Phoenix Spree Deutschland — Positive return to core strategy

Phoenix Spree Deutschland (PSD) is a Jersey-based, closed-ended investment company that was founded in 2007. It was initially listed on the Channel Islands Securities Exchange in 2007 and, after a period of strong growth, moved to a Main Market listing on the London Stock Exchange (LSE) in June 2015. It targets an attractive total return from residential property investment in the Berlin Brandenburg metropolitan region, predominantly within the city of Berlin. It is externally managed by QSix, a specialist real estate manager with an established track record of performance in the German residential property market.

PSD has a strong track record of creating value from a two-pronged strategy that comprises:

Refurbishment and subsequent re-letting of vacated units at a premium to existing rents, and closer to market rent levels, is the key driver of reversionary capture in the German market with its restrictive Federal rent laws. The Mietendeckel, introduced by the Berlin state authorities in early 2020, sought to reduce or cap Berlin rents for a five-year period and disrupted PSD’s strategy until it was ruled unconstitutional and repealed in April 2021. Far from resolving the underlying fundamental issue of a shortage of housing, the Mietendeckel reduced the number of available rental apartments and discouraged investment in new stock, and the market remained resilient. Similarly, the pandemic has had little direct impact on PSD’s performance, and it has continued to extract the value embedded in its portfolio, generating an FY21 accounting total return of 8.4%, in line with its 8–10% pa medium-term target. As we discuss in the following section, PSD has significantly exceeded its target returns in recent years.

While war in Ukraine, the sharp rise in inflation and upward pressure on interest rates have created uncertainty in capital markets,1 the capture of rent reversion through re-letting should support medium-term rental growth, irrespective of market rental growth. PSD is yet to see any impact on investor appetite for residential real estate in its market, in keeping with continuing investor support for real assets and, while transaction activity may slow, we would expect PSD to be able to continue sales of condominiums at a premium to book value, albeit at a reduced pace.

Additional opportunities for growth include exploiting underutilised space in the footprint of the existing portfolio, adding units in attic space for example, and further accretive acquisitions, for which capital funding is available.

PSD has an experienced board with a diverse range of non-executive directors who bring a wealth of experience in real estate, corporate finance, investment funds and capital markets. The board is chaired by Robert Hingley, appointed in June 2015, with over 30 years’ experience as a corporate finance adviser. Full biographies can be found on the company’s website. The board has appointed QSix as the external property adviser, an independent and owner-managed specialist real estate manager with more than £1bn in assets under management, with offices in London and Berlin. Founded in 2006, QSix consists of a team of experienced real estate investment professionals with an established track record in the German residential property market. It advises PSD on property acquisitions and disposals, supervises the renovation of properties, provides oversight of the property managers and reviews tenant selection. It also advises on the initiation of bank finance and the preparation of business plans.

The property adviser receives a portfolio and asset management fee calculated annually as:

The property adviser is also entitled to fees relating to property transactions and debt financings, lettings and investor relations activities. A capex monitoring fee (7% of capex) is also payable to the investment adviser and this is reported in the financial statements within capital expenditure.

The property adviser is also entitled to a performance fee calculated as 15% of the excess by which annual EPRA NTA total return exceeds 8% pa on a cumulative basis measured over consecutive three-year periods, subject to a high watermark, and payable and settled in shares.

PSD has a consistently strong track record of NAV total return2 generation and has exceeded its 8–10% pa medium-term target range in each full year since its listing transferred to the Main Market of the LSE in 2015. This remained the case during FY20/21 despite the temporary introduction of the Mietendeckel. Total returns in the period have been driven by capital growth, which reflects the current low running income yield on the portfolio and the company’s strategy of unlocking the reversionary income potential that is embedded within it. Our forecasts indicate that returns will continue within or around the target range during FY22 (8.1%) and FY23 (7.8%). Not included in our forecasts is the the potential positive impacts of fair value gains on interest rate derivatives, used for interest rate hedging, that are likely as a result of higher market interest rates, further NAV enhancing share repurchases, or accretive acquisitions.

PSD’s resilience during the uncertainties of the Mietendeckel and throughout the pandemic reflect the strong fundamentals of the Berlin market. Berlin is the most populous city in Germany (3.8 million people) and represents the largest rental housing market in Germany (almost 2m units, according to the Berlin-Brandenburg Statistical Office, BBSO). The city’s population has grown in recent years, primarily due to net inward migration, encouraged by relatively low rent levels compared with other metropolitan areas and a strong job market. Over the past two years, population growth has levelled off, in part due to the pandemic but also the Mietendeckel, which reduced the number of apartments available to rent. Net inward migration was negative in 2021 for the first time in 20 years, albeit only slightly. PSD expects net inward migration to strengthen when restrictions associated with COVID-19 are permanently removed. On 5 April, the government announced a significant easing of national restrictions, although entry rules for incoming travellers were maintained.

Over many years, housing demand has been driven by an increasing number of single and two-person households and a rising number of employed persons, in addition to population growth. While the supply of new homes has increased, it has remained well below the level needed to satisfy this growing demand. Berlin faces a chronic shortage of affordable housing, with well over 100 applicants per rental flat, far outstripping any other German city.3 Negatively affected by the Mietendeckel, last year’s building permits represented less than 1% of Berlin housing stock. In the event that net inward migration picks up, the shortage of available housing stock could be exacerbated still further.

Reflecting the shortage of housing, rents and condominium prices have risen strongly. The German property agent Guthmann estimates that median asking rents for existing properties increased more than 4% in 2021 and have increased by an average c 10% pa over the past 10 years.4 Jones Lang LaSalle (JLL) estimates that the median asking price for owner-occupied apartments increased by 11.6% year-on-year in H221 and by an average c 14% over five years.5 JLL also estimates Berlin residential market investment transactions at a record €26.2bn in 2021, including c €2.5bn in sales (c 15,000 residential and commercial units) to the State of Berlin as a condition of the acquisition of Deutsche Wohnen by Vonovia.

Having started from a relatively low level, Berlin rents and condominium prices remain relatively affordable in a European context. Average Berlin rents are still below those in Munich, Frankfurt and Hamburg but it is the pace of growth in Berlin that is driving resistance to further increases.

The Mietendeckel was a failed political response to the housing crisis, reducing the supply of rental accommodation and inhibiting development of new stock. This was followed in September 2021 by a referendum on whether to nationalise housing units owned by large private sector landlords. Although non-binding, the referendum received the support of 56% of those who voted. However, expropriation would do nothing to resolve the underlying shortage of housing and, according to the Senate of Berlin’s own estimate, would have cost up to €36bn in compensation. Key elements in solving the housing crisis are reckoned to include a simplification of the bureaucratic process for bringing forward new developments and redensification. PSD believes that the new federal government, consisting of the SPD, Greens and FDP, holds out the prospect of a more stable legal framework for the residential property sector for the foreseeable future. While it expects the general direction of policy initiatives will continue to be towards tightening tenant protections, particularly in areas with overstretched housing markets, it believes there is now a recognition that blunt policy instruments, such as the Mietendeckel, are not the best way to address housing market imbalances. Rather, the new government appears to be shifting its focus towards increasing the supply of housing and, with a target of 400,000 new homes per year, the new coalition is ahead of the previous government´s goals.

PSD shares had historically traded at around net asset value or higher until mid-2019 as anticipation of the Mietendeckel began to build, ahead of its temporary implementation in 2020. The shares responded positively to Mietendeckel repeal, but are yet to close the discount that had emerged despite the 8 June 2021 adoption by the board of a more proactive share buyback strategy.6 This takes advantage of the discount, while aiming to ensure that the share price better reflects the underlying net asset value. During FY21, PSD repurchased c 4.5m shares or 4.5% of the total for an aggregate consideration of c £17.7m (392p per share), representing a 17.8% discount to the end-FY20 EPRA NTA per share. Share repurchases have continued into FY22, with an additional c 0.5m shares acquired at an average price of 376p, a 20.7% discount to the end-FY21 EPRA NTA per share.7

Share repurchases have been funded from a combination of existing cash resources, refinancing and condominium sale proceeds, and PSD says that this has been achieved without impacting on investment plans or organic growth prospects.

Despite the share repurchase programme, the discount to NAV has remained stubbornly wide at c 27% currently, with the share price failing to keep pace with NAV growth and, more recently, weakening with markets in response to rising inflation and bond yields, exacerbated by the crisis in Ukraine. Compared with sector peers, this is a very positive result with PSD shares c 5% lower over the year compared with an average for peers of c 25%. Excluding PSD, the group is trading on a median c 0.5x P/NAV.

The external valuation of the portfolio at 31 December 2021, conducted by JLL, was €801.5m or an average €4,225 per sqm and reflecting a fully occupied net yield of 2.4%. The EPRA topped-up net initial yield8 at end-FY21 of 2.0% was slightly lower than the 2.1% at end-FY20.

The portfolio comprises 97 buildings, providing 2,569 residential units and 138 commercial units. The properties are mainly classic ‘Altbau’, built before 1914, and typically five-storey buildings, each containing 20–40 units, made up of one- to three-bedroom apartments, often with shops or other commercial units on the ground floor. Structural alterations to buildings of this age and design are often easier than would be the case for some more modern post-war buildings and environmental risks such as asbestos are far less likely. Central Berlin accounts for c 95% of the portfolio by number of units, valuation and annualised contracted rents. This mainly comprises assets that are valued on the balance sheet at ‘rental valuation’ and those that are carried at ‘condominium valuations’. The balance of the portfolio is located in the surrounding State of Brandenburg, where in December 2019 PSD acquired a 259-unit apartment complex for c €40.6m (excluding costs), located in Blankenfelde‐Mahlow, a municipality 7km south of central Berlin. The property is a former army barracks, offering significant asset management potential from the completion of refurbishment and development, leasing and reversion. In March 2022, PSD announced that it had exchanged contracts to acquire a portfolio of 17 newbuild, semi-detached, residential properties (34 houses) located Erkner, Brandenburg, for a purchase price of €18.5m (see below). Both assets benefit from positive demand-supply fundamentals and strong transport links to central Berlin.

On a like-for-like basis, excluding the impact of disposals, valuations increased by 6.3% in the year (3.7% in H221), supported by market rent growth, progress with condominium splitting and certain asset-specific factors. The end-FY20 valuation had assumed implementation of the Mietendeckel and the resulting negative impact on rental income, for the full five-year term, and the positive valuation impacts of its repeal were softened by the high probability attached to such an outcome by property investors, with pricing continuing to harden despite the uncertainty.

Despite 75% of Berlin residential units being legally designated as condominiums, with positive indications for valuation, this is only partially reflected in the portfolio valuation. Just eight of the 97 properties are valued as condominiums with an aggregate value of €38.8m (less than 5% of the total portfolio valuation). Condominium market values are typically 30–35% higher than the rental-based valuations that apply to units within the portfolio that do not currently have condominium permission (25% of the Berlin portfolio). As the condominium-splitting process develops in stages through to eventual sale of selected units, the independent external valuation process, based on a discounted cash flow methodology, applies a progressively lower discount rate, capturing some of the potential valuation uplift that is expected to result from sale. The difference between the market values of condominium units and their carried values represents additional capital upside embedded in the portfolio that is not reflected in net asset value (see page 14).

The process is illustrated in Exhibit 9, although this will not accurately reflect actual outcomes. The illustration points to a final 12.5% uplift at the point of sale (135%/120%), although in FY21, for example, the average achieved sales value per sqm for condominium units was 21.7% ahead of the December 2020 book value for each property.

Annualised contracted gross rent roll at end-FY21 was €20.3m or an average €9.6 per sqm per month. On a like-for-like basis, rents per sqm increased by 3.9% during the year and, reflecting higher vacancy, like-for-like rental income by 1.6%. By area, vacancy increased to 8.4% compared with 6.8% at end-FY20, reflecting an increase in refurbishment activity following the repeal of the Mietendeckel, which in turn resulted in a higher number of newly modernised apartments returning to market for re-letting. On an EPRA basis, excluding properties that remain under refurbishment, vacancy was at a low level of 3.1%, but up from 2.1% at end-FY21.

Aside from the temporary introduction of the Mietendeckel, existing legislation has acted to slow the increase in the rents that can be applied to tenancies already in place. For older tenancies, rent increases are limited to a maximum of 15% over a three-year period, with a minimum of 15 months between increases. The increases have been pegged to local market levels, as determined by a local government rent table (the Mietspiegel), which calculates a reference rate every two years and is based on rent data collected over the preceding four years, and which therefore typically lags free market levels. Once a tenant vacates a property, the landlord has been able to increase rents up to a maximum 110% of the reference rate unless the property has been comprehensively modernised. Only a minority of PSD’s tenants pay Mietspiegel table rents with the significant majority paying rents above this level, reflecting the fact that refurbished apartments can be re-let at levels which fall outwith the Mietspiegel prescribed limits. Refurbished apartments can be re-let at free market rents and this is the key driver of reversionary capture. Although the regulatory drag on rent increases for existing tenancies acts as a disincentive for tenants to vacate, some tenant turnover is inevitable, and it has typically been at a level of c 10% pa. Around half of the vacated units will generally be modernised, at a cost of €20,000–30,000 each, prior to re-letting at a substantial premium to previous in-place rents.

With some variation year to year, the average premium on the re-letting of refurbished apartments over in-place rents in the five years to end-FY21 was 35%. During FY21, across the portfolio, 240 new leases were signed, representing a letting rate of c 10.2% of occupied units. The average rent achieved on net lettings was €12.2 per sqm per month, a level that was 4.4% higher than in the prior year, and 26.8% above the previous passing rent for those apartments. There has been a tendency for the premium to narrow in recent years, which is largely attributable to portfolio mix. The overall letting premium has been suppressed by the Brandenburg acquisition in 2019 where rents start from a higher level and where free market rents are lower than those being achieved in central Berlin. Looking solely at the Berlin portfolio, the reversionary premium achieved was 33.8%, in line with FY20.

Reflecting an overall shortage of Berlin housing, the market sales values per square metre for individual apartments/condominiums is at a significant premium to the value of tenanted apartment blocks. As a result PSD has been able to selectively crystallise the value embedded in the portfolio by dividing and selling blocks of apartments as individual condominiums. The process is subject to full regulatory approval and involves the legal splitting of the freeholds in properties that have been identified as being suitable for condominium conversion. PSD estimates that the uplift in market valuation from a pure rental property to that of a fully permissioned, fully separated condominium is c 35%.

New federal government legislation is likely to grant legal powers to state authorities to ban the conversion of rental apartments into condominiums. With 75% of its portfolio already legally designated as condominiums, PSD is well placed for any change. It is also hopeful that existing applications covering a further 10% of the portfolio, more than half of which in the late stages, may still proceed. PSD expects the new measures to increase the scarcity of condominiums available for sale across the market, further exacerbating the supply-demand imbalance that currently exists, with a likely positive valuation impact on its condominium assets.

PSD’s prime strategy and preference has been to extract the full value embedded in the portfolio through reversionary capture. However, sales have been a useful way to demonstrate the value inherent in the portfolio while generating free cash flow for distributions.

PSD notarised for sale a record €15.2m of condominiums in FY21, a 4.1% increase on FY20, with a particularly strong performance in H221 (€10.9m) as the effects of the Mietendeckel and pandemic lockdowns receded. A total of 37 residential and commercial condominium units were notarised at an average value of €4,988 per sqm, an 18.3% premium to the end-FY20 book value. Residential condominiums were notarised at a 21.7% premium to book value.

Since end-FY21 PSD has reported on the notarisation for sale of 16 condominium units and one attic unit for an aggregate consideration of €7.8m.

Investment for growth increased in FY21, including stepped up refurbishment activity following the removal of Mietendeckel uncertainty, ongoing renovation of the Brandenburg asset acquired in 2019, further work on bringing assets into a position to be sold as condominiums, and asset management to exploit under-utilised space.

Investment in the existing portfolio increased to €4.7m from €3.6m in FY20, with an acceleration in H221 following the repeal of the Mietendeckel. Refurbishment had been completed on around half the 259 units acquired in 2019 in Brandenburg and refurbishment of the remaining units is scheduled to complete this year, a little later than originally expected due to the pandemic. The asset has additional potential for the construction of a further 60 units.

In H221, PSD commenced an asset management project, involving building out the attic and renovation of existing commercial units to create a total of seven new residential units. The total construction budget is €3.9m and the first of the units is expected to be available for sale or rental in H222. The company also has building permits to renovate the attic space in 19 existing assets to create a further 45 units for sale as condominiums or as rental stock, although no decision has yet been taken to proceed.

Including investment in development activities, capex amounted to €9.5m (FY20: €4.2m). An additional €1.7m (FY20: €1.6m) was spent on maintaining the assets.

PSD continues to review potential acquisition opportunities that will both meet its strict investment return requirements (a target internal rate of return of at least 8%) and compare favourably against the alternative of share buy-backs. In March 2022 it announced an exchange of contracts to forward fund and acquire a portfolio of 17 environmentally efficient, new-build, semi-detached residential properties (34 houses) for a purchase price of €18.5m. The property is located in Erkner, in Brandenburg, within the Berlin Beltway, adjacent to the new Tesla Giga factory, which is being constructed at a cost of €4bn and is expected to employ around 40,000 staff, significantly more than Erkner’s 12,000 population. PSD expects the factory to generate migration from central Berlin, leading to increased rents and property values. PSD will fund the costs of construction as these progress and will acquire the property at the agreed price on completion, with no broker commission (typically c 6%) incurred. PSD estimates a prospective gross yield at completion, based on current market rents, of 3.5%. Completion is expected in Q424 and before then the company expects significant market rental growth. The acquisition is entirely debt funded through a new €45m acquisition debt facility agreed with Natixis in January (discussed in the financial section below) at a low fixed cost of c 2%.

Amid a continuing move towards more sustainable, socially and environmentally friendly accommodation, the Europe-wide drive towards carbon neutrality by 2050 is increasingly embedded in the decision-making process of real estate investors and landlords. For investors, the issues surrounding the benchmarking of environmental credentials are complex and still evolving. While the environmental benefits that are available from the operation of well-designed new-build properties is clear, the refurbishment and modernisation of existing buildings, which is the core of PSD’s strategy, will in many instances represent a more sustainable solution when the CO2 emissions produced during demolition and construction, and the production of building materials (embedded carbon) is taken into account. Industry data gathered by PSD suggests this typically represents three-quarters or more of all emissions across the entire life cycle of a new build property completed to modern efficiency standards. This embedded carbon is released almost entirely during the demolition and construction phases, with an immediate impact on the environment, in contrast to long-term existing stock where these emissions have already been incurred. A comprehensive carbon emission tax, capturing embedded carbon, would tip the scales in favour of the refurbishment of existing property should it be introduced. In this direction, the EU is developing plans to tax the carbon emissions embedded in goods imported from outside the EU. Meanwhile, the new German federal coalition government has already declared its intention to look more closely at the use, impact and measurement of embedded carbon.

For the financial year ended 2021, PSD intends to report on its ESG and carbon emissions strategy in a separate report, compliant with EPRA ESG reporting standards. We expect this to be available in H222. We expect a focus on enhancing the energy efficiency of refurbishments including the effectiveness of insulation, windows and heating systems. PSD does not control the energy consumption of tenants, but the introduction of sub-metering may offer possibilities to incentivise reduced energy use. We would expect any measures introduced to seek a balance between investment returns and the satisfaction of tenants in addition to the expected environmental benefits. The ESG screening process that is now embedded in all investment decisions is reflected in the recent Erkner acquisition. The technical design of the asset provides high energy-saving standards with geothermal heat pumps and electric vehicle charging stations for every unit, resulting in it being given a KfW 559 energy efficiency rating, which PSD says is one of the highest ratings that newbuild housing properties can be given.

Key highlights from the FY21 results include:

PSD’s financial returns are driven by capital growth, reflecting the current low running income yield on the portfolio, the capital growth that results from the impact of steady reversionary rent capture on portfolio valuation, and valuation upside crystalised by the condominium sale strategy. As a result, recurring income earnings as measured by the EPRA reporting standard, widely used across the sector, have historically been negative but were close to break-even in FY21. We forecast this trend to continue as rent reversion continues to contribute to current income.

As Exhibit 12 shows, the FY21 results were broadly in line with our expectations. Although gross profit was slightly lower (higher property costs) this was made up at the operating profit level by higher valuation movements and a lower property advisor performance fee accrual. Including a more positive movement in the fair value of interest rate derivatives than we had allowed for (driven by the increase in market interest rates) PBT was c 9% ahead of our forecast and EPS c 11%. The change in the value of interest rate derivatives is excluded from EPRA NTA, leaving EPRA NTA per share in line with our expectations.

Our FY22e total return of 8.1% is slightly down on our previous forecast, including relatively modest reductions in gross profit and property gains of €0.9m to €9.8m and €0.9m to €43.1m respectively. The former is driven by the increase in refurbishment activity with a short-term impact on occupancy (by area) and the latter by a slower rate of condominium splitting (from the high level of 75% already achieved), partly offset by an increase in the pace of condominium notarisations.

Our key forecasting assumptions are:

At end-FY21 PSD had gross borrowings (nominal value, including unamortised loan arrangement fees) of €288.4m, and cash balances of €10.4m, resulting in net debt of €278.0m and a net loan to value ratio (LTV) of 34.7% (FY20: 33.1%), well below the long-term target of 50% (with a 60% maximum). Mostly fixed through hedging, the effective interest rate was 2.0% with an average remaining duration of 4.9 years.

In December 2021, PSD signed a new €60m facility with its main existing lending partner, Natixis Pfandbriefbank (‘Natixis’), comprising a €45m acquisition facility and a €15m capital expenditure facility, although just €0.9m of the development facility had been drawn at year end. The acquisition facility provides additional flexibility to pursue potential future acquisitions if there are suitable opportunities and will be part used to finance the recent €18.5m Brandenburg acquisition. The capex facility will support PSD’s continuing extensive capital expenditure programme, accelerated since Mietendeckel repeal. In January 2022, PSD agreed the refinancing of €49.7m of existing debt provided by Berliner Sparkasse and leveraging the increase in valuation of certain underlying assets to provide an additional €14.9m of capital.

Post the refinancing PSD’s debt facilities comprise:

Our forecasts indicate that net LTV will remain around 30% with increased debt more than offset by retained earnings, including property revaluation gains. We have not assumed ongoing share repurchases although these seem likely for as long as a significant share price discount to NAV persists. Lower retained earnings, particularly resulting from lower than forecast property revaluation gains, would also increase LTV above our forecasts. Nonetheless, our forecasts indicate that gearing will remain well below PSD’s long-term target, while its predominantly fixed borrowing costs provide significant protection against a potential further increase in market interest rates.

The trailing FY21 dividend yield is 1.8%, and we forecast an unchanged FY22 DPS, while the trailing FY21 P/NAV of 0.73x remains below the long-term average. From listing on the LSE to end 2019, as anticipation of the Mietendeckel began, the average P/NAV was 0.98x but from listing to date is now 0.91x. We estimate that the current P/NTA would be even lower if the NTA were adjusted to include all condominium-designated assets at market values. Exhibit 15 shows the historical data for notarisations. The average notarised values per sqm are specific to the mix of assets (different locations, floor space, etc) sold in that period and estimating the value of the portfolio on a full condominium basis is difficult.

The average notarised value over the past three and five years has been c €4,459 per sqm but this increased to €4,988 in FY21. Applying a value of c €4,650 per sqm, the average of the past two years, and more likely to capture the continuing increase in condominium market values, to the 75% of the Berlin portfolio that is designated as condominiums (and which may increase further) and excluding those assets that are already valued on a condominium basis, would lift the FY21 reported EPRA NTA per share by c 7%, implying a trailing underlying discount to NTA of c 33%.

We do not believe a peer comparison to be viable. PSD is the only German residential property investment company listed on the LSE. The 2001 acquisition of Deutsche Wohnen (which was majority invested in Berlin) by Vonovia was a significant vote of confidence in the Berlin market. However, as well as being much larger than PSD (Vonovia has a market cap of c €30bn) the Berlin exposure of the enlarged Vonovia is lower at c 45%.

We highlight the following key sensitivities that would have an impact the outlook for PSD and our forecasts: