absolute return, Austria, dividend yield, financial crisis, financial derivatives, German bunds, German property, Germany, home ownership, income/dividend bubble, intrinsic value, land grab, Leverage, Margin of Safety, Mr. Market, NAV discount, Net LTV, Price/Book, REIT/MLP sector, relative value, rental yield, residential property, safe-havens, special situations
Continued from here.
OK, now we’ve looked at German residential property fundamentals. The current supply/demand & home ownership rate, rental yields, safe-haven status, and particularly the low valuations, certainly appear to offer a persuasive investment case. So, how do we exploit it?!
As I’ve said, I’m perplexed by the general investor obsession over direct property investment. What a hassle! And let’s correct a key misconception: People say they prefer direct investment as they can leverage it up – something you can’t, or shouldn’t, do with an equity investment! Yeah, sounds logical…but it’s complete rubbish! That coveted (?!) leverage is already embedded in listed companies (and far more efficiently/cheaply than you could obtain).
Let’s say you’ve a spare 300 K knockin’ around. You could buy a 1 mio property, with the help of a 70% mortgage (and years/decades of property/tenant headaches to come!). Or you could invest in the equity of a listed property company that owns 1 mio of property (with the same 70% leverage). All at the click of a button & an occasional read of their financial reports. What an easy choice… OK, but who knows where the hell the share price might trade?!
Well yes, admittedly Mr. Market is one crazy sonnuvabitch…but share prices do return to fair value, in due course. And that’s the beauty of the market – it offers frequent opportunities to buy at a discount, to sell at a premium, or even to do both simultaneously! On occasion, that spare 300 K could easily buy you 400 K of equity & ownership of 1.3 mio of property. Transform the company into a REIT, and soon idiot investors will be falling over themselves to buy you out at a huge premium 😉
Yes, bargains are pretty much always available in the market. Sometimes an entire sector’s a bargain, or sometimes a sector just has one or two bargains lurking. Such gems might be obvious, or they might be special situations that require a lot more digging. Of course, the opposite’s true too – the market gets caught up in its own euphoria, and then nobody notices market values have far outpaced underlying intrinsic/asset values…
Before drilling down to look at individual companies, it’s only sensible to first evaluate how the entire residential sector stacks up. To do that, note I’m sticking with (for simplicity) a subset of the sector – residential property pure-plays which provide English websites & reporting. That amounts to about a dozen companies. Since this subset includes most, if not all, of the well-known/largest companies, I think this analysis is pretty representative of the entire sector:
Rent per sqm per month:
Minimum: EUR 4.11
Maximum: EUR 7.80
Average: EUR 5.72
Thinking about German property? You need to go metric – you’ll go crazy if you keep converting square metres back into square feet. Also, don’t fall for a common misconception – it’s not nine sq ft: 1 sq m actually equals 10.76 sq ft! German companies tend to quote rent in terms of EUR per sqm per month, more so than yields. This is a little obtuse, but get used to it…
However, it’s certainly not as useful: For example, a portfolio with double the valuation & rent of another portfolio is not unusual (due to relative quality, location, use, etc.), but one can reasonably expect rental yields to be fairly similar. Unfortunately, rent’s also quoted a number of ways in Germany – cold rent is just bare rent, warm rent includes water & heat, or rent might even consist of warm rent & other services/utility charges. It’s often unclear what headline rent figures actually consist of, and there’s no standard methodology – so peer company rent/yield comparisons are complicated that much more.
Including outliers, average property yield is 7.6%, but yields are clustered ’round a median 7.2%. As I’ve highlighted, this compares v favourably with current EUR 3 mth LIBOR of 0.13% & a 10 yr Bund yield of 1.46%. Urban rents are also increasing, at +6.2% annually. Most portfolios also offer structural upside, over time, as new/market rents are often 20-25% higher than average portfolio rents.
Average portfolio occupancy of 91% looks pretty healthy, but tends to understate underlying portfolio strength. Most companies source portfolio acquisitions from municipal/housing authorities. These tend to have higher running costs, higher levels of required maintenance, sub-market rents and higher vacancy rates – the usual government efficiency, eh..?! This has actually proved a blessing, offering companies the opportunity to quickly build large apartment portfolios at substantial discounts & with significant property management potential.
Most companies actually manage two portfolios: A core (developed/mature) portfolio with vacancy often in low single digits, and an investment portfolio with vacancy ranging up to 25%! New acquisitions often require renovation & modernization, cost rationalization, and intensive property management. Fortunately, that aspect’s pretty much self-financing – return on investment’s attractive & predictable, and the resulting rise in rents & valuations offers increased debt capacity to fund this incremental investment. New acquisitions are ultimately recycled from investment into core, and then equity raises & selective disposals start up this acquisition & investment cycle again.
Most property companies understate Net Loan-to-Value (LTV) ratios. They focus on (Borrowings less Cash) / Property. This might seem perfectly acceptable, but lesser ships have literally been sunk by other financial liabilities lurking on the balance sheet. I prefer to calculate Net LTV as follows:
(Borrowings + Financial Derivative Liabilities + (Convertible/Preference Liabilities + Pension/Employee Liabilities + Government Loans/Repayable Grants etc.) * 50% – Cash/Marketable Securities – Derivative Financial Assets) / (Current/Non-Current/Held-for-Sale Property)
The unprecedented collapse in interest rates has meant net financial derivative liabilities has evolved into a significant item on many balance sheets. For banks, just like loans, that’s additional credit exposure. Employee & government liabilities can be a legacy for German property companies – they increase leverage & rank high(er) in terms of priority. However, these are ideally long term/soft liabilities, so a 50% haircut seems a reasonable compromise for LTV calcs. Convertibles & other types of preference capital are somewhat similar (and some companies include them in leverage ratios) – arguably they’re equity/non-callable liabilities, but they also increase risk/leverage for ordinary shareholders, so the same haircut’s acceptable here too.
I usually don’t recommend including values for JVs/Associates in any way, as the net equity presumably supports (similar) levels of underlying leverage. If payables significantly exceed receivables, it might be prudent to also include net payables in your LTV calc. – on the basis it may reduce cash/increase debt in due course. Any announced/post-balance sheet acquisitions should be incorporated also – it’s easy to include an equal addition to Property & to Borrowings. If you lack exact figures, your best estimate’s still a good idea as acquisitions & their impact are often significant.
Overall, I believe German companies have a good handle on leverage. The recent credit crisis is still v relevant. You might have been surprised by the rent & valuation charts/figures in my last post. There was no retracement in values at all, even post-credit crunch! So why the hell did German property shares collapse like everything else? Well, two reasons – first, you can never completely escape the market no matter how good fundamentals are. And second, never forget that old reliable – leverage!
Looking back to 2005-06, German property companies & general confidence was booming. The banks carelessly offered, & companies merrily accepted, 70-85% leverage for new acquisitions. That left precious room for manoeuvre if things went wrong with a portfolio, or the wider economy & market. Which is a great reminder: Significant upside investment potential will almost inevitably become totally irrelevant (or lost) if there’s too much leverage involved. On the other hand, considering the under-valuation of German property, its slow & steady appreciation, rising rents & other compelling secular trends, you could definitely argue the attractions of more leverage..!?
Personally, my tolerance for leverage tops out ’round a net LTV of 65%. And specifics matter: I’d prefer (much) lower leverage if I’m in a market which appears vulnerable to a renewed lurch lower, or if a company’s biased towards property development. For the reasons I’ve mentioned, a high(er) German net LTV might be palatable, esp. if it’s a special situation, but why bother if there’s attractive opportunities on offer at a sub-65% LTV?
German property companies have been slowly but surely working off the leverage acquired pre-2008. This was subsequently reflected in a sustained share price rally since 2009. And now, in the past year or two, they’ve finally been firing back up their acquisition strategies, with credit available at a far more sensible 60-65% (even 70%) of asset value. The current 60.3% net LTV sector average seems to offer that elusive balance of leverage vs. the maximization of the (equity) reward potential from continued valuation gains.
Valuation per sqm:
Min: EUR 500
Max: EUR 1,751
Avg: EUR 954
Valuations depend, of course, on location & type of property. Most portfolios are focused on E & W Germany, with properties in the east having the lowest valuations. Exposure to the north is relatively sparse, while property valuations in the south are at significantly higher valuations (which continues as you travel into Austria & Switzerland). Portfolio valuations are also substantially lower on a relative basis than average valuations in Germany. Again, this is due to the typical acquisition strategy – the purchase of large municipal/housing apartment portfolios, with a high level of vacancies & required refurbishment, offers significant purchase discounts.
This generally offers potential for significant long term valuation gains from lower costs & rising occupancy, increased sales on a ‘retail’ basis (to satisfy a rising home ownership rate), the general relative convergence of property values within Germany, and likely appreciation from a particularly low valuation base in absolute (and European/global) terms.
Min: EUR 0.5 mio
Max: EUR 2,004 mio
Avg: EUR 638 mio
Market cap should be (fairly) irrelevant, but it seems to make a real difference. The largest companies attract the most investor attention & buying, the inside track on potential portfolio acquisitions, the best financing terms, and obviously the greatest economies of scale. All this is evidenced by a distinct step-up in relative valuations: EUR 100 mio+ market cap. companies currently trade at a 75% premium to sub-100 mio companies in terms of their Price/Book ratios.
Most property companies are now enthusiastically back in acquisition mode – in fact, recent news & developments suggests the makings of a real land grab… [You know prices look set to rise when multiple buyers are bulking up, jumping into portfolio auctions, and generally appear terrified they’ll miss out on sealing a deal or two!] This means dividends are low priority right now – the actual average sector yield’s more like 0.7%, if I count the majority of companies with a zero dividend. A shame really, greater emphasis on REIT structures & dividend policies would likely attract the dividend lunatics (like in the US) & far higher valuations. But, at this point, acquisitions clearly seem to be the correct call – a dividend focus will naturally become a priority as portfolios & valuations mature.
Not surprisingly, lower P/Bs are usually the result of excessive leverage. And higher P/Bs usually correspond with higher market caps and/or higher portfolio yields. Overall, the sector still provides attractive value at an average 0.85 Price/Book ratio. I haven’t checked, but I suspect the average London listed property company trades slightly cheaper – but with far less upside valuation potential, in my opinion. Then we have New York, which plays host to plenty of property companies with far more leverage & investors who couldn’t care less about Price/Book… I think I’ll stick with Germany!
Based on my own analysis & target P/B ratio for each company, and relying on current balance sheets/valuations, I see an average 22% upside potential for the sector. Which corresponds to an average 1.0 P/B target ratio – yeah, no surprise for me, eh?! If I re-calculate on a market cap weighted basis, the average upside’s still a v respectable 16% (reflecting higher multiples for larger companies).
If I do some rough & ready calculations to equalize portfolio valuations at a common 7.2% rental yield, things get that much more interesting:
Upside Potential (@ 7.2% Rental Yield):
This potential convergence in yields offers a better 33% upside (but the market cap. weighted average only improves to 17%). But what it really highlights is some v interesting divergences in valuation potential for certain individual companies…
OK, next we’ll take a closer look at individual German residential property companies. To be continued…