Phoenix Spree Deutschland — Continuing strong returns despite rent cap

This note reviews the recently released FY20 results and updates on the analysis provided in detail in our December initiation note.

PSD is a Jersey-based, closed-ended investment company, listed on the Main Market of the London Stock Exchange. It targets an attractive total return from investment in residential property in Berlin, the most populous city in Germany, and represents the largest rental housing market in the country. It is externally managed by QSix (formerly PMM Residential), 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.

With strong demand for housing in Berlin driven by net migration and a relative lack of supply, open market rents and capital values have steadily increased in recent years. Against this background, PSD has built 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-FY20 of 19.8% per year was well ahead of the 8–10% per year medium-term target. The FY20 return of 8.8% was also above the target despite the introduction of the Mietendeckel rent cap (see next section). PSD estimates the average free-market value of rents for the portfolio at €12–12.5 per square metre per month, well ahead of the end-FY20 average contracted level of €9.3 (applicable assuming Mietendeckel repeal, see below), and local demand for accommodation continues to significantly outstrip supply.

Reflecting 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, the Berlin rent cap (Mietendeckel) was introduced in stages during 2020, becoming fully effective in November. Legal challenges to the cap are in process and PSD and its legal advisers firmly believe the Mietendeckel legislation will ultimately be ruled unconstitutional and overturned; the timing of this remains uncertain but PSD expects a resolution by mid-2021. The rent freeze and, in some cases rent reductions, introduced in in 2020 remains in place and will have a material impact on rental income on a full year basis in 2021 if not repealed. In the short term, pending clarification of the legality of the Mietendeckel rules, PSD has adapted its strategy, seeking to maintain and optimise its strategic flexibility. This includes:

If not repealed, the 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 more material and permanent change in PSD’s strategy (discussed below) to realise this value.

In line with the industry, PSD has amended its tenancy agreements in an effort to avoid uncertainty among tenants as to their contractual rental obligations during the period when the legality of the Mietendeckel remains unresolved. These new agreements specify both the rent currently payable as prescribed by the Mietendeckel while in place (‘Collected’) and the free market rents that would be permissible under the German Civil Code (‘Contracted’). The contracts make clear that if the Mietendeckel is voided, suspended, repealed or otherwise abolished, the contracted rent will again apply and back-payments may be payable. Tenants have, therefore, been advised by the Berlin government to set aside appropriate reserves to cover this possibility.

Although we incline to agree with the company’s view that eventual repeal is the most likely outcome, the uncertainty around this, particularly in terms of timing, renders an accurate prediction for the next 12 months impossible. For that reason, in our initiation note we embedded the potential strategic responses and financial effects 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. We would strongly encourage readers who have not seen the initiation note to examine the details of these scenarios.

Assuming a rent cap repeal and return to the traditional strategy based on reversionary rent capture, we would expect total return to remain consistent with the company’s long-term 8–10% return target range. Relative to the low rates of return prevailing in the market, taking account of the historically low volatility displayed by residential assets and considering the near 30% discount to FY20e EPRA NAV, we believe this level of total return is attractive.

If there is no repeal, we would expect a material strategic response, focusing on accelerated condominium sales to realise the value embedded in the portfolio, which has continued to increase despite the Mietendeckel introduction. In this case, we would expect investors to focus on the significant discount to net assets and the potential enhancement to NAV from condominium splitting and sale. Around 85% of the Berlin portfolio may soon be legally split into condominiums and our analysis indicates the discount to underlying NAV, adjusting asset values to reflect market-level condominium pricing, the discount to NAV is likely to be c 40%.

The long-term positive demographic trend has created a housing shortage in Berlin, which if anything seems likely to be aggravated by the Mietendeckel rent cap. Since its introduction, there has been a noticeable reduction in market transaction activity and a significant reduction in the availability of rental accommodation for tenants who require it most. Investment in the Berlin housing market has declined sharply. Against this backdrop, free-market rents and condominium prices have continued to rise.

The Mietendeckel had a limited impact on PSD’s financial performance, with strong realised gains on condominium sales offsetting the part-year rental income impact. If the rent cap is not repealed, the impact will be much larger in FY21.

Existing rents were frozen from February 2020, with rent limits imposed on new leases. From November 2020 rents were reduced where they exceeded newly introduced upper limits by more than 20%. Around 44% of PSD tenants received rent reductions and on the ‘collected’ basis that applies under the Mietendeckel, average gross in place rents per square metre fell 15.8% to €7.5. The company estimates the part-year negative impact on FY20 net rental income at 4%. If the Mietendeckel is not repealed, PSD estimates the full year FY21 impact at c 20%. Reflecting the underlying positive demand-supply balance in the Berlin market, rents continued to increase on a free-market contracted basis. EPRA vacancy (which excludes refurbishment properties) of 2.1% was at a record low.

During the year 269 new leases were signed, representing a letting rate of c 11.6% of occupied units. The average contracted rent achieved on new lettings was €11.7 per square metre, an average premium of 25.2% to the previous passing rent. This is a lower premium than in FY19 (36.4%), which substantially reflects the impact re-letting of properties from the 2019 Brandenburg acquisition. The central Berlin premium reduced from 36.4% to 33.9% with more of the properties re-let without renovation on an ‘as is’ basis. The Mietendeckel has reduced the financial return available on capex.

Exhibit 2 shows a summary of the financial results, and in particular we note:

As previously disclosed, the property portfolio was externally valued by JLL at €768.3m at end-FY20 (end-FY19: €730.2m) and assumes the rent cap is in place for a full five years. Annualised growth of 6.3% on a like for like basis (of which 3.6% was in H220) reflects yield compression and low interest rates. The fully occupied net yield of 2.4% compares with 2.9% at end-FY19. The decline in yield substantially reflects the Mietendeckel impact on collected rents and we estimate a much smaller reduction in yield on a contracted rent basis. The cash flow analysis underlying the external valuation will have benefited from increased reversionary potential once the Mietendeckel expires after five years as a result of the further growth in free-market contracted rents.While a repeal of the Mietendeckel would be a positive for PSD, providing significantly greater strategic flexibility for extracting the value embedded in the portfolio, we would not expect a significant near-term impact on portfolio valuations and NAV. We would expect repeal to support recurring income earnings and a closing of the discount to EPRA NTA per share.

Although most units within the portfolio are 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 nine properties valued as condominiums, with an aggregate value of €52.4m (end-FY19: five properties with an aggregate value €26.5m). The properties concerned benefit from the potential (eg necessary structural adjustments) and all relevant permissions to be sold as individual apartments/condominiums. Continuing condominium sales highlight the value embedded in the portfolio and represent a complementary way to realise this value alongside reversionary rent capture. The sales values from period to period depend very much on the mix of assets (different locations, floor space etc) and estimating the value of the portfolio on a full condominium basis is difficult. Applying a value of c €4,500 per sqm to the 75% of the portfolio that is or will soon be designated as condominiums would imply an underlying P/NTA at the current share price of c 40%. Using the FY20 average notarised value of €4,320 per sqm the implied discount to NTA is 37%.