Phoenix Spree Deutschland — Flexibility to extract value

The repeal of the Mietendeckel allows PSD to resume its core reversionary rent strategy, based 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. The reversionary strategy, supplemented by the division and subsequent resale of selected apartment blocks as private units (condominiums) at market-level valuations, significantly above their value as apartments and carried book value, has generated strong returns. The cumulative EPRA net tangible asset (NTA) total return (dividends added back but not reinvested) over the five years to end-FY20 was 146.2% or an average annual return of 19.7%, well ahead of the 8–10% pa target. Despite the twin challenges of the rent cap and the COVID-19 pandemic, the FY20 total return was 8.8%.

PSD estimates the average free market value of rents for the portfolio at c €13 per sqm per month, well ahead of the end-FY20 average portfolio contracted rent of €9.3. This significant reversion opportunity results from a combination of the positive demand-supply fundamentals in the market and the strict rent controls in place in Berlin over many years. The controls mean that tenants often pay rents that are well below market levels, and the gap has increased with significant rent market growth in recent years. PSD believes this reversionary gap should underpin rental growth in the medium term, irrespective of market conditions and rental growth. Alongside permissible rent indexation,1 PSD’s reversionary rent capture is driven by the refurbishment of vacated apartments, which enables PSD to re-let them at market-level rents. Despite the Mietendeckel being in place, during FY20 PSD’s average contracted rents per sqm increased by 4.1% on a like-for-like basis. New Berlin lettings were signed at an average 34% premium to passing rents and the average across the portfolio (including Brandenburg, where rents are lower) was 25%.

The reversionary rent strategy has been supplemented by the division and subsequent resale of selected apartment blocks as private units at a significant premium to book value. PSD is differentiated among listed peers by having a high proportion (more than 70%, with a further 15% in application) of its Berlin portfolio legally split into condominiums. In FY20, a record c €15m of PSD’s condominiums were notarised (sales legally agreed), a 65% increase over 2019, with an achieved sales value at more than a 19% premium to book value. The scale of the increase was partly in response to the Mietendeckel, as well as the introduction of a marketing agreement with Accentro, a large listed real estate agent and property manager, and we expect sales to revert to a more normal level in the current year.

Although most units within the portfolio are officially registered as condominiums, this has not generally been reflected in portfolio values. Only active sales projects, accounting for c 7% of the portfolio, are valued on a ‘condominium basis’. More generally, portfolio valuations reflect the expectation that they will be held for long-term rental income.

At end-FY20, the property portfolio was externally valued by Jones Land LaSalle at €768.3m and assumed the rent cap would be in place for a full five years. Nonetheless, the valuation increased with 6.3% annualised growth on a like-for-like basis reflecting yield compression and low interest rates. The cash flow analysis underlying the external valuation will have benefited from increased reversionary potential once the Mietendeckel was scheduled to expire after a five-year period as a result of further growth in free-market contracted rents. While a repeal of the Mietendeckel is a very clear positive for PSD, providing significantly greater strategic flexibility for extracting the value embedded in the portfolio, we would expect this to be reflected in the share valuation ratios rather than a significant near-term uplift to portfolio valuations and NTA. We nonetheless forecast continuing increases in property valuations and NTA, driven by rent growth and supported by continuing positive market fundamentals.

In addition to refurbishment, PSD’s asset management strategy includes exploiting underutilised space within the footprint of the existing portfolio. It currently plans two new construction projects, representing an aggregate 34 additional units, for which planning approval has been granted. At one property, a new 23-unit apartment block will be built within the curtilage, alongside the creation of four additional units in the existing attic space. At a second property, the attic space will be built out, and existing commercial space renovated, to create an additional seven units. Construction is expected to commence in mid-2021 with the first units available during H122, at an expected total cost of €11.8m. Building permits are in place for the renovation of attic space in 20 other properties, with the potential to create an additional 49 units.

Since introducing a share buyback programme in October 2019, PSD has “passively” repurchased c 5.1% of the issued share capital, designed to limit downside risk to the share price. With the shares continuing to trade at a significant valuation discount to NTA and reflecting its renewed confidence in the outlook following the Mietendeckel repeal, the company recently adopted a more proactive buyback strategy to take advantage of the discount while seeking to ensure that the share price better reflects the underlying net asset value. A material capital allocation to the buyback programme will be funded through existing cash balances, additional debt funding, and proceeds from the sale of condominiums and non-core assets, which PSD believes can be achieved without compromising its organic growth prospects. The original buyback programme set out to repurchase up to 10% of the shares and the AGM held in June 2021 replaced this with authorisation to repurchase up to 14.5m shares or 14.99% of the outstanding shares at the time. Since announcing the new, more active approach to share repurchases the company has acquired c 646k shares (c 0.7% of the total) at a cost of c €2.6m or an average c €3.97 per share2. The ultimate number of shares repurchased will depend on the continuing level of the discount and the accretion available. By way of illustration only, rather than any attempt to quantify the scale of the share repurchases, we estimate that each 5% repurchase of the shares outstanding is c 1% accretive of FY21 NTA per share.

The Berlin rent cap, now repealed, was a political response to the city’s housing shortage, which has seen rents increase sharply in recent years, although having started from a relatively low level, Berlin rents and condominium prices remain relatively affordable in both a national and international context. As many predicted, the Mietendeckel did nothing to solve the housing shortage and in 2020 had the impact of reducing the volume of transactions in the investment market (which continued to rise elsewhere in Germany), the availability of affordable rented property and investment in the creation of new housing stock. With the housing shortage still in place, unrestricted market rents and residential sales prices continued to increase. The COVID-19 pandemic had little direct impact on the housing market (PSD’s rental collection rate was above 99% and EPRA basis occupancy was at a record high), but softened net migration into Berlin, a driver of population growth in recent years; as with many cities, lockdowns and the ability to work from home has increased the attractions of suburban locations relative to more central locations. Given the scale of the Berlin housing shortage, it seems unlikely that even if sustained this will have a material impact on the market.

Given the uncertainty surrounding the Mietendeckel rent cap at the time of our initiation of coverage in December 2020, we provided two scenarios to illustrate the likely financial outcome; one assuming Mietendeckel repeal and the other assuming it remained in place and that PSD’s strategy was adapted as a result. For clarity, both scenarios were based on the assumption that the Mietendeckel outcome would be known by the beginning of FY21.

In Exhibit 3, we show our old ‘Mietendeckel repeal’ scenario, as well as our new FY21 and FY22 forecasts. Our FY21 forecast is ahead of the old FY21 scenario, which primarily reflects stronger H221 like-for-like growth in contracted rents and in capital values than we had allowed for (see our last update note).

Our new forecasts include the following key assumptions:

As noted above, PSD has a strong track record of EPRA NTA total return generation, well above its 8–10% pa target range. Our forecasts indicate EPRA NTA returns (change in NTA plus dividends paid) of 8.9% and 8.0% in FY21 and FY22 respectively.

The FY20 yield is 1.6% and the current P/NTA of 0.87x compares with an average c 0.92x since IPO. We estimate that the P/NTA would be significantly lower if the NTA were adjusted to include all condominium-designated assets at market values (see below).

The average notarised values per square metre reflected in Exhibit 2 above 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 years has been c €4,530 per sqm. Applying a value of c €4,500 per sqm to the c 75% of the portfolio that is or will soon be designated as condominiums, and which is not already valued on a condominium basis, would imply an underlying P/NTA at the current share price of c 24%.

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. Germany-listed residential property developers with significant Berlin exposure are all much larger and include Deutsche Wohnen (75% Berlin), Vonovia (14% Berlin) and Grand City (24% Berlin).

Exhibit 7 shows a valuation and performance summary for PSD and its Germany-listed peers. Given PSD’s Berlin focus, Deutsche Wohnen represents the closest comparator in terms of portfolio exposure, although only a minority of its Berlin portfolio is designated as condominiums. The PSD trailing dividend yield is slightly below the peer average (similar to Deutsche Wohnen) and P/NTA is also slightly below the average (and well below that of Deutsche Wohnen). The agreed acquisition price for Deutsche Wohnen is around the last published NTA, a c 18% premium to price immediately before the offer and a 25% premium to the three-month average. The transaction represents a significant vote of confidence by Vonovia in the long prospects for the Berlin residential property market.