Is small-cap Palace Capital plc the best or worst buy in the property sector?

Can AIM upstart Palace Capital plc (LON:PCA) continue to outperform the wider commercial property sector?

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AIM-listed commercial property group Palace Capital (LSE: PCA) has been one of the top performers in the sector over the last year.

Today’s interim results show that Palace’s rental income and net asset value both rose during the first half of the year. Can this performance continue? In this article, I’ll highlight some key differences between Palace and one of its larger peers.

The good news

Palace will increase its interim dividend by 29% to 9p this year, the firm said today. Based on last year’s payment of two equal dividends, this should mean that shareholders can expect a total payout of 18p this year. That’s equivalent to a yield of 5.0%.

The net value of the company’s assets rose by 1.2% to 419p per share, during the first half. This means that at the current share price of 360p, Palace stock is priced at a 15% discount to book value.

Palace’s strategy of redeveloping properties to maximise rental yields seems to be working well. Rental income rose to £7.0m during the first half, up from £5.4m during the same period last year. This equates to adjusted earnings of 10.8p per share, which puts Palace on track for full-year forecasts of 21.3p per share.

What’s worrying me

Palace Capital’s strategy is to buy properties that need a helping hand. For example, management targets properties whose owners may be in financial distress, or where occupancy levels are low.

This approach has worked well during the strong market conditions we’ve seen in recent years. But my feeling is that the firm’s strategy could be riskier if the market slows down.

Palace Capital’s portfolio has an occupancy level of just 89% and a weighted average unexpired lease term of 5.8 years. The group’s debt also has relatively short maturities — 84% of total debt must be refinanced within five years.

The short-term nature of Palace Capital’s borrowings means that its debt costs are very low at the moment. Palace has an average interest rate of just 2.9%. My concern is that this situation may be too good to last.

If Palace fails to raise occupancy levels or secure longer leases, then refinancing could be costly. If property values fall in the regions, as we’ve seen in London, then Palace’s loan-to-value ratio of 39% could also rise to a level where it would become a concern.

A safer alternative?

I think it’s worth comparing Palace Capital’s key metrics with those of a much larger, older commercial property firm. Land Securities Group (LSE: LAND) is one of the UK’s biggest listed commercial property businesses.

Shares in the group have fallen since the referendum, in part because of Land Securities’ exposure to the London market. But on the face of it, Land Securities now offers very good value at quite low risk.

Land stock currently trades at a whopping 30% discount to book value, and offers a dividend yield of 3.7%. The group’s loan-to-value ratio is just 22%, with a weighted average debt maturity of 9.0 years. Land’s properties have an average unexpired lease term of 8.9 years.

Taken together, these figures suggest to me that if you are concerned about the outlook for the market, Land Securities could offer a more attractive balance between risk and reward than Palace Capital.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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