Phoenix Spree Deutschland — Accelerating the unlocking of value

PSD’s historical strategy and track record were built around the significant shortage of supply in the Berlin PRS market, which has driven market rental growth over many years. It focused on acquiring under-rented apartment blocks at low valuations and actively managing the assets to realise reversionary rent potential, driving growth in rental income and capital values. This was supplemented by the division and subsequent resale of selected apartment blocks as private units (condos) at market-level valuations, well ahead of rental property valuations. The significant opportunity that this reversionary rental strategy was able to exploit resulted from strict rent controls in Berlin, which means that many tenants pay rents that are well below market levels. In addition to relatively modest permissible rent indexation, reversionary rent capture has been driven by the refurbishment of vacated apartments and re-letting at market-level rents.

The PRS market continues to benefit from a favourable demand-supply balance, rental growth, high levels of occupancy and strong rent collection. PSD’s portfolio continues to offer significant reversionary potential, but in the highly regulated Berlin residential market this takes time to feed through into income. The Berlin re-letting premium to average in-place rents has continued at above 30%, while average in-place cold rents (rents paid excluding service charges) per sqm have increased by around 4% in each of the past four years (4.1% in FY23). Nonetheless, war in Ukraine, increased inflation and interest rates, weak economic growth and uncertain capital markets have created challenging conditions in the real estate investment market, reflected in sharply lower investment market transactions and valuations. While this has contributed to an increase in the net yield on PSD’s Berlin rental portfolio to 3.3% at end FY23, from around 2.8% in FY21, the current Euribor benchmark lending rate is around 3.8%. Market expectations are that this will begin to decline, to a long-term level of 2.5–3.0%, much higher than in previous years.

In contrast to the fragility of the investment market for single apartment buildings or portfolios of buildings, the Berlin condo market has remained relatively robust and liquidity remains, particularly for vacant units. There is now a significant valuation gap between the average value per sqm of an apartment block and the resale value of an individual apartment to a private buyer as a condo. PSD now believes that the best way to maximise shareholder value is to exploit this arbitrage opportunity and greatly accelerate its condo sales.

In this report, we provide an update on current trading and review the FY23 results. However, the main aim is to provide a detailed analysis of the financial impacts of PSD’s strategic refocus, on the assumption that it is successful in agreeing changes to its banking arrangements. While the underlying performance of the PRS business is relatively predictable, its result will depend very much on PSD’s success in disposing of assets. The latter is impossible to predict, both for the property advisor and more so for us, in terms of volume, pricing and timing. For this reason, we provide a detailed illustration based on a set of assumptions that we believe are consistent with the company’s plans, incorporating sales values that are reasonable in both a historical and market context. We have also avoided providing sensitivities around each assumption made, as to do so would introduce a level of complexity that would be unlikely to provide any clarity.

At end FY23, PSD’s portfolio was externally valued at €676m, or an average €3,598 per sqm. On average, portfolio valuations decreased by 11.9% in FY23, and the portfolio net rental yield increased to 3.3% from 3.0% at end FY22. Portfolio vacancy is low. By area, 5% is vacant but, adjusting for refurbishment properties and those reserved for sale, EPRA vacancy is just 2%.

The end-FY23 portfolio comprised 95 buildings, providing 2,489 residential units and 140 commercial units with 188k sqm of usable space. 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 around 90% of the portfolio by number of units, valuation and annualised contracted rents. This mainly comprises assets that are valued on the balance sheet on a ‘rental valuation’ basis and those that are carried on ‘condo valuation’ basis. Condo valuations are higher than rental valuations and disposals have historically been achieved at prices well above book value. We provide condo sales data below.

The share price implies a valuation per sqm that is well below the externally assessed fair value/book value and even further below condo sales values. At the current share price of 157p, PSD estimates the implied value to be around €2,600 per sqm. The methodology for this calculation is shown in Appendix 1.

The achieved average sales value for vacant condos in FY23 was more than double the implied fair value (based on €2,600 per sqm) and, although lower, the average value for occupied condos was 28% higher. The average condo sales premium of 7% to the book value of units sold in FY23 was slightly accretive to NAV, before taking account of sales costs, and more so compared with the implied value. Sales costs are not immaterial in the German market, primarily comprising real estate transfer tax (6% of the sales value) and any agency costs (typically 1–1.5%). Our analysis above includes an average 7% sales cost as well as the 1% disposal fee due to the investment advisor.

PSD’s portfolio is well-positioned to exploit the significant potential valuation arbitrage between the value per sqm of condos and the value of PRS buildings. Although 78% of the end-FY23 portfolio was legally split as condos, only 6% was being marketed as such. Legislation passed in 2021 has made it much harder for landlords to split properties into condos, leaving PSD in a very strong position compared with its larger peers. The key elements of PSD’s strategy include the following:

Combining our expectations for the more predictable PRS business with our illustrations for potential assets sales, we show:

In H223, 17 condos with an aggregate value of €5.2m were notarised, up from eight with an aggregate value of €2.0m in H123, and up from 15 units (including two attic units) with a value of €4.7m in the whole of 2022. The start of FY24 has been promising and, with the publication of the FY23 results in late April, PSD reported that since the start of the year, nine condos had been notarised, with an aggregate value of €3.4m.

For 2023, the average achieved notarised value was €3,976 per sqm, an average 7.2% premium to their carried value at end FY22. The sales premium in any period is specific to the mix of assets, including location, floor space and, importantly, whether the condo is occupied or vacant. Given the shortage of condos in Berlin, the purchase of occupied units is becoming more popular. Occupied condos in specified areas (‘milieu protection areas’) can only be sold to the tenant during the seven-year period following splitting. However, around 80% of PSD’s condo units are located in properties that are exempt from this seven-year rule due to location or tenure, rising to 85% in 2025.

The 2023 premium was lower than the c 20% of recent years, but was nonetheless at a good premium to the portfolio average book value per sqm and even more so compared with the value per sqm implied by the share price (see below). This lower premium in FY23 reflected a higher share of occupied condos, where values are lower, as well as price reductions to stimulate demand. Whereas vacant units were sold at an average €5,345 per sqm, the average for occupied units was €3,332 per sqm.

We estimate that the expanded pool will comprise around 40 buildings compared with the seven that are designated for condo sales currently. Based on the portfolio average 28 units per building, we estimate that the number of units made available for sale will increase to c 1,100 compared with 76 at end FY23. Units from the pool will be sold as they become vacant, and occupied units will also be offered for sale to both tenants and investors.

The company aims for annualised condo sales of more than €50m by 2025 and our illustration shows sales of €15m in FY24, €54m in FY25 and €68m in FY26, based on the following key assumptions:

Despite the challenging conditions in the financial and property investment market in FY23, PSD was able to sell two properties designated as rental properties for an aggregate €7.3m, c 8% below the book value of €7.9m. With the FY23 results announcement, PSD said that two further buildings had been notarised for sale since end FY23, with an aggregate value of €7.4m.

Our illustration for the sale of buildings assumes a similar rate of progress, with a total of 12 properties sold, out of 95 at the end of FY23 (or the 55 that are not in the expanded condo pool). We show sales of €10m in FY24, €22m in FY25 and €34m in FY26. Again, we believe the illustrated sales value to be realistic and consistent with, although more cautious than, what the property advisor hopes can be achieved.

It is based on the following key assumptions:

Aggregating the condo sales potential with that for single buildings shows aggregate disposal proceeds of €25m in FY24, €76m in FY25 and €102m in FY26, at values not materially different from book value.

We expect the refurbishment and re-letting of vacant apartments at closer to market rent levels will continue to be the main driver of rental growth in the tightly regulated Berlin rental market although the permitted uplifts on regulated tenancies have increased in the past two years.

In response to the speed and extent of the increase in inflation and interest rates that occurred from mid-2022, a transitional Berlin Mietspiegel (rent index)2 was announced in June 2023, replacing the previous rent index of 2021, and a new qualified rent index was published in May 2024. On average, the transitional index permitted increases in rental values of 5.4% versus 2021 and the new index allows for further modest increases, averaging 0.7%. For those of PSD’s tenancies that ‘qualified’ for an increase under the transitional arrangements, this became effective from October 2023. The new qualified rent index will support rental growth from Q324 onwards.

Market rents are at record levels, with new lettings across the portfolio signed at an average premium of 31.3% to passing rents (FY22: 31.8%). During FY23, 255 new leases were signed (FY22: 319), representing a letting rate of approximately 10.1% of occupied units. (FY22: 12.9%). The lower letting rate is a reflection of the shortage

Our forecasts for ‘rental activities’ include the contribution from all rental properties, whether held within the condo pool or within the PRS portfolio. On this basis, we forecast net rental property income to increase in the current year, driven by like-for-like rental uplifts, but to decline as condo sales gather pace. By FY26, we expect net rental property income to be slightly lower than in FY23. Despite any drag on rental income, there is a clear benefit at the company level as disposal proceeds are used to reduce borrowings and net finance expense.

The summary below combines our asset sales illustrations with our expectations for recurring (PRS) earnings that are shown in detail in the following section. We also show the FY26 projections adjusted for a full year of refinanced debt at a cost of 4.5%.

Including our sales illustrations we note the following:

Assuming no asset sales, an unrealistic outcome, but included to provide a comparison, we note the following:

PSD will continue to invest in the properties operating within the PRS portfolio, primarily targeting an improvement in energy efficiency and a medium-term increase in EPC ratings to C or better. This will not only benefit tenants but is increasingly important to investors, with energy-efficient properties, more able to meet expected regulatory requirements, attracting a premium.

A relatively low proportion of the portfolio is rated EPC C or better, reflecting that it primarily comprises Altbau. These are typically older, pre-war properties, often prized for their character and central locations, and valued at a premium compared to the more generic ‘out-of-town’ housing schemes of the latter half of the 20th century. However, compared with newbuild properties, designed with modern construction techniques and materials, they are notably less energy efficient.

Investments to improve the energy efficiency of the portfolio include upgrades to windows, heating systems, insulation, installing LED lighting and the implementation of advanced controls that allow residents to manage their heating more effectively and reduce unnecessary energy consumption and emissions.

PSD is in discussions with a leading energy technology company regarding the installation of energy valves, contact sensors and actuators in the basement of rental properties, which PSD says has the potential to increase EPC ratings by as much as two notches with no upfront costs to the company. The procedure has the advantage of being minimally invasive, eliminating the requirement to enter individual rental apartments, with potential savings of 20–30% on energy costs and CO2 taxes. German law allows all ongoing costs to be passed onto tenants, while a percentage of the energy cost savings can be passed on as higher rents.

PSD has not quantified what additional investments may be required. Like-for-like capital expenditure has averaged c €5m pa in the past five years, although this primarily relates to refurbishments undertaken on vacant apartments prior to re-letting. As a working assumption, our forecasts allow for €10m pa in FY25 and FY26. Importantly, we have no recognition of this capex in property valuations, which may be conservative. Fully recognition would reduce FY26 LTV by c 2 percentage points.

End-FY23 borrowings were €324m on a nominal basis, gross of unamortised loan arrangement fees of €2.7m. Net borrowing increased by c €10m in the year, primarily to fund capital expenditure. Net debt was €313m and the LTV was 46.3%.

The main borrowing facility with Natixis is a seven-year, non-amortising, interest-only facility that matures in September 2026. The majority (84%) of the floating rate interest cost for the Natixis facility has been hedged to give a blended effective rate of 2.8% at end FY23.

With Berliner, PSD has an amortising facility that matures in October 2027. The facility has been fully drawn and, after loan amortisation, €60.3m remained outstanding at end FY23, the interest cost on 92% of which is fixed or hedged, with an end-FY23 blended average cost of 2.0%. In total, the interest cost on 85% of debt drawn (at book value) at end FY23 was fixed or hedged with swaps at a blended effective rate of 2.5%. The end-FY23 average remaining debt duration was 2.8 years, closely matched by the swaps.3

Financial covenants relating to the Natixis loans include a projected interest cover of at least 150%4, minimum debt yield of 4.3%5 and a maximum LTV of 67.5%. There are no financial covenants relating to the Berliner loans.

Of the covenants, it is the minimum debt yield that has the lowest level of cover, reflecting the portfolio gross yield of 3.3%, and this would benefit from asset sales and debt repayment.

We expect that the renegotiation of financing arrangements, to allow additional buildings to be marketed as condos, will trigger additional banking fees but we do not expect these to be material.

The FY23 results were published in April and followed a portfolio valuation update in February, which had also provided details on condo sales and rental growth.

Key features of the FY23 results were:

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 is externally managed by QSix, an independent and owner-managed specialist real estate manager, founded in 2006, with an established track record of performance in the German residential property market. QSix advises PSD on property acquisitions and disposals, supervises the renovation of properties, provides oversight of the third-party property managers and reviews tenant selection. It also advises on the initiation of bank finance and the preparation of business plans.

In February 2024, Christian Daumann was appointed CEO of the property advisor’s German operations, succeeding Jörg Schwagenscheidt, who had held the position since 2015 and remains a partner of QSix Group. Christian Daumann has over 25 years of experience in the real estate and asset management sector and has strong industry contacts.

Management and governance

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.

Under the investment advisory agreement, currently subject to temporary amendments, QSix is entitled to receive 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.

During 2023, the company and the property advisor, with shareholders’ approval, agreed a temporary 12-month amendment to the investment advisory agreement (IAG), with effect from July 2023. Aggregate asset management, capital expenditure monitoring and investor relations fees were capped at €5.0m and a disposal fee was introduced, set at 1% of the gross value of assets sold. The disposal fee is aimed at aligning the incentives of the property advisor with the company’s intention to accelerate disposal activity.

The company and the property advisor expect soon to conclude a further temporary amendment to the IAG, to be effective from July 2024. This is expected to reduce the fee cap by a further 14%, to €4.3m, while retaining the disposal fee at 1%.

QSix will continue to receive an additional 1% fee on all disposals, but intends to use the post-tax proceeds to buy shares in PSD.

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

PSD’s implied portfolio value per sqm is based on total capital value or enterprise value (the market capitalisation plus net borrowings), with adjustment for deferred tax and excluding the fair value of interest rate derivatives.

The deferred tax adjustment represents a theoretical recalculation of the deferred tax liability, based on the implied portfolio value compared with its external valuation.