Phoenix Spree Deutschland — Rent cap decision will determine strategy

PSD has a strong track record of creating value by acquiring under-rented apartment blocks at low valuations and actively managing them to capture reversionary rent potential and drive income and capital growth, supplemented by the division and subsequent resale of selected apartment blocks as private units (condominiums) at market valuations. The average annualised EPRA net asset value (NAV) total return over the five years to end-FY19 of 20.4% pa was well ahead of the 8–10% pa target. PSD estimates the average free market value of rents for the portfolio at €12–12.5 per sqm per month, well ahead of the current contracted €9.1, and local demand for accommodation significantly outstrips supply. If not repealed, the Mietendeckel rent cap seems likely to limit investment in the sector, aggravate the housing shortage, and support further growth in free market rents and capital values, but will require a change in PSD’s strategy to realise this value.

While we share management’s strongly held view that repeal of the rent cap is the most likely outcome, the timing is difficult to predict and is by no means certain, making the financial impacts impossible to predict. When the outcome is known the strategy will adapt, but we do not know when this may happen. Rather than forecasting the FY21 financial performance, we present alternative scenarios that illustrate the potential outcomes on a full-year basis, assumed to be in FY21. Our central FY21 scenario thus assumes rent cap repeal, reversing the recent rent reductions with effect from 1 January 2021. If the rent cap is not repealed, rental income will significantly reduce with little growth for five years. In our non-repeal scenario, realised gains from stepped-up condominium sales partly offset the impact of rent reductions (PSD estimates a reduction in FY21 rental income of up to 17%). We expect reported profitability to be relatively modest and for investors to focus more on the value embedded in the portfolio, represented expected condominium sales values. On this basis we estimate the underlying discount to NAV to be c 40% with sales proceeds supporting continuing accretive share repurchases.

Despite COVID-19 and first effects of the Berlin rent cap from February 2020, H120 performance was robust. More than 99% of rents due in H120 were collected, broadly in line with the prior year, and there was no direct impact on the external property valuation, which showed a 2.6% like-for-like increase in H120 despite first-time inclusion of the rent cap measures in the valuation for an assumed five-year period. Refurbishment and letting activity slowed slightly, with vacancy increasing from 6.7% at end-FY19 to 8.0% at end-H120, but the delay should be positive for medium-term value creation in the event that the Mietendeckel is repealed, allowing future re-letting at uncapped market rents. The H120 EPRA NAV total return per share, including an unchanged DPS, was 3.9%.

Aside from the crucial uncertainty surrounding the legal challenge to the Mietendeckel, we see the main fundamental sensitivities as being economic and market driven, although residential property has historically been much less cyclical than is the case for commercial property, and the current market supply-demand position continues to be positive with supportive demographic trends predicted to continue. Political risks, reflected in changes to the legal and regulatory structure, as the Mietendeckel highlights, are tangible and require vigilance and flexibility on the part of management, as has been the case since the company was formed c 13 years ago.

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 Stock 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 investment in Berlin residential property and is externally managed by QSix (formerly PMM Residential). QSix is an independent and owner-managed alternative asset manager with an experienced team of property and investment professionals and established track record in the German residential property market. It has offices in London and Berlin.

Corresponding to its asset and liability base, the company reports its results in euros. Dividends are also declared in euros but are paid in sterling.

Berlin is the most populous city in Germany and represents the largest rental housing market in the country. With strong housing demand driven by net migration and a relative lack of supply, rents and capital values have steadily increased. This has allowed PSD to comfortably exceed its target 8–10% pa NAV return over several years and in the five years to end-FY19 the NAV total return (change in EPRA NAV with dividends paid added back but not reinvested) was 153.0% or an average annual compound return of 20.4%. Returns have been biased towards capital (c 90% of the five-year return) rather than dividend income and we expect this to remain the case, reflecting the low current yield on the assets and the cost of actively managing these to unlock the value embedded in the portfolio.

The Berlin rent cap (the ‘Mietendeckel’) that began to take effect from February 2020 reflects concern at the pace of rent growth over recent years and a desire by local authorities to maintain Berlin as a city of affordable rented accommodation. However, while Berlin rents have grown strongly in recent years, they remain affordable on both a national and international basis; by dis-incentivising investment in the sector, the cap seems destined to exacerbate the fundamental supply-demand imbalance that has been the driver of free market rent growth and property values.

PSD and its legal advisers remain firmly of the view that the Mietendeckel legislation will ultimately be ruled unconstitutional and overturned, although the timing of this process remains uncertain. The company notes that in Bavaria, a similar move to introduce a six-year rent freeze was blocked by the Bavarian Constitutional Court in July. In this note we start by examining the strategic and financial implications of the cap on PSD.

PSD’s core strategy has traditionally 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 has been supplemented by the division and subsequent resale of selected apartment blocks as private units at market level valuations. The significant opportunity that this strategy seeks to exploit results from strict rent controls in Berlin, which means that many tenants pay rents that are well below market levels, which have increased materially in recent years. In addition to modest permissible rent indexation, reversionary rent capture has been driven by the refurbishment of vacated apartments and re-letting at market level rents.

However, in June 2019 the Berlin municipal government announced its intention to freeze local rents for five years and the law (the Mietendeckel) came into force on 23 February 2020. The key components of the legislation include a freeze on rents (at least until January 2022, with modest increases thereafter), rent ceilings, rent reductions in certain circumstances, and a limit on the ability of landlords to recapture modernisation costs through higher rents. If not repealed, the rent cap and rent reductions will have a material financial impact in FY21 and will ultimately require a significant adaptation of strategy to release the value embedded in the portfolio. In the current year, while legal challenges to the cap are in process, the company has sought to mitigate its effects while maintaining its ability to benefit from the repeal that it expects.

As a result of the new law, since February 2020 there has been an upper limit on the new rent that may be charged on first time lettings and re-lettings, while existing leases have been subject to a rent freeze that lasts until January 2022, with limited increases possible thereafter for the remainder of the five-year period. In some cases, the limit on new rent levels could result in landlords having to lower the rent compared with that paid by the previous tenant. The second phase, which came into effect from 23 November 2020, goes further and imposes automatic reductions in existing rents in certain circumstances. Where rents exceed a local limit by more than 20%, the landlord must reduce the rent to no more than 120% of the limit or face a fine of up to €0.5m for each breach.

The company has guided to a relatively modest impact from the first phase of the Mietendeckel, introduced in February 2020, and this is supported by the H120 results. Based on a similar level of tenant churn to FY19 it has estimated the negative impact of FY20 annualised rental income of the new rent limit on first time letting and reletting at c 1.5% and, assuming no mitigating action (see below), the negative impact of the rent freeze at around 1%.

However, the automatic rent reductions that were recently introduced will have a significantly larger impact and assuming no mitigating action (see below) PSD has estimated the negative impact on FY20 annualised net rental income at c 1.5%, but increasing to a c 17% on a full year basis in FY21.

The actual financial impact on PSD and its strategy, both in the short and longer term, is significantly dependent on the timing and eventual outcomes of the legal challenges to the rent cap. Given the ongoing legal challenge, there had been hopes of a voluntary (by the state authorities) or legal injunction, pending final determination, thereby avoiding the potential for chaos and confusion among renters and landlords alike of rents being reduced and then possibly restored. However, this has not been the case and although PSD expects the Mietendeckel will ultimately be judged illegal and repealed, at least in the short term until determination is reached, some adaptions to the business model are inevitable. If the legal challenge to the Mietendeckel fails, more significant strategic changes to the business model will be required.

Although we incline to the company’s view that eventual repeal is the most likely outcome, the uncertain timing of this, and the reduction of certain existing rents from 23 November 2020, render an accurate prediction for the next 12 months impossible. Nevertheless, we have embedded the potential strategic responses and financial impacts into two scenarios, intended to illustrate the alternative strategic paths that the company may take and the financial implications of these on an annualised basis: the first scenario assumes that the Mietendeckel is repealed, fully effective throughout FY21, such that strategy returns to ‘normal’ throughout FY21; and the second scenario assumes no repeal and captures the likely strategic response and financial implications of accelerated condominium sales to realise value embedded in the portfolio.

In the following section we discuss the strategic features of these scenarios and in subsequent sections we review their financial implications.

As we discuss below, during the current year, as the legal challenges to the Mietendeckel are being considered, there has been a noticeable slowdown in discretionary refurbishment and re-letting activity and for the full year we expect an acceleration in sales of individual apartments (condominiums). In part this reflects the impact of COVID-19, but also the company’s efforts to mitigate the impacts of the rent freeze and maintain its strategic flexibility. Assuming that the rent cap is ultimately repealed, we expect the company to continue the strategy that it has successfully followed since it was founded.

Prior to the introduction of the rent cap, which is intended to be in place for five years, existing legislation has acted to slow the increase in the rents that can be applied to existing tenancies. Under the existing legislation, rents increases have been 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.

PSD estimates the average market rent per square metre per month for its portfolio at €12–12.5 per sqm/month, a more than 30% premium to the average in-place rent of €9.1, and its active management strategy has focused on capturing this reversionary rent potential to lift rental income, dividend capacity, capital values and total return. The company indicates that in the absence of the rent cap, c 25% of its tenancies would be governed by the Mietspiegel, allowing for rental growth of c 1.5% pa. However, for more recent tenancies (c 75%), the company has included annual indexation (the Staffel) of c 3.5% for a period of 10 years. Although the regulatory drag on rent increases 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 market rates. In the five years to end-FY19, new lettings were at an average premium of 40% to the portfolio average in-place rents.

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%. To date, PSD has limited condominium sales (an average of c €9.0m pa over the five years to end-FY19) as its 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.

Given the company’s firm belief that the Mietendeckel will eventually be repealed, the current year focus has been on mitigating the initial effects. However, should repeal not occur PSD has provided guidance on how its strategy is likely to adapt, including:

PSD has historically focused on selling relatively small numbers of vacant condominiums, for which QSix has in-house capability. Occupied condominium units are usually acquired by investors seeking income and less frequently by individual buyers who are prepared to wait before taking possession. A 2019 agreement with Accentro Real Estate, one of Germany’s leading condominium sales platforms, provides scope for a significant acceleration of condominium sales if required, including tenanted condominiums, without need for volume discounts. The agreement allows PSD to offer properties to Accentro to market, receiving an agreed minimum value for the assets and continuing to benefit from the rental income while they are marketed and sold.

As at 30 June 2020 (H120) PSD’s portfolio was externally valued by Jones Lang LaSalle (JLL) at €746.7m (end-FY19: €730.2m). The like-for-like increase during the period was 2.6%, reflecting the combined impact of active asset management and modest yield compression supported by the decline in interest rates. The valuation reflects an average value per square metre of €3,839 (end-FY19: €3,741), a gross fully occupied yield of 2.8% (31 December 2019: 2.9%) and a net yield, using EPRA methodology, of 2.4% (31 December 2019: 2.3%).

The portfolio comprises 98 buildings, providing 2,571 residential units and 141 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 environment risks such as asbestos are far less likely. Around 90% of the portfolio units are located within City of Berlin and 6% in the surrounding State of Brandenburg, where PSD acquired an apartment complex in December 2019 for c €40.6m (excluding costs but including €16.4m of debt assumed and subsequently refinanced), reflecting a prospective gross yield of 4.1%. The property is a former army barracks, comprising 259 residential units, one commercial unit and parking, with significant asset management potential from the completion of refurbishment and development, leasing and reversion.

Despite the introduction of the rent cap, the Berlin residential property market has remained stable in the first half of the financial year and, although transaction volume has reduced, investment demand observed by JLL continues to support current pricing. JLL conducted a full RICS Red Book property-by-property analysis for H120 and the portfolio valuation provided to PSD included no matters of concern or material uncertainty. The fair value of investment properties is determined using discounted forecast cash flows, cross checked against comparable market transactions where they are available. JLL has assumed that the Mietendeckel is fully implemented by PSD and is in place for its five-year lifespan; this was not the case for the 31 December 2019 valuation as the Mietendeckel was not in force at that time. This does not mean that market values will not change, particularly as the legal challenges to the rent cap are decided. However, many market participants, including PSD’s investment adviser, believe that even if the rent cap is not repealed, condominium values are likely to increase as existing tenants remain in place and fewer rental apartments become available, while investment in new supply is choked off.

As at 14 September 2020, 66% of the portfolio had been registered as condominiums, providing opportunities for the implementation of further projects where appropriate. A further 19% are in application, over half of which are in the final stages of the process. Although the majority of units within the portfolio are now officially registered as condominiums, this has not generally been reflected in portfolio values and in most cases their valuations reflect an expectation that they will be held for long-term rental income. Included within the portfolio are six properties valued as condominiums, with an aggregate value of €33.0m (end-FY19: five properties with an aggregate value €26.5m). The properties concerned benefit from both the potential (eg necessary structural adjustments) and all relevant permissions to be sold as individual apartments/condominiums. Where a sale is expected in the coming year these assets are considered held for sale and when notarised for sale, the sale value is reflected.

Against the positive backdrop of consistently rising market rents over many years, the achieved average contracted rents for PSD’s Berlin portfolio have also increased steadily (Exhibit 2). The restricted indexation of rents on existing tenancies allowed by the regulations has been significantly enhanced by the refurbishment and subsequent reletting of vacated units at a premium and closer to market rent levels (Exhibit 3).

During H120, PSD continued to sign new leases but at a slower pace following the rent cap introduction and including the impact of COVID-19. To avoid uncertainty among tenants as to their contractual rental obligations during the period when the legality of Mietendeckel remains unresolved, PSD has amended its tenancy agreements to specify clearly rents currently payable as prescribed by the Mietendeckel while it is in place and the higher free market rents that would have been permissible under the German Civil Code, and which will become payable if the Mietendeckel or any part thereof is voided, suspended, repealed or otherwise abolished. As a result, there is currently a small difference between contracted rents and the lower collected rents on new lettings. Tenants have been advised by the Berlin government to set aside appropriate reserves to cover this possibility. 

The 88 new leases signed represented a half-year letting rate of c 3.7% of occupied units, with most (78) signed prior to the commencement of the rent cap. The average contracted rent achieved on new lettings was €10.7 per sqm (12% lower than in H119) and the average premium to passing rents also showed a reduction to 18.6%. The average collected rent of the 88 new leases was €10.5 per sqm, a 17.7% re-letting premium to passing rents. PSD says that the decline in reversionary premium mainly reflects the inclusion of the re-lettings from the recent acquisition in Brandenburg, where rents are lower than those achieved in central Berlin. It says that the reversionary premium achieved on the Berlin portfolio was 37.0%, down from 39.9% in H119. The company has noted some tenants in higher rented accommodation cancelling leases to look for apartments that have lower collected rents due to the Mietendeckel, but expects this to be only a temporary factor.

The slowdown in H120 letting activity was also reflected in increased vacancy (8.0% compared with 6.7% at end-FY19), while the increase from 4.2% at end-H119 significantly reflects the Brandenburg acquisition in late 2019. On an EPRA basis, which adjusts for units that are undergoing development/refurbishment and made available for sale, the vacancy rate was 4.3% (end-FY19: 2.8%.

From listing through to 3 April 2020, 116 units had been notarised (contracted for sale), representing an aggregate sales value of €38.4m, an average uplift to book value of 16%. Sales in the three years to end-FY19 average c €9m pa. The uplift to book value does not capture the full value creation from redesignation, but only the realised gain to the carried book value at the point of notarisation/contracted sale.

PSD typically expects to achieve a 30–35% overall valuation uplift compared with the rental based valuation of much of the portfolio and an alternative way to demonstrate this is to analyse the sales data on an annualised basis. We are unable to compare the sales values with the rental valuation of the actual assets sold, but the sale valuation premium to the portfolio average values appears supportive, although it was lower in H120 as we discuss below. Continuing condominium sales highlight the value embedded in the portfolio and represent a complementary way to realise this value alongside reversionary rent capture. As we discuss in the forecast section below, assuming no repeal of the Mietendeckel we expect overall reported profits to be lower and for realised gains on sale to represent a larger share of these. Under these circumstances we would expect investors to increasingly focus on the potential realisable value of the portfolio. Estimating this value with accuracy is difficult, but as we show in the valuation section below, applying a value of c €4,500 per sqm to the 75% of the portfolio that will soon be designated as condominiums would imply an underlying P/NAV at the current share price of c 40%.

Despite the COVID-19 lockdown for part of the period, 10 condominiums units were notarised in H120, representing total sales proceeds of €3.0m (H119: €2.5m). The average achieved notarised value per square metre for the residential units was €4,392, representing a 15.7% premium to book value and a 14.4% premium to the average residential portfolio value as at 30 June 2020. We understand that the lower average selling price in H120 predominantly reflects mix effects, and in particular sales of remaining, lower value units at Boxhagenerstrasse, marketed under the sales agreement with Accentro and to be completed by the year end. Accentro is contracted to purchase any unsold units from the fund for a cash consideration, guaranteeing revenues of €4.5m in the second half of this financial year. Including the Accentro contract and a positive impact from relaxation of the lockdown restrictions (and assuming they are not re-imposed), PSD anticipates that condominium sales will accelerate in the second half of the financial year and that the full year total will materially exceed the €8.8m recorded in FY19. As at 14 September 2020, additional H220 condominium notarisations amounted to €3.3m and new reservations were also showing a significant improvement.

Growth in contracted rents and a tightening of valuation yields have driven strong like-for-like valuation growth in recent years and this has driven the upwards trend in EPRA NAV per share.

EPRA NAV per share has increased steadily, driven by strong realised and unrealised portfolio valuation growth resulting from asset management driven rental growth, yield compression and strategic disposals. The 50.5% increase in NAV per share in 2017 included a significantly positive impact from the disposal of the group’s non-Berlin assets.

Although returns are biased towards capital, PSD has targeted a progressive dividend since listing, although FY19 was held flat due to the uncertainty created by the Mietendeckel rent cap proposals, subsequently adopted. Dividends have not been, and are unlikely to be, covered by recurring earnings (excluding realised and unrealised property gains) and distributions are supplemented by condominium disposal proceeds.

PSD has an NAV target of 8–10% pa, which it has comfortably exceeded since IPO. Returns have been biased towards capital rather than dividend income and we expect this to remain the case, reflecting the low yield on the assets and the cost of actively managing these to unlock the value embedded in the portfolio. Assuming repeal of the Mietendeckel, we expect returns to continue within the target range, but if it is not repealed this would be unlikely and we would expect management to review the target. Our FY21 scenario, assuming no repeal, generates a broadly break-even result.

In the five years to end-FY19 the NAV total return (change in EPRA NAV with dividends paid added back but not reinvested) was 153.0% or an average annual compound return of 20.4%. Capital returns accounted for slightly more than 90% of the total return during the five-year period and dividends for the balance.

The Berlin rent cap is a political response to the city’s housing shortage, which has seen rents increase sharply in recent years. Aside from the constitutional argument being waged against the rent cap, many in the industry argue that on top of existing bureaucratic obstacles and land shortages, it will only have a negative impact on investment in the sector, further aggravating the housing shortage.

Berlin, the most populous city in Germany, 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 inward migration, which would have been encouraged by relatively low rent levels and a strong a strong job market. The number of people with their main residence in the city had reached c 3.8 million by the end of 2019 (although growth was slower than in previous years and below 1%).

Housing demand is being driven by the growing population, an increasing number of single and two-person households, and a rising number of employed persons (even though unemployment remains above the national average). Meanwhile, although the supply of new homes has increased in recent years it has remained well below the level needed to satisfy this growing demand. Berlin faces a housing shortage and it is estimated that to meet this demand c 20,000 new apartments are need for several years in a row. The decision to cap rents, on top of other bureaucratic obstacles and land shortages, has seen building permit applications decline and seems certain to have a negative impact on investment in the sector, further aggravating the housing shortage.

Berlin rents have grown strongly from a relatively low level over a number of years, although the rate of increase has recently slowed. Company data and our analysis indicates that in the five years to end-2019, average rents per square metre per month increased by c 13%. More recently, rents have continued to increase at the top end of the market while stagnating at the lower end.

Berlin residential property has attracted significant investment, and this has been reflected in declining yields despite rising rents. Company data and our analysis indicates that average market prices for condominiums have increased by c 45% to around €5,000 per sqm in the past five years. JLL estimates an 8.4% increase in 2019, down from 12.9% growth in 2018, with the strongest increases noted at the lower end of the market.

Having started from a relatively low level, Berlin rents and condominium prices remain relatively affordable in both a national and international context. Combined with continuing positive demographic trends and the current housing shortage, this is a positive indicator for the continuing performance of PSD’s portfolio.

PSD is overseen by a non-executive board of directors, with overall responsibility for the company’s activities including determination of the company’s investment objective and investment policy. Having no direct employees, the company has appointed as external property adviser QSix (formerly PMM Residential), an independent and owner-managed alternative asset manager with and experienced team of property and investment professionals and an established track record in the German residential property market. It has offices in London and Berlin.

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. The other current board members are Jonathan Thompson, appointed in January 2018, a chartered accountant and honorary fellow of the Royal Institute of Chartered Surveyors, with extensive real estate and board experience; Monique O’Keefe, appointed in April 2018, a Jersey resident with investment banking and extensive board experience; Greg Branch, appointed in September 2020, a Jersey resident with more than 30 years’ experience in the financial service and real estate sectors, including working with complex business structures; Antonia Burgess, appointed in August 2020, a Jersey resident with more than 25 years’ experience working in the legal and financial services sectors with leading real estate fund managers and investment companies; and Quentin Spicer, appointed in April 2007, a Guernsey resident and lawyer experienced in commercial property transactions including funding for non-UK residents and associated low tax jurisdiction. The company considers all the directors to be independent other than Quentin Spicer due to his length of service on the board. The recent appointments of Antonia Burgess and Greg Branch allow for the retirement of Charlotte Valeur at the last (2020) AGM and the expected retirement of Quentin Spicer at the next AGM. Full biographies can be found on the company’s website.

Founded in 2006, QSix originates and manages real estate and real estate debt investment on behalf of leading institutional investors. It consists of a team of experienced real estate investment professionals with a recognised track record of advising on fund origination, structuring, acquisitions and disposals, due diligence and asset management in Germany. QSix advises the company of 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. These functions are split between offices in London and Berlin, where the asset management functions are based.

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. In FY19 investment adviser fees of €6,098k comprised €5,944k of management fees and €154k of other fees. 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 and written off.

The property adviser performance fee is based on the excess by which annual EPRA NAV total return exceeds 8%, measured over consecutive three-year periods, and payable and settled in shares. For three-year performance periods ending before 31 December 2020 the investment adviser is entitled to 16% of the excess, falling to 15% for subsequent periods, and is subject to a high watermark.

The FY19 performance fee charge was €2.8m (FY18: €4.0m) but in H120 a reduction in the cumulative accrual resulting from slower NAV total return growth resulted in a €1.9m credit.

The group structure has recently been simplified by the exercise of an option to acquire the remaining 5.2% partnership interest in the Phoenix Spree Property Fund (PSPF), a core component of the group since the ‘effective merger’ of the company and PSPF in 2015, prior to listing on the LSE. In 2015 the company acquired a 94.8% partnership interest in PSPF, a similar investment fund managed by the investment adviser, avoiding the potential adverse tax consequences of an immediate full merger. In economic terms, full merger equivalence was provided by a variable rate loan instrument (VRL) under which all investors in both PSPF and PSD participated in the NAV (gains and losses) of each other’s respective funds as if they were holders together in a single fund. As a result, the company has had an effective 98.3% interest in PSPF, which has now increased to 100%. The value of the put option was reflected in an ‘other financial liability’ of €7.5m at end-H120, which was settled in July net of a €1.6m adjustment in respect of effects.

H120 financial performance was robust despite the COVID-19 pandemic and the first effects of the Berlin rent controls. Like-for-like rental income and property values increased, driving a 3.9% EPRA NAV total return including dividends paid.

At end-H120 PSD had gross borrowings (nominal value, including unamortised loan arrangement fees) of €283.6m, slightly increased on end-FY19 (€280.2m) as a result of the refinancing of €16.4m in debt acquired with the acquisition of the apartment building in Brandenburg in December 2019, refinanced over a longer period and at lower cost by €20.3m of drawing on the €50m acquisition facility agreed with Natixis in September 2019. The end-H120 debt facilities comprised:

Although the interest cost on the majority of PSD’s debt has been fixed through hedging (at a little under 2.0% on average), because the reference rate on the swaps is currently negative the overall cost of debt is higher (PSD is currently paying both the fixed rate of the debt and negative interest on the swap). We have assumed an average cost of borrowing, including swap costs of 2.25%.

With cash of €37.3m at end-H120, net debt was €246.3m (end-FY19: €237.8m) and the net loan to value ratio was 33.0% (end-FY19: 32.6%) well below the long-term target of 50% (with a 60% maximum).

Our FY20 forecast reflects the impact of the Mitenendeckel (on the company’s behaviour in terms of capex, lettings, and disposals) in that year. The rent cap measures introduced in February will continue to act as a significant drag on rent growth while the 23 November reductions in 2020 will have their first impact in the closing weeks of the year. More positively, we expect some reduction in vacancy (from 8% by area at end-H120 to 6% at end-FY20) now that COVID-19 lockdown restrictions have been eased. PSD has also indicated it expects condominium sales to accelerate.

Looking ahead, we share the view of the investment adviser that repeal of the Mietendeckel rent cap in some form or another is likely (but not certain), but the timing of this is difficult to predict. From a financial forecasting perspective for FY21 this poses some challenges and we have sought to address this by illustrating two quite different scenarios:

For FY21 our key assumptions include:

If the Mietendeckel is not repealed and it becomes likely that it will remain in place for the next five years, PSD’s strategy would change, although in reality this may not be the case immediately, if the legal challenge continues during 2021 with a reasonable expectation of success. However, to better illustrate the impact of any strategy shift we have assumed this becomes effective at the beginning of FY21. We assume the November 2020 reduction in rent per square metre remains in place with no increase in FY21, with a significant negative impact on rental income, partly offset by additional void reduction and increased realised gains from accelerated condominium sales. Our key assumptions for this scenario include:

If condominium sales were to be greater than we assume, it would have a positive impact on profitability. However, our scenario as it stands generates a broadly break-even result, hence the strategic shift towards accelerated condominium sales as a way to crystallise the value embedded in the portfolio. As with the base case scenario, we have assumed an unchanged DPS and although it is well covered by disposal proceeds, we suspect that PSD would consider a rebalancing of returns away from income and towards capital growth if the Mietendeckel were not repealed.

PSD is the only German residential property investment company listed on the LSE. Other London-listed German property companies, Summit Germany and Sirius RE, are focused on commercial property. German-listed residential property developers with significant Berlin exposure are all much larger and include ADO Properties (49% Berlin following the reverse take-over with Adler), Deutsche Wohnen (94% Berlin), Vonovia (14% Berlin) and Grand City (25% Berlin).

The whole group has de-rated in terms of P/NAV in recent months, but the de-rating of PSD has been somewhat larger, and contrasts with the share price performance and P/NAV rating of the larger and more liquid Deutsche Wohnen, with a similar Berlin focus. The current c 30% discount on PSD shares compares with a five-year average of 8% and our base case scenario indicates that with a repeal of the Mietendeckel, the EPRA NAV total return should continue to at least fall within the targeted 8–10% pa range.

Exhibit 17 shows a valuation and performance summary for PSD and the German listed peers; the PSD P/NAV and trailing yield are both similar to the peer average, although the average is reduced by ADO (which paid no DPS for FY19 ahead of a capital raise).

Assuming no repeal of the Mietendeckel, PSD would be significantly more dependent on condominium sales to realise the value embedded in the portfolio. In these circumstances we would expect investors to focus on the underlying portfolio value, adjusting the balance sheet property values and NAV to a condominium basis valuation. The average realised values per square metre reflected in Exhibits 4 and 5 above are specific to the assets disposed of in any period. With that caveat, we estimate a value-weighted average sale price of just over €4,500 per sqm from the beginning of FY17 to end-H120. Applying a €4,500 per sqm value to the c 75% of the portfolio that will soon be designated as condominiums suggests a c 20% uplift to the reported H120 EPRA NAV per share, implying an adjusted discount to NAV of c 40%.

As noted above, although we believe that a repeal of the Mietendeckel is likely, the timing is uncertain, and it is by no means certain. In this context, the financial impacts on PSD remain difficult to predict and we refer to our modelled outcomes as scenarios. Non-repeal of the Mietendeckel would have a material negative impact on rental income, which the company plans to partly offset with increased condominium sales. We see the main fundamental sensitivities as being economic and market driven, although residential property has historically been much less cyclical than is the case for commercial property, and the current market supply-demand position continues to be positive, with supportive demographic trends predicted to continue. Political risks, reflected in changes to the legal and regulatory structure, as the Mietendeckel highlights, are tangible and require vigilance and flexibility on the part of management, as has been the case since the company was formed c 13 years ago. In particular, we highlight: