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Shares in Palace Capital could do well in 2020 and beyond with a conservative Brexit

After the Conservative victory in the December 2019 General Election, business confidence, as measured by a Deloitte survey, rose to its highest level in 11 years.

Brexit has happened, and businesses now have a more certain future to plan for and are expected to increase investment. The government plans to spend billions on the UK’s regions outside London and the South East.

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A better economic mood and more spending should see job creation and increased demand for residential and commercial properties in the regions.

Regional powerhouse

I believe shares in Palace Capital (LSE: PCA), a property investment company, will do well in such a scenario. Its portfolio of residential, commercial, and leisure properties are located mainly in the North, Midlands, and South West of England.

In August 2019, Palace converted to a real estate investment trust (REIT). REITs invest in properties and trade on public markets. Property income earned by a REIT is exempt from corporation tax, so long as they distribute 90% or more of that income as dividends and adhere to other conditions.

Shareholders in Palace, therefore, receive chunky dividends, and they receive them quarterly. Holding Palace in an ISA would mean the trailing 12-month dividend yield of 5.8% is tax-free.

Palace earned £19m in property income over the year that ended on 30 September 2019. At the start of that year, the market value of the property portfolio was £260m. Divide property income by property value and you arrive at a capitalisation rate of 7.31%.

Solid foundations

The capitalisation rate at Palace looks good compared to other REITs. Comparing the cap rate with the company’s weighted average interest rate of 3.2% suggests that the company earns a considerable excess return over the cost of financing its property investments.

A £100,000 property bought with a £34,000 deposit and a £66,000 mortgage, would have a loan-to-value ratio (LTV) of 34%, which is what Palace reports. High LTVs are concerning when interest rates rise. Palace’s LTV is above average for REITs in general, but not worryingly so.

Even if interest rates do rise, Palace converts a chunk of its variable rate borrowings into fixed-rate ones with instruments called interest rate swaps. It also, as mentioned earlier, has a good deal of spread between its cap rate and its average interest rate, to absorb modest rate increases.

Permanent structure

If a company gets liquidated, creditors get the first claim on assets. Once they get paid off through asset sales, what is left over, the net asset value (NAV), goes to the shareholders. Palace reports its NAV as 391p per share. Shares in Palace are trading around 330p at the moment, and an investor can, therefore, pick up £1 of assets for a little over 80p, assuming the reported NAV is correct.

Palace shares do look like a bargain, but there are risks. Failing to negotiate a trade deal with the EU would rock business confidence. Regional investment may not work, or not be as big as suggested. I would be looking at whether both phases of the HS2 rail link get approval or not. Approving these would show a real commitment to regional economies.

Nevertheless, there is a defensible long-term investment case for Palace. There is also a margin of safety with the share price being below the reported NAV per share.

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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.