CLS Holdings

The main activity of the Group is investment in commercial real estate across four European regions: London, France, Germany and Sweden. There is a particular focus on providing well-managed, cost-effective offices and property for cost-conscious companies in key European cities.

The Group's total property interests at 31 December 2011 were £919.9 million, comprising the wholly-owned investment property portfolio valued at £902.1 million, and a 29.9% investment in Swedish listed property company Catena AB, which had a market value of £17.8 million. The Group's Other Investments comprised the corporate bond portfolio, valued at £85.1 million at the year end, and smaller equity holdings of £13.3 million.

Overview
At 31 December 2011, the directly held investment portfolio totalled £902.1 million, a like-for-like increase of 2.1% in local currencies or 0.5% when translated into sterling. In local currencies, the French portfolio rose by 1.9%, Germany by 1.0%, London by 2.7% and Sweden by 1.5%. The capital value of £2,202 per sq m is close to replacement cost, meaning that the land element in these key European cities is minimal; this highlights how competitive the Group can be in attracting tenants with cost effective rents.

The contracted rent at the year end was £66.3 million, representing a net initial yield of 7.0% on value and an average rent of just £170 per sq m. The income stream is strongly secured as 40% is from government tenants, 29% from major corporations and 65% of rents are subject to indexation. The weighted average lease length is 7.7 years, or 6.6 years to the first break. Only 16% of the current rent roll expires in the next three years.

The overall vacancy rate has been further reduced to 3.9%, reflecting the benefits of active, in-house asset and property management together with maintaining strong relationships with our tenants, working to understand their needs.

In all markets there is less availability of debt than 12 months ago, leading to fewer buyers for the high yielding property that the Group prefers. This situation is expected to continue for a considerable period; we can thus be highly selective about our purchases. Further, the depth of our banking contacts and relationships means that we continue to find debt obtainable.

Across the portfolio the Group is increasing its focus on the sustainability of its properties and ways to make them more energy efficient. There is a wide range of quick and medium-term wins that can and will be made. The employment of a full time Sustainability Manager has helped the Group to promote this and the Corporate Social and Environmental Responsibility Report in the 2011 Annual Report expands on these activities.

LONDON

It has been particularly encouraging to be able to reduce the vacancy rate with more lettings given the economic climate. We are seeing fewer but better quality enquiries and a clear trend for tenants to target the better managed buildings, where stable landlords are able to maintain and refurbish to a good standard, and be flexible on lease terms to meet customer needs. This is a key differentiator compared to buildings owned by landlords who are under financial pressure. During the year 6,497 sq m became vacant, we let 8,690 sq m and renewed leases on 2,894 sq m with existing tenants, with particular activity at Great West House, Brentford and Cambridge House, W6, and we completed the refurbishment programme of common parts at Westminster Tower, SE1.

In September, we acquired two office buildings in Hounslow for £5.5 million. The total initial rent of £582,091, gave a yield after costs of 10.1%, rising to £627,562 after fixed rental uplifts. The one vacant floor of 574 sq m has let since the year end, increasing the yield to over 11%. The buildings total 4,693 sq m over four floors, and tenants include Aer Lingus, Alitalia, Telefonica O2, Vandemoortele, First Rate Exchange Services and Quest Diagnostics. The purchase price equated to a capital value of £1,172 per sq m, which is well below replacement cost.

The commitment of the Greater London Authority, and the London boroughs of Lambeth and Wandsworth to the Vauxhall Nine Elms regeneration zone is absolute and the Group is very well placed as one of the credible parties which can help deliver. In December, and after public consultation, we submitted a planning application for a 20,800 sq m mixed use scheme called Spring Mews, behind Albert Embankment in Vauxhall. This comprises: student accommodation of 402 student rooms and amenity space; a 120 bed mid-market hotel; a new 561 sq m community centre and café; 469 sq m of office space; a 245 sq m convenience retail unit; and the creation of a new pedestrian mews linking the development to Spring Gardens. Subject to receiving planning consent, the Group would aim to start on site in the second half of 2012, with completion in 2014. The development, the total cost of which is expected to be in excess of £50 million, would significantly improve the area, bringing immediate benefits to the Group's property at Spring Gardens, which is directly opposite.

Also in December, after almost a year of stakeholder consultations, the Group submitted a planning application for a 154,000 sq m (1,657,650 sq ft) mixed-use development scheme called Vauxhall Square, on the site owned by the Group close to Vauxhall’s transport interchange. The proposed scheme comprises: two residential towers of 50 stories containing 510 homes and 15,231 sq m of office space; 3,500 sq m of retail, restaurant and café space; 416 student units; a 438 bed hotel; a 4 screen cinema; 94 affordable housing units; a new homeless hostel; a major new public square (of similar size to Paternoster Square in the City of London); and public realm improvements. Our strong belief is that the redevelopment of the Vauxhall/Nine Elms regeneration area will start at the Vauxhall end and Vauxhall Square is strategically located between the Vauxhall transport links and the proposed new US Embassy. Importantly, it is not dependent on the proposed Northern Line extension. Subject to receiving planning consent, we would aim to start on site in 2014, with phases being completed from 2017. The development cost of the proposed scheme is in excess of £400 million. Prudently, no hope value has yet been ascribed to either this development site or Spring Mews and, consequently, their values fell on a like-for-like basis during the year, due to planning costs.

The Group has been very active in promoting a Business Improvement District (BID) for Vauxhall. BIDs are an established way for local businesses to be actively involved in improving an area. In early 2012 local Vauxhall businesses voted in favour of a BID, which will be called Vauxhall One, and which will start in April 2012, initially for a 5 year period. Richard Tice, Chief Executive Officer of the Company, has been the chairman of the campaign to launch a BID, which we believe can be beneficial for our holdings in Vauxhall.

FRANCE

The reduction of the vacancy rate from 3.6% a year ago was particularly pleasing given the flexible nature of the traditional French 3:6:9 year lease expiry structure. The year saw 8,043 sq m of new lettings or renewals with tenants vacating from 6,524 sq m. The economic activity on the ground appears healthier than the macro reports in the press. Letting demand continues to be most encouraging across the portfolio, with signs of rental growth, especially in Lyon where we were delighted to secure the British Council into our Forum building in 374 sq m. Renovation work this year has been limited, at £1.7 million, mainly at this Forum building.

The early indications we mentioned a year ago that there would be very little new construction of offices in our locations is holding true, with no sign that this will change in the foreseeable future. This is a most positive situation for the Group given that vacancy rates in Paris and Lyon are below 7%; take up in both locations rose by over 14% in 2011 compared to the previous year. There are no new schemes forecast to be delivered in Lyon in 2012 and the immediate supply of available space is just over one year.

Investment activity, particularly in the first half, was up by over 25% in the Ile de France, making it hard to acquire additional property. Agents forecast lower investment levels in 2012 as banks restrict their lending, and investors wait to see developments in the Eurozone, but there are almost no signs of distress in this region. Domestic investors made up approximately 63% of the investment market and prime Paris yields are still somewhat below 5%.

GERMANY

* plus one under construction

The average capital value of £1,428 per sq m is comparable with replacement cost and the year end vacancy rate is higher than last year's 5.5% due to the bankruptcy of one tenant in the first half of 2011.

Although the German economy is forecast to grow more slowly in 2012, it is robust and we continue to see signs of confidence in the future plans of our tenants and potential occupiers. In the economy as a whole, leasing take up grew by 16 % in 2011 to the second highest level in 10 years, most markedly in Munich. Likewise investment volumes increased by some 20%.

The main activity during the year has been the construction start for the two pre-let developments near Munich which will add 7,042 sq m when completed. The 1,642 sq m extension for Dr Hönle AG in Gräfelfing was completed at the end of February 2012, and the new 5,400 sq m Landshut building pre-let to E.ON Service Plus GmbH completes in summer 2012. The total additional rent from these two pre-let developments will be €856,000 per annum.

There is growing pressure in Germany on overseas owners of commercial property, funded by overseas banks, who need to dispose of their assets. This is likely to deliver opportunities for CLS in 2012, and there continues to be reasonable availability of bank debt from domestic banks.

SWEDEN

The Group’s Swedish property interests consist of two parts. First the 45,400 sq m office complex in Vänersborg near Gothenburg, called Vänerparken. The £2.3 million investment in energy saving plant for the property was completed in the second half and early data shows the expected savings of over 80% in consumption and CO2 emissions are already being achieved. We are using the same Swedish engineers to advise the Group on opportunities to achieve savings in London which can benefit both the Group and tenants alike.

Second, the Group owns 29.9% of the Stockholm-listed real estate company, Catena AB, which now is focused on its one remaining but significant property in Stockholm. Negotiations are progressing with the local authorities on the 150,000 sq m mixed-use scheme which has been submitted for planning consent for almost 1,000 apartments and 50,000 sq m of commercial space. It is interesting to note that the overall cost of submitting an application for a similar sized mixed-use scheme in Stockholm is only 20% of the comparable cost in London. At the year end, based on Catena’s share price the market value of the Group’s investment was £17.8 million, being a surplus of £4.3 million over the book value, which equates to an additional 10 pence per share to CLS's net asset value. Following a rise in Catena’s share price since the year end, the surplus over book value at 1 March 2012 was £9.4 million, or 21 pence per share of additional net asset value for the Company.

The Swedish economy has been one of the better performers in 2011 with GDP growth of 4.0%, which is forecast to slow in 2012. Property markets are stable and tenant demand is firm, both of which bode well for the Catena site in Stockholm.

Headlines
Profit after tax of £38.8 million (2010: £60.1 million) generated EPRA earnings per share of 64.9 pence (2010: 42.5 pence), and basic and diluted earnings per share of 82.0 pence and 81.9 pence, respectively (2010: 127.1 pence each). Gross property assets at 31 December 2011 were £902.1 million (2010: £876.9 million), EPRA net assets per share were 3.2% higher at 983.1 pence (2010: 952.9 pence), and basic net assets per share rose by 6.6% to 817.5 pence (2010: 766.7 pence).

Approximately 40% of the Group’s business is conducted in the reporting currency of sterling, around 50% is in euros, and the balance is in Swedish kronor. Overall, compared to last year profits benefited marginally from foreign exchange rate movements as on average the euro was 1.2% stronger and the krona 6.8% stronger against sterling than in 2010. However, the euro weakened markedly towards the end of the year, restricting gains in the value of net assets made earlier in the year.

EXCHANGE RATES TO THE £

Statement of Comprehensive Income
Profit after tax comprised the underlying operating performance of the Group, known as EPRA earnings, and assorted other elements, such as fair value movements, profits on sales and other non-recurring items. EPRA earnings were £9.6 million higher than last year at £29.7 million (2010: £20.1 million). The net uplift on revaluation of the investment property portfolio was £18.0 million (2010: £30.1 million), but the fair value of derivative financial instruments, included within finance costs, fell by £18.5 million (2010: £3.1 million). Other non-recurring profits in the year were £9.6 million (2010: £13.0 million). Consequently, although EPRA earnings rose significantly over those of 2010, in aggregate profit after tax was lower than last year at £38.8 million (2010: £60.1 million).

Rental income of £66.2 million was £4.1 million, or 6.6%, higher than last year. £2.5 million of this increase was from acquisitions, primarily made in 2010, and £0.6 million came from indexation increases, particularly in Germany and France. The comparative weakness of sterling accounted for a further £0.8 million of uplift, and the effect of expiries was largely matched by new lettings.

We monitor the administration expenses incurred in running the property portfolio by reference to the income derived from it, which we call the administration cost ratio, and this is a key performance indicator of the Group. In 2011, administration expenses fell to £12.1 million (2010: £13.0 million), but property-related administration costs increased to £9.7 million (2010: £9.1 million), in part through extending our development team. The administration cost ratio of 15.4% (2010: 15.2%) was close to the KPI target of 15.0% and, notwithstanding the relative complexity of our pan-European operation, was well below that of many real estate companies in our peer group.

The net surplus on revaluation of investment properties in the year was £18.0 million (2010: £30.1 million). £10.2 million of this uplift came from the London portfolio, £4.9 million was from France, £2.0 million from Germany, and our sole direct property investment in Sweden rose in value by £0.9 million. Overall, the underlying revaluation surplus was 2.1% (or 0.5% after foreign exchange effects), comprising 1.7% (4.6% after foreign exchange) in the first half of the year, and 0.4% (minus 3.9% after foreign exchange) in the second half.

Finance income of £12.2 million comprised predominantly interest income of £9.2 million (2010: £6.1 million) from our corporate bond portfolio. This portfolio fell in value towards the end of 2011 during the euro crisis, and ended the year down by £15.6 million, but since first investing in corporate bonds towards the end of 2008, the portfolio has produced an annual compound return on equity of 9.1%. At 31 December 2011 the portfolio generated a yield on market value of 10.2%. To date, the valuation of the portfolio at 31 December 2011 has proved to be a low point, with steady growth in value of £8.2 million in the first two months of 2012.

The rise in Group borrowings (see below) led to an increase in interest expense on bank loans, debenture loans and other loans to £29.2 million (2010: £24.0 million), and the fall in the long-term swap rate in particular created an adverse movement in the fair value of interest rate swaps and caps of £18.5 million (2010: £3.1 million). Consequently, finance costs for the year to 31 December 2011 were £47.7 million (2010: £31.1 million).

In late 2010, Catena AB, in which the Group owns a 29.9% interest, sold the majority of its business and in April 2011 distributed the proceeds, of which our share was a cash dividend of £19.9 million. The main drivers of the profit of associates after tax of £3.0 million (2010: £7.7 million) were a profit of £3.7 million (2010: £9.4 million) from the reduced business of Catena, and a loss of £0.5 million (2010: £1.6 million) from our 48.3% holding in Bulgarian Land Development Plc.

Our French operation was the only part of the Group which paid tax. Elsewhere in the Group, tax losses, including those generated by closing out an interest rate swap, absorbed taxable profits made in the year, creating a current tax credit of £1.2 million. Tax for the year also contained a deferred tax charge of £0.1 million (2010: £6.4 million), which largely represents an adjustment required under IFRS for the potential tax occasioned by valuation movements on investment properties, offset by tax losses.

Distributions to Shareholders
In April 2011, £7.2 million was distributed to shareholders by means of a tender offer buy-back of 1 in 47 shares at 725 pence per share. In September, a further £4.4 million was distributed by means of a tender offer buy-back of 1 in 72 shares at 700 pence per share, and a proposed tender offer buy-back of 1 in 42 shares at 735 pence per share to return £7.9 million will be put to shareholders in April 2012. This represents a 10% uplift over the equivalent distribution last year.

EPRA net asset value
At 31 December 2011, EPRA net assets per share (a diluted measure which highlights the fair value of the business on a long-term basis) were 983.1 pence (2010: 952.9 pence), a rise of 3.2%, or 30.2 pence per share. Elements of the business which increased EPRA NAV in the year included profit after tax (83.3 pence per share), the property portfolio revaluation uplift (39.8 pence), and the two tender offer buy-backs (8.6 pence). However, due to uncertainty over the euro, the fair value of our corporate bonds fell by the equivalent of 34.5 pence per share, the resulting strength in sterling reduced EPRA NAV by 13.5 pence, and the early redemption of an interest rate swap reduced it by a further 53.5 pence per share.

Cash flow, net debt and gearing
At 31 December 2011, the Group’s liquid resources of £140.4 million – comprising cash of £55.3 million and corporate bonds of £85.1 million – were £14.0 million higher than £126.4 million twelve months earlier. In May a one-off dividend from our associate Catena AB added £19.9 million. The underlying operations of the business generated cash of £25.1 million during the year, of which £11.8 million was distributed to shareholders. New loans of £171.4 million, after costs, replaced those repaid of £132.2 million, being a net cash inflow of £39.2 million, which financed in part capital expenditure and acquisitions of £20.4 million. The early repayment of an interest rate swap cost £24.2 million, and the bond portfolio fell in value by £15.6 million.

Early in 2011, the Board decided that the Group should raise debt in anticipation of a reduction in the general availability of bank finance later in the year, and this proved to be a well-judged decision. In May, we issued the first CLS corporate bond, for SEK 300 million (£29.5 million), in Sweden. This unsecured, five-year bond, which attracts interest at 375 basis points above STIBOR, has since been listed on the NASDAQ OMX in Stockholm. It was noteworthy that the Group looked to issue the bond in London, but investors in Sweden proved more accommodating to the issue, even though CLS’s shares were not listed there. In June, 19 loans in the French portfolio were refinanced by separate facilities from two banks, including one bank which was new to the Group. The new loans of £116.1 million in aggregate replaced others of £85.7 million, increasing the loan to value ratio on the properties which they financed to 68% from under 50%. In London, a new loan of £3.3 million was taken out on the acquisitions in Hounslow, and two were refinanced for £6.0 million, whilst in Germany, £1.7 million was drawn on a new development loan. A short-term SEK 300 million facility taken out during the year was subsequently repaid. Other repayments of bank loans of £19.1 million were made by way of amortisation in the ordinary course of business. Following all of these transactions, and retranslating the resulting loans into sterling, at 31 December 2011 gross debt of £625.1 million was £32.8 million higher than the £592.3 million of twelve months earlier.

The weighted average unexpired term of the Group’s debt at 31 December 2011 was 4.4 years. £151.2 million of loans fell due in 2012, including £14.3 million of amortisation of loan balances in the normal course of business.

Since 1 January 2012, £30 million has been refinanced, and £89.1 million has been approved by credit committee and all other appropriate bank internal processes, and is subject to completion of legal documentation. On refinancing of these loans, the weighted average unexpired term of the Group’s debt will be 5.1 years.

Adjusted net gearing, which is based on EPRA net assets, was 128% at 31 December 2011 and the weighted average loan-to-value on borrowings against properties was a comfortable 62.5%. Adjusted solidity was 40.5% (2010: 41.7%).

The weighted average cost of debt at 31 December 2011 was 4.1%, one of the lowest in the property sector, and down from 4.3% twelve months earlier. The fall was primarily caused by cancelling a long-term swap (see below). With bank financing now more expensive than when existing loans were taken out, all other things being equal refinancing them as they fall due will gradually increase the average cost of debt of the Group.

In 2011, our low cost of debt led to recurring interest cover of a comfortable 2.6 times (2010: 3.2 times). The fall was caused by a lower share of profit of associates after tax of £3.0 million (2010: £7.7 million), and a higher recurring net interest cost due to higher borrowings.

Financing strategy
The Group’s strategy is to hold its investment properties predominantly in single-purpose vehicles financed primarily by non-recourse bank debt in the currency used to purchase the asset. In this way credit and liquidity risk can most easily be managed, around 70% of the Group’s exposure to foreign currency is naturally hedged, and the most efficient use can be made of the Group’s assets. Around 10% of the Group’s debt is not property specific and is taken out by the parent Company to provide additional financial flexibility. This comprises the Swedish bond issued in 2011, and short-term overdraft facilities. Bank debt ordinarily attracts covenants on loan-to-value and on interest and debt service cover. None of the Group’s debt was in breach of covenants at 31 December 2011. The Group had 64 loans across the portfolio from 20 banks. None of the loans at 31 December 2011 had been securitised by any lender, and the Group had no exposure to the CMBS market.

To the extent that Group borrowings are not at fixed rates, the Group’s exposure to interest rate risk is mitigated by the use of financial derivatives, particularly interest rate swaps and caps. The Board believes that interest rates are likely to remain low longer than the forward interest curve would imply, and therefore, its policy is to allow the majority of debt to remain subject to floating rates. To mitigate the risk of interest rates increasing more sharply than the Board expects, the Group enters into interest rate caps. At 31 December 2011, 21% of the Group’s borrowings were at fixed rates or subject to interest rate swaps, 54% were subject to caps and 25% of debt costs were unhedged.

The Group’s financial derivatives – predominantly interest rate swaps and interest rate caps – are marked to market at each balance sheet date; at 1 January 2011 the net liability of such derivatives was £15.7 million. The fall in medium and long-term interest rates in 2011 increased the net liability of these derivatives by £18.5 million. To provide more flexibility in the Group’s financing we chose to close out our major long-term interest rate swap in December crystallising a £24.2 million accumulated loss. This left the Group with six interest rate swaps with an aggregate notional amount of only £50 million and a derivative liability of £9.1 million at 31 December 2011, at which date they had a weighted average unexpired term of 4.1 years. Other derivatives at 31 December 2011 were mainly interest rate caps and had a net positive value of £1.8 million.

Share capital
At 1 January 2011, there were 51,381,244 shares in issue, of which 4,793,000 were held as treasury shares. On 28 April, under the tender offer buy-back, 991,239 shares were cancelled in exchange for £7.2 million distributed to shareholders, and on 22 September, under the tender offer buy-back, 633,291 shares were cancelled in exchange for £4.4 million distributed to shareholders. In November and December, an aggregate of 10,103 shares were purchased in the market and placed in Treasury. Consequently, at 31 December 2011, 44,953,611 shares were listed on the London Stock Exchange, and 4,803,103 shares were held in Treasury.

The Directors intend to put to shareholders in April 2012 a proposal to issue a tender offer to buy-back 1 in 42 shares at 735 pence per share. If approved by shareholders this could lead to the purchase and cancellation of 1,070,324 shares, and a distribution to shareholders of £7.9 million.

TOTAL RETURNS TO SHAREHOLDERS
In addition to the distributions and share cancelations associated with the tender offer buy-backs, shareholders benefited from a rise in the share price in the year from 535 pence on 31 December 2010 to 590 pence at 31 December 2011. Accordingly, the total shareholder return in 2011 was 11.1%. In the four years to 31 December 2011, our total shareholder return of 64.9% – a compound annual return of 13.3% – represented the best performance in the listed real estate sector.

Since the Company listed on the London Stock Exchange, it has outperformed the FTSE Real Estate and FTSE All Share indices.

KEY PERFORMANCE INDICATORS
Total Shareholder Return
Aim
– to provide a TSR of over 12% p.a. over the medium term
Achievement
– 2008-2011: 64.9%, or 13.3% p.a. compound

Effective management of balance sheet
Aim
– to sell assets with limited growth potential and invest in high yielding alternatives
Achievement
– 2006 to 2011: £746 million of property sales
– 2011: Pre-let developments in Landshut and Gräfelfing, Germany will provide returns on equity of 19.4% and 18.3% p.a., respectively

Administration cost ratio
Aim
– to maintain administration costs below 15% of net rental income
Achievement
– 2011: 15.4%
– 2010: 15.2%
– 2009: 14.9%

Occupancy rate
Aim
– to maintain an occupancy level of over 95%
Achievement
– 2011: 96.1%
– 2010: 95.7%
– 2009: 95.5%

TOP 10 TENANTS
The 10 tenants which contribute most rental income to the Group account for 40.5% of the rent roll, and comprise:
London
• The Home Office Government
• Secretary of State for Work and Pensions Government
• Cap Gemini Major Corporation
• BAE Systems Major Corporation

France
Grand Duchy of Luxembourg Government
Veolia Major Corporation

Germany
City of Bochum Government
E.ON Major Corporation

Sweden
Västra Götaland County Council Government
Vänersborg Kommun Government