Phoenix Spree Deutschland — Well positioned for market turbulence

Given the significant changes in economic and market conditions, this note provides a detailed update on our May outlook note, which provides greater detail on PSD’s strategy and the market in which it operates.

Only partly reflecting the significantly changed environment, interim results to 30 June 2022 were robust. During the period, gross in-place rents per sqm increased by 1.9% and were the driver of 2.2% like-for-like portfolio valuation growth (H121: 2.5%). NAV increased by 1.2% to €5.72 and, including DPS paid, the total return was 2.2%. H122 DPS was unchanged at €2.35. The Berlin re-letting premium was 33.7% and including the assets in Brandenburg, where in-place rents are higher, the all-portfolio re-letting premium was 28.4%. Although condominium notarisations for sale were lower than in H121 (€3m versus €4.3m), the premium to book value was maintained (19.2%). PBT was €17.0m (H121: €20.4m), affected by lower valuation gains and higher property costs. Although the factors that drive rental income growth remain in place, the key drivers of lower condominium sales are unlikely to quickly reverse, and PSD expects that condominium sales for the full year will be materially lower than in FY21. Period-end borrowings were €305.1m, including unamortised loan arrangement fees, and cash balances were €9.6m, giving net debt of €295.6m (FY21: €278.0m). The increase in net debt reflected acquisitions and portfolio investments as well share repurchases and payment of the FY21 final DPS. LTV was 36.0% (FY21: 34.7%).

The equity market appears to be anticipating a very sharp downturn in the German residential sector

The Berlin housing shortage has been built over many years by demographic trends, including net migration and insufficient new development. If anything, these drivers seem likely to strengthen, with almost a million Ukrainian refugees entering Germany1 and higher construction prices, disrupted supply chains and materials shortages adding to the existing drag on development from strict planning laws. Nonetheless, the equity market appears to be anticipating a very sharp downturn in the German residential property sector.

We expect positive demand-supply fundamentals for rented accommodation to continue to support rental values but a material deterioration in buyer sentiment since the beginning of the year is evident, for PSD reflected in its lower condominium sales. The flip side of this is that with higher interest rates increasing the cost of home ownership, potential buyers are likely to remain within the rental system for longer, placing further pressure on the significant shortage of housing that already exists. For renters, Federal support initiatives have been introduced to mitigate the financial impact of rising fuel costs. PSD notes that year-to-date rent collection levels have remained stable and is hopeful that this will remain the case

At the institutional investor level, driven by an increased cost of funding, the appetite for real assets has weakened. This includes German residential real estate, where demand for larger portfolio transactions has significantly slowed. A number of larger market participants, including PSD’s larger listed German peers, are now net sellers of assets as they seek to reduce leverage from levels that are currently significantly higher than at PSD. Although transactional evidence is yet sparce, the company notes sufficient anecdotal evidence to suggest that pricing has weakened.

Despite the near-term headwinds presented by the current economic backdrop, the company remains confident in the long-term outlook for PSD, based on the significant rent reversion that remains embedded in the portfolio, along with unrecognised capital value in the majority of its residential units that have been designated as condominiums. Meanwhile, the balance sheet remains robust, and starting with a moderate LTV, PSD is in a good position to manage the impact of a decline in asset values. With the cost of all borrowing fixed until 2026, we forecast sufficient liquidity to maintain dividend payments and continue to invest in the portfolio (to unlock rent reversion) despite the negative impact of lower condominium sales on cash flow.

Federal laws significantly restrict the pace at which market rental growth can be passed through tenancies already in place. We expect this to gradually accelerate as the rent growth of recent years is increasingly reflected in permissible uplifts, but the process is complex and the timing is difficult to predict. In any case, refurbishment and subsequent re-letting of vacated units at a premium to existing rents, and closer to market rent levels, will remain the key driver of reversionary capture.

Across the portfolio, average gross in-place rents were €9.8 per sqm per month at end-H122, up 3.5% versus H121 and 1.9% versus end-FY21. On a like-for-like basis, adjusted for the impact of acquisitions and disposals, H122 rents were 3.7% above the H121 level.

In H122, 174 new leases were signed, representing a letting rate of c 7.3% of occupied units. The average rent achieved on all net lettings was €12.7 per sqm per month, a level that was 8.5% higher than in the prior year, and an average 28.4% above the previous passing rent for those apartments (H121: 23.5%). Excluding assets in Brandenburg, acquired in 2020, where rents are lower than those achieved in central Berlin, the reversionary premium to previous passing rents was 33.7% (H121: 35.8%). The premium to previous passing rents varies from period to period, mainly determined by mix. The average re-letting premium for the whole portfolio in the three years to end-FY21 is c 27%.

Condominium market prices are typically 30–35% higher than rental-based valuations The division and subsequent resale of selected apartment blocks as private units (condominiums), with vacant possession, at market valuations, supplements PSD’s rental income, increases cash flow and accelerates the release of significant value embedded within the portfolio.

During H122, nine condominium units were notarised for sale for an aggregate €3.0m, a slowdown from €4.3m in H121. So far during H222, a further two units have been notarised with a total value of €1.0m. H221 notarisations of €10.9m set a high bar, and to the extent that the key drivers of weaker buyer sentiment (higher mortgage rates and a higher cost of living) are unlikely to reverse during the second half of the year, PSD expects that condominium sales for FY22 will be materially lower than FY21.

The average notarised values per sqm in any period are specific to the mix of assets (different locations, floor space, etc) sold in that period, but the sales premium to the book value of the assets sold, 19.2% in H122, has been relatively stable.

The process of splitting and impact on asset valuations is illustrated in Exhibit 6, although actual valuation changes will differ.2 At each stage, 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 eventual sale. The difference between the market sale values of condominium units with vacant possession and their carried values represents additional capital upside embedded in the portfolio that is mostly not reflected in net asset value.

Differentiating it from listed German peers, approximately 76%3 of PSD’s Berlin portfolio is legally designated as condominiums, although within the portfolio valuation only six properties, with an aggregate value of €32.8m, are valued as such. The carried value of the legally designated condominium units that are not valued as condominiums is broadly consistent to the valuation at the point of ‘land registry split’ in Exhibit 6. This provides opportunities for the implementation of further sales projects where PSD considers this to be appropriate and is a positive indicator for underlying portfolio valuation and NAV. The strategic advantage of having a large share of the portfolio legally designated as condominiums is highlighted by recent federal government legislation, which places significant restrictions on the ability of landlords to split their properties into condominiums in the future. The measures will inevitably increase the scarcity of condominiums available for sale in the future, further exacerbating the supply-demand imbalance that currently exists.

The recent legislation is not retrospective and does not affect assets that have already been split into condominiums. It remains uncertain whether PSD will be successful with the additional 9.5% of Berlin units that are in application, over half of which are in the final stages of the process.

At end-H122, PSD had gross borrowings (nominal value, including unamortised loan arrangement fees) of €305.1m and cash balances of €9.6m, resulting in net debt of €295.6m and a net loan to value ratio (LTV) of 36.0% (FY21: 34.7%), well below the long-term target of 50% (with a 60% maximum). Interest costs are mostly fixed through hedging at a blended average effective 2.1%, protecting against further increases in interest rates. The end-H122 average remaining duration was 4.3 years (with no maturities until September 2026).

Compared with some of the larger listed German companies, PSD’s gearing is lower and it continues to be a net investor in its portfolio. LEG Immobilien (H122 LTV of 42.1%) and Vonovia (43.5%) have both said that they expect to be net disinvestors as they seek to reduce gearing.

Total debt facilities have increased to c €360m, including a new €60m loan facility agreed with existing lending partner, Natixis Pfandbriefbank (‘Natixis’), announced on 25 January 2022, and the refinancing of an existing debt facility with Berliner Sparkasse adding an additional c €14m. The new Natixis facility comprises a €45m acquisition facility and a €15m capital expenditure facility. The acquisition facility provides additional flexibility to pursue potential future acquisitions if there are suitable opportunities. Since end-H122, PSD has completed/agreed net acquisitions pf c €3m and has a c €13m remaining commitment in respect of the forward funding development at Erkner in Brandenburg. Allowing for disposals and other cash flows, we forecast no material change in net debt or LTV by end-FY23.

Market expectations, reflected in the Euribor forward curve are that policy rates will increase to around 3% by the end of this year and remain broadly at that level through 2026, in line with the bulk of PDS’s debt maturities. Exhibit 8 shows our existing rental income and interest cost forecasts for FY22 and FY23. Forecast rental growth includes disposals impacts and underling growth is c 4% pa. As an illustration, assuming rental income growth accelerates to 5% pa through FY24–26, the change in rental income from end-FY21 (the last fully reported year) to end-FY26 would be c €5.2m. Assuming a full refinancing of debt in FY26, on annualised basis, at a 1.5% margin and 3.0 Euribor rate, FY26 cash interest cost would be €6.9m higher. The net negative impact would be €1.7m but we believe this would be manageable. Meanwhile, assuming free market rents also increase during the period, significant portfolio income reversion upside would remain.

By refurbishing selected apartments as they become vacant, PSD can re-let them at or around free market rent levels, capturing reversion potential in the portfolio. In FY21, this accounted for €4.7m from total capex of €9.5m and was €1.8m in H122. This excludes maintenance expenditure reported through the income statement (c €1.6m pa). In addition, PSD’s asset management strategy includes exploiting underutilised space within the footprint of the existing portfolio, which provides an attractive return with relatively low risk. During H221, a project commenced to build out the attic and renovate existing commercial space in one property to create an additional seven residential units at a cost of €3.8m. PSD also has building permits to renovate attics in 19 existing assets to create a further 45 units for sale as condominiums or as rental stock.

PSD continues to acquire assets and in March 2022 announced that it had exchanged contracts to forward fund 17 new-build, semi-detached residential properties (34 units) for a total agreed purchase price of €18.5m. The asset is located in Erkner, in Brandenburg, within the Berlin Beltway, adjacent to the new Tesla Gigafactory, 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. Construction is expected to complete in the second half of 2024. PSD estimates a prospective gross yield of 3.5% once the project is fully occupied. In May 2022, it exchanged contracts to acquire four multi-family houses consisting of 24 residential units for a purchase price of €6.3m. These properties are located in Hoppegarten and Neuenhagen, Berlin. Built in 1995 and 1998, they are in good technical condition and offer significant reversionary potential, having benefited from recent positive demographic changes. Since end-H122, the company has exchanged contracts to acquire a multi-family house with 22 residential units and three commercial units for €4.9m. This property is located in Berlin-Neukölln, is well maintained and offers significant reversionary and attic potential.

In addition to the condominium sale programme, PSD continues to consider options for the disposal of buildings deemed to be non-core. Typically, these buildings will have a mature tenant structure with limited scope for further capital expenditure and subsequent reversionary re-letting. Since the half-year end, it has exchanged contracts to sell two such properties for an aggregate consideration of €8.6m, a small discount to the end-H122 external valuation of €8.8m. The buildings were acquired in 2008 and 2017 respectively, for an aggregate purchase price of €3.9m.

PSD has a strong track record of EPRA NTA total return generation, well above its medium-term 8–10% pa target range. This has been substantially 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, valuation upside crystalised by the condominium sale strategy and the broader increase in market valuations of recent years. In current market conditions, we expect significantly lower capital returns as market valuation increases stall (or perhaps weaken), and as lower condominium sales slow the realisation of value embedded within the portfolio. We expect income returns to remain robust, driven by the continuing capture of reversionary income as in-force rents continue to adjust to significantly higher free market rents.

In the period since listing on the Main Market of the London Stock Exchange in June 20154 until end-H122, PSD has generated a total return of 198.8% or an annual average return of 16.9%. Capital returns have represented almost 90% of the total return over this period, although the income return has been increasing, reaching 17% in FY21 and 42% in H122.

Reflecting the current low running income yield on the portfolio, the condominium sales programme has contributed significantly to cash flow in addition to earnings. Over the three years to end-FY21, operational cash flow broadly matches dividend payments (FY19 operational cash flow was reduced by the payment of investment adviser performance fees accrued in respect of the preceding three years), while disposal proceeds largely fund interest payments and capex. Net borrowing and LTV increased, primarily as a result of discretionary property additions and share repurchases.

Although PSD considers the current level of gearing (H122 LTV of 36.0%) and cash balances to be appropriate at this stage of the cycle, it is not looking to increase its debt capacity5 until market conditions become more stable. We do not forecast FY22 dividends to be covered by net cash flow although this is the case in FY23. However, we do expect significant proceeds from non-core asset sales (a part of which is included in the end-H122 balance of held-for-sale assets of €41.6m, along with condominiums earmarked for sale) during FY22 and FY23. For that reason, we expect unchanged dividends. The board has indicated that further share repurchases will be dependent on the strength of the balance sheet and future condominium sales. Based on our forecasts, we do not expect further repurchases.

PSD’s results for the six months to 30 June 2022 (H122) were robust, although the headwinds of war in Ukraine, increasing interest rates and a sharp rise in the cost of living were in place for only part of the period. Exhibit 12 provides a detailed summary.

Key highlights from the H122 results include:

Our forecasts are shown in detail in Exhibit 17 and are summarised below. These reflect our expectation of lower property gains, the result of slower condominium sales and a pause in market-wide valuation increases. Our reduced forecasts for realised and unrealised property gains, by €30.9m in FY22 and €34.6m in FY23, account for most of the projected PBT decline.

Our forecasts are based on the following:

PSD shares have been significantly de-rated in the past year, down by c 38%, but have materially outperformed peers, down by an average of c 53%. We believe that the company’s share repurchase programme, relatively lower gearing, rent reversion potential and high proportion of units designated as condominiums will all have contributed to this outperformance.

The FY22e yield is 2.6% while the discount to H122 EPRA NTA of c 50% is significantly below the long-term average7 and we estimate that the P/NTA would be lower still if the NTA were adjusted to include all condominium-designated assets at market values.

PSD is the only German residential property investment company listed on the London Stock Exchange (LSE). Other London-listed German property companies, Summit Properties and Sirius RE, are focused on commercial property. Germany-listed residential property investors are all much larger, have significantly lower exposure to Berlin, and more diversified portfolios. Unlike PSD, condominium splitting is not a material element of their strategy and they are somewhat less focused on rent reversion. Notwithstanding that, Exhibit 16 shows a valuation and performance summary for PSD and selected Germany-listed peers.