull this model off, what does it need to look like for you?’
Another factor for them is that they are investing in something which is an absolute need. Everyone needs a place to live. Not everybody can afford to buy a place. For me, it was how do we get to something of scale, a model which was attractive to institutional investors. In fact I want to get this to £5bn-£10bn because that is the sort of risk mitigation they want.
I wanted to create a model which was repeatable, i.e. very consistent output. We do standard family homes – two, three and four bedroom, and are aiming to deliver across hundreds and hundreds of sites in 30 or 40 major conurbations in England. The risk mitigation in that is significant.
Then we create a consistent flow of capital into the model. That’s obviously what’s driving Sigma and what grows The PRS REIT plc, which is that collective model that we’re managing now.
Q. Let’s move on to talk about Sigma. There are five wholly owned subsidiaries, and The PRS REIT plc is a separate vehicle? Could you briefly describe how the activities of Sigma are shared out?
When we took the decision to launch The PRS REIT plc, we had two significant PRS partnerships, with Gatehouse Bank and the Kuwait Investment Authority. And we took the view that for the PRS REIT to be successful we needed to remove any concept of conflict.
Broadly speaking in Sigma, there are three key operations now.
There’s a historic regeneration business, where we’ve built c. 18 schools and c. 3,500 houses. We are finishing a big project in Lime Street, Liverpool, and some housing projects in Liverpool. However, we will be doing less in this business, just those projects that are accretive to what we’re doing on the PRS side.
The second part of our business is the historic partnerships – the management of our two partnerships with Gatehouse Bank and the Kuwait Investment Authority (what we called ‘Thistle’ and ‘UK PRS’). We’re just in the process of finishing the last site for that second partnership, and then we’ll continue to manage those assets but we are not doing any new development for them. We’ll be paid asset management fees for managing and we get carried interest on those assets when they are ultimately sold.
To be clear, the creation of those assets were the foundation for us to have the credibility to be in a position to launch the PRS REIT.
We couldn’t go straight to PRS REIT because no-one else in the UK had ever done it before, and, if we had turned up and asked for £500m from institutional investors, we would have just been laughed at. We needed to prove that the model worked and those partnerships were the proof of our model.
Sigma PRS is our management business for managing The PRS REIT plc and also for managing the acquisition and development of our own balance sheet assets, and we’ll come on to talk about how they fit together with the PRS REIT.
So, essentially, the future driver of the business is the growth and management of the PRS REIT. However we also manage our two historic parts of the business. These were quite fundamental, because our regeneration business gave us our contacts and three big geographic bases in England, with our partnerships in Liverpool, Salford and North Solihull. It allowed us to leverage our credibility to build this model. We now work with some 30 or so local authorities.
From that point of view, Sigma’s model going forward is pretty streamlined. We have some historic activities, which make a nice contribution, and the real drive is to grow the PRS REIT and make that £4bn-£5bn, not just £1bn.
Q. In terms of the size of the PRS REIT, you have raised £500m in equity, you have a £200m debt facility and there’s a target of £900m, fully geared?
Yes. The PRS REIT’s capacity for gearing is limited to 45% – £500m of equity and c.£400m of debt – so its capacity is c. £900m. The PRS REIT doesn’t need the second c.£200m debt at the moment. We will most likely put that in place next year. In terms of what’s visible to deploy of that full £900m, as I sit today, all of that is visible. We’re sitting on a pipeline which is about double that size in fact. We’re already contracted on c. £450m+ and we are in the process of having more sites all the time.
What we remain really focused on is getting the ‘inputs’ into that model predictable – whether it is the management fees, letting management fees, housebuilding contracts. Long term pension funds, managing pensioners’ money are very risk adverse and the PRS REIT needs to be as de-risked and predictable as possible.
Predictability is one of the reasons why we do brand-new housing. Brand-new housing brings with it a consistency of pricing delivery, but also, our specification within these houses is identical. The same boilers, kitchens, window fittings, alarm systems, lighting fitting etc. So your maintenance regime is extremely predictable and very easy to manage.
If you go back to where the PRS market was ten years ago, it was mixed portfolios – a site in Hull, Bradford, Edinburgh, Southampton, etc and the houses would range in age from 200 years to 2 years and everything in them could be different. The variability in managing those sorts of secondary portfolios – what investors call “leakage”, the cost of managing – that is very, very high, typically 35%.
Whereas for us, with brand-new homes, you have your 10 years NHBC [GN note: National House Building Council warranty], you have your one year from the housebuilder, snagging etc. Training our maintenance teams is straightforward. Often the issues that come up are identical. So, for us, if you can get that input as systematic as possible, then the financial output becomes much more predictable.
And that’s the issue with a lot of these models in the past. Because of the variability of the delivery cost and the management cost, working out the yield was very difficult. Whereas, what we’re able to do now is present real scale and real predictability in the input, and then all you’re left with is demand for the product, which is vast. If you want to live on a managed housing estate, we are one of the main providers.
Q. How does the PRS REIT decide on gearing? Is that 45% level a rule, set in stone – how is it determined?
The cap was set by the commerciality of the investors we were talking to. Pension funds probably will never have invested anything in something where the gearing is more than 50%.
The for-sale value on our homes is easily determinable because our housebuilders build exactly the same type of houses on the same site, because most of our sites are mixed tenure. The houses are identical – they are ‘tenure’ blind. We believe that 45% gearing is low.
Traditionally, because REITs have been aimed at very large scale investors and because they are invariably an income model as opposed to a capital appreciation model, for instance there are rules that you have to distribute 90% of your distributable income, then invariably the gearing tends to be quite low in them, as a result of that. It was really the Government’s view around risk mitigation for these large investments. The Government invented the REIT as a vehicle for the UK. It was to ensure that investors didn’t get into the vagaries of what was going on in 2005/06/07 – when people were geared at 120% and so on.
So it’s a security, safety mechanism in the model. Clearly, it has a slight restriction on returns. If we geared to 65% for instance, you would have the potential for higher returns, but 45% is our model for the PRS REIT.
Q. I’d like to drill into the relationship between the Asset Manager, Sigma, and the PRS REIT itself. The PRS REIT has first right of refusal over Sigma’s pipeline, and pays 4% of gross development costs (as development manager fee), and then, on fully completed sites, Sigma earns profit from the sale of those sites that the PRS REIT buys from it?
There are three ways which Sigma generates value from our management of the PRS REIT. And I’ll start by making the point that our pipeline is exclusive to the REIT, so the REIT gets access to all of our pipeline and our PRS Platform that we have created over the course of the last six or so years with our partners, our network of local authorities, our extremely deep relationship with central government and all the opportunity coming through that – the PRS REIT gets first call on that. Now clearly, if the PRS REIT didn’t have capital to spend, then we are free and clear to do what we like with it, but if the PRS REIT has capital to spend, it gets first choice over everything.
The PRS REIT is capable of buying completed PRS sites from Sigma, up to one third of the REIT’s total assets. The remainder (a minimum of two-thirds of the assets) it develops internally – that is, it acquires and funds the development of suitable sites.
The reason that model came about was that big pension funds liked the idea that the PRS REIT would acquire some assets that were fully complete and let at the point of acquisition – even if the PRS REIT paid a little more that way. They felt that it gave them a further little bit of a risk adjustment to the whole of the portfolio – as compared with the whole portfolio being built from scratch, especially in the early days.
To get the 6% dividend that the PRS REIT is targeting, it falls at about a third of properties can be acquired. You could not buy more than a third from Sigma, because the extra price paid for those assets, at 45% gearing, you’d struggle to get more than 6%. What it means is that each time the PRS REIT raises capital, some of the assets that the new capital can buy are completed assets that generate rent from ‘Day One’ as opposed to building the asset over time. It was that blend that the investors liked.
On the assets that Sigma builds and that the PRS REIT acquires, the sites have to be fully complete and let. We get a valuation before we even start the site, from Savills (the PRS REIT’s valuer), and we make roughly a 8-10% margin on cost.
So, if we do £75m of assets per annum, broadly speaking we’ll make something between £6.5m and £7.5m profit. The PRS REIT gets income on day one from that asset and they are bought at investment value.
For the vast majority of the assets, a minimum of two-thirds, we have granted the PRS REIT exclusivity over our pipeline and our platform. In addition to that, the PRS REIT doesn’t actually take any development risk, as Sigma procures the planning, the fixed design & build contract, and the clean title for the site, before the REIT is involved. So actually the REIT doesn’t take any core development risk at all, we take the development risk for the REIT, even for a site which is actually built in the REIT. The development risk piece is done before the REIT gets involved. And again, this is risk mitigation for those long term investors – they didn’t want the REIT to take planning risk, or pricing risk etc. It is all dealt with by our platform before the PRS REIT gets involved. And then we deliver the physical site and get it let, and for that we charge 4% of Gross Development Cost.
The last part is our asset management fees, for actually managing the PRS REIT itself, and that’s on a sliding scale of Net Assets, starting at 1% for the first £250m, 0.9% for the next £250m, 0.8% for the next and 0.7% for the next.
If you looked at the total potential resource that the PRS REIT should have to deploy when fully geared – the £900m figure. If that was split, one third/two- thirds, the PRS REIT would buy up to £300m of completed PRS sites from Sigma, which would throw off c.£24m development profits (assuming an 8% margin) to Sigma over a 2.5 year period. The remaining £600m would fund development sites bought by the PRS REIT, over the same time, and that would generate c.£24m (c.4% of the gross development cost) for Sigma. Sigma would also earn an asset management fee of about £4.75m per annum from the PRS REIT, based on the £900m figure. (And that £4.75m assumes no asset growth). And then Sigma generates c. £1.5m of revenues from our other activities.
You can see in the context of where Sigma has come from that generates £70m of revenues over a three years period, on a cost base of c. £5.5m.
The play in this is big. It is designed to be big. It was very difficult over the last four or five years putting a model together at scale when you didn’t have scale! Now of course, we are getting there, and our partners, are, of course, delighted. Scale drives a lot of efficiencies with our partners because that visibility of capital allows them to plan and design their business around that predictability, which you don’t get with market-for-sale housing business, when you are subject to the vagaries of the market etc.
The whole idea around the PRS REIT was to create a substantial model, which was capable of, in terms of its output, becoming the equivalent of a top ten housebuilder. We expect to deliver thousands of houses per annum from next year onwards, so we will be making a significant contribution to housing delivery in the UK. Also remember that 95% of the new housing for the Private Rented Sector has been and remains apartments. That’s mostly because PRS investment has been driven by London, but, even in the regions, 95% of PRS development is apartments, with only 5% in houses – and we are responsible for 95% of those houses.
And our focus is family homes. We think politically, economically with the councils, and from an ongoing management perspective, it is far simpler to build and manage family homes, and demand for rental homes is significant.
Q. Do you see the model spreading South?
We are seeing quite significant negotiations going on, on a number of sites in the South, with one of our partners.
Q. What sort of a team have you got behind you?
There’s about 34 of us. When we started down this route, we had about £800k in the bank so our ability to do all this by ourselves was limited – and we had a market cap of £3.5m at the time. So ours is a partnership model. I use the ‘partnership’ word a lot and what I mean by that is partnership with a small “p”. Also what made us fundamentally different was our focus on family housing as opposed to apartments.
The heavy lifting in our model is done by our partners, which are substantial companies that employ thousands of people. I joke that I have 4,000 people working for Sigma, but only have to pay 34 of them. And that’s because we have created a model of mutual benefit between us and our partners – local authorities, central government, house builders. Our model feeds theirs. And their input feeds us.
I used to get asked all the time, “Could you get a better deal off your house builders” but why would I try and squeeze an extra £100k off a £10m site, when the relationship is about working together for the interest of both parties?
Our view was that we would partner with people where we could create a huge level of trust and where our model feeds theirs. We significantly derisk the delivery of housing for our house building partners, and we accelerate housing for the partners. If you take Countryside Properties, our bigger partner, we’re delivering somewhere between 20 and 25 homes a month on our mixed tenure sites. They’ll do their 4-5 a month market-for-sale, like every other housebuilder, but they are doing 15-20 houses a month for us.
If you think of 20 families per month moving in on a site, for local authorities that is huge and its 20 families moving in who can’t afford to buy a house and do not qualify for social housing. For councils this is a huge thing. They are under a pressure to provide housing, which they can’t if they don’t have the money or resources or skills sets to do it anymore. Social providers are slowing down and market-for-sale just builds four or five new houses a month. We come along and enable 20/25 new house a month to be built on a mixed tenure site.
For our house building partners that gives them something unique in their discussions with local authorities in relation to their broader business as well, as they have this accelerated delivery platform working with us.
It’s transformational, changing housing delivery at that speed.
Q. If we try to value Sigma, I don’t think we start with the net asset value any more do we? It’s all about the income now really, isn’t it?
I think over the next few years our net asset value is going to grow quite significantly, I have to say. But I think we are an interesting mix.
Let’s makes the assumption that we don’t raise any more money for the PRS REIT; we just generate our £70m-£75m revenues over the next few years, and that’s it – although that’s not our plan! What is left at the end of that?
If you assume the net assets are £560m, then our pro-rata share asset management fees would be £5.3m per annum. The asset management fees from our historic partnerships, and the dividend income we get from the PRS REIT – we subscribe half our development management fee in shares in the PRS REIT, so we get that dividend as well. And that dividend is growing. It’s quite a decent sum. We get 0.2% on the cash we sit on the bank and I’d rather be getting paid 5%-6%.
And then if the PRS REIT doesn’t raise any more capital, we are already on with building our own portfolio. As it currently stands, our financial resources would allow us to build a portfolio of £110m of assets, if we didn’t raise any more capital and we didn’t recycle all our free cash into assets, the real number is much bigger than that. But let’s say £110m. The net rent after all costs, a typical gross to net management costs, the typical financing costs we would generate another c. £3.6m of net rent. And again the actual number I’d expect to be higher, we’re just being conservative. So, even if all we did was see the PRS REIT out, we would generate a very strong profit stream over the next three years, and we’d be left with a business, and we’re not renowned for doing nothing, and we’d be left with a business that has £10m- £11m of recurring revenue, on a conservative basis.
If that’s all I was doing, my cost base would be about £1.5m a year. So you’re probably making about £10m pre-tax – that’s your downside.
Q. That’s the correct assumption to make? In terms of valuing the shares today?
I think from our point of view, that’s if we do basically nothing. That’s if all we do is build out what we are currently doing with the REIT and that’s it. The chances of that happening is slim!
And that’s one of the things I wanted to show – what’s the downside. Because the downside, I think, still underwrites where we’re at today.
It’s been a long hard journey in creating the model, but the strength in the model for us is significant, and the visibility for our investors is very strong as well, that’s the key thing – so there is a proper community of interest. If we do well, they everyone does well.
No payment was made in relation to this interview. The transcript was edited prior to publication. At the time of publication, Graham Neary does not own shares in any securities mentioned. This interview is for journalistic purposes only and does not constitute investment advice.