Globalworth Real Estate Investments — Update 8 August 2016

FY15 showed a continuation of the rapid operational and financial progress that GWI has made since it first listed on the AIM market of the London Stock Exchange in July 2013. In 2015 GWI continued to build its portfolio and was one of the most active real estate investors in Romania. It now has a portfolio of 15 assets, a mix of completed, income-generating assets (11), development projects (two) and land plots (two), with an externally appraised value of €931m (2014: €599m) at 31 December 2015 (€19m higher at 31 March 2016 due to capex with no revaluation undertaken). Assuming full completion of current and intended development projects the value was €1,084m at 31 December (2014: €890m). Significant progress on financing was made in 2015 and the early months of 2016, including new debt and equity, with an LTV of 43.5% as at 31 March 2016. Importantly, the technically challenging flagship development Globalworth Tower was completed and delivered in Q116, substantially (59.5% at the end of Q1) pre-let. The completion of Globalworth Tower increased the share of income-producing properties in the portfolio from 74.7% at 31 December 2015 to 89.6%, which represents a significant de-risking of the portfolio. As acquisitions begin to fully contribute to income and developments complete, GWI should be able to generate strongly growing cash flows that can support shareholder distributions. There is good potential for NAV to benefit from a convergence of property yields towards those seen in more established CEE capitals.

Net operating income (NOI) increased by 120% to €28.4m in FY15, driven by the acquisition of yielding properties. In Q116 it continued to increase, reaching €6.5m. Administrative and acquisition costs fell and, despite higher finance expense (more debt to fund the growing portfolio and the relatively high cost of short-term financing), the PBT loss, excluding revaluation and bargain purchase gains, decreased to €4.0m from €9.4m in Q115. Operating cash flow turned to a small positive. Our forecasts show NOI continuing to grow strongly during FY16-18 as the recent acquisitions fully contribute to income and as developments complete and are let. This forms the basis for potentially strong growing free cash flow that would support distributions to shareholders. EPRA net assets grew 31% in FY15 and after share issuance (€54m raised at €6 per share) by 12% in per share terms. We expect further growth in NAV but have only included development gains reflected in the external valuation.

GWI has indicated an intention to pay out up to 90% of available free cash. We estimate operating cash flow after financing costs will increase to 51.9 cents per share in FY18, with development spending on current projects complete, and that this may support an FY18 DPS of 30 cents per share (a c 60% pay-out), equivalent to a 5.5% yield on the current share price. The shares are trading at a substantial discount (c 46%) to a growing NAV, with potential additional benefit (not included in our estimates) from yield convergence on more established markets like Warsaw and Prague, where yields have declined to c 5.75% from 6% a year ago. We show a sensitivity analysis on page 12.

In addition to the usual development risks and funding risks, we highlight on page 12 the significant role played by GWI’s founder and major shareholder, as well as Romania’s reputation for weak political and business transparency. Risks include:

GWI is a real estate investment company that focuses on property investment opportunities in South-Eastern Europe and Central and Eastern Europe, but primarily in Romania, where all of the current assets are located and where it is one of leading players in the commercial real estate market. It was incorporated in Guernsey in July 2013 and listed on the London AIM market in July 2013. With 65 property professionals on the ground in Romania, GWI operates as a fully integrated real estate investment company. Its investment strategy seeks a balance of yield and capital appreciation based on:

By managing a portfolio of existing and development assets, GWI can provide turnkey commercial real estate solutions for its clients, helping them to manage their requirements over time as their own businesses develop and grow.

In 2015 GWI continued to build its portfolio and was one of the most active real estate investors in Romania. It now has a portfolio of 15 assets, a mix of completed, income-generating assets, development projects and land plots with an externally appraised value of €931m (2014: €599m) at 31 December 2015 (€19m higher at 31 March 2016 due to capex with no revaluation undertaken). Assuming full completion of current and intended development projects, the value was €1,084m at 31 December (2014: €890m).

From listing in 2013, GWI moved quickly to assemble its initial portfolio, which at the end of 2014 had reached 11 assets, of which six were standing let assets. During 2015 portfolio growth continued, with four new assets acquired, all standing and let, while two additional pre-let extensions were internally developed and delivered. Total assets at the end of 2015 were 15, of which 10 were standing assets, three were assets are under development and two were land assets for future development. In Exhibit 1 below we show the flagship Globalworth Tower development as completed, reflecting its delivery in Q116.

During the year GWI invested €244m in growing the portfolio, c €70m in capex on development projects (including TAP, Globalworth Tower, Globalworth Campus, and Gara Herastrau) and the balance on acquisitions (UniCredit HQ, Nusco Tower, Green Court A and Green Court B).

The highest concentration of the portfolio is in Bucharest, and particularly within the new central business district (CBD). Of the 15 assets in the portfolio, nine are located in the new CBD, which is located in the northern part of Bucharest, and benefits from its connectivity and infrastructure (metro, road, bus and tram services, and close proximity to both Bucharest airports). The Bucharest portfolio also includes TCI, a landmark asset in the historical CBD, for which we believe it would now be impossible to obtain planning consent (due to both restrictions on height and building intensity), UniCredit HQ (a landmark tower leased to UniCredit on a long-term basis) and City Offices, a recently refurbished office building with good transport links, two metro stops south of the city centre. Outside of Bucharest, GWI owns the TAP light industrial park in Timisoara, one of the country’s principal peripheral industrial hubs. TAP was extended to accommodate existing tenants in 2015 and is undergoing similar additional extension.

The tenant mix is diversified, with more than 85 different multinational and national tenants from more than 15 different countries. At the end of 2015, 88.9% of leases were with multinational tenants, 5.5% with mostly large national tenants and 5.6% with local state-owned enterprises. Leases are on a triple net basis, which means the tenant covers local tax, insurance and maintenance expenses, denominated in euros and index-linked on an annual basis to European inflation.

The weighted average lease length (WALL) on commercial lease space at 31 December 2015 was 6.9 years. The WALL for the majority of commercial leases signed over the past 18 months or so has been above eight years, in line with management’s “longer lease” policy which, as well as providing security of income to GWI, can also appeal to relocating multinationals, which in some cases may find it easier to access subsidies when their application is supported by a longer lease, an explicit sign of their commitment to the country.

There were 10 standing let properties, fully owned by GWI at 31 December 2015, while Globalworth Tower was completed and delivered by the end of Q116. Including Globalworth Tower, these properties represent €836.3m of the €931.1m property valuation at year end, covering c 410,000sqm of gross lettable area (GLA). All the properties are located in Bucharest, with the exception of the TAP logistics park in Timisoara, and all are modern or have been completed or refurbished since 2008. Globalworth Tower is GWI’s flagship development project in the heart of the new CBD. It was completed on schedule at the end of 2015 and was delivered for operation at the end of Q116. At completion, 51% of the c 55,000sqm GLA was pre-let, and in May 2016 occupancy had increased to 66.7%.

In addition to the Bucharest office properties, there is one residential complex, Upground Towers, a modern, two-tower residential complex with 435 apartments, well situated in close proximity to the CBD office properties. Leased apartments at Upground Towers generate NOI of c €1.5m, but as the residential market continues to gradually improve, GWI has continued to sell surplus apartments (12 in 2015 at an average €129k).

Following the delivery of Globalworth Tower, the main current development project is the two-phase Globalworth Campus project, which on completion will offer three Class “A” office towers with a total c 89,000sqm GLA, with an estimated value at completion of €172.9m. Phase A comprises two towers of c 57,000 GLA and Phase B is the third, central, tower. Construction of the core of tower 1 has been finished and the shell is nearly complete. In addition, the excavations and ground preparation for Tower 2 are complete. Tower 1 is scheduled for completion in Q416 and Tower 2 in Q217.

On a smaller scale, Gara Herastrau is a c 12,000sqm GLA Class “A” office development located in the northern part of Bucharest, with an estimated value at completion of €26.3m. It is adjacent to Green Court Building A and c 200 metres from the Nusco Tower and Bucharest One. The building is now complete and the first tenants moved in in June; as at May 2016 it was 50.6% pre-let (NOI c €1.0m).

The light industrial complex at Timisoara (TAP) has been developed in phases and in 2015 added c 55,000sqm of space to take the total to c 81,000sqm, let to Valeo, Continental, and Elster (part of Honeywell Group). Valeo has exercised the option to expand further and c15,000sqm are currently being built for the company. Elster and Continental each have options to expand further too, possibly taking TAP to c 124,000sqm, which GWI believes would represent one of the largest logistics parks in the country. GWI expects the options to be exercised in the next two years and for the additional space to be delivered at an investment cost of €10.2m.

Two land plots in prime locations (Luterana Street and Herastrau), carried at a value of €18.2m, are undergoing planning and permitting work. Luterana in particular presents a scarce opportunity for an office development, given its large size and location in the centre of Bucharest.

The commercial real estate environment in Romania remains supportive. With 3.7% GDP growth in 2015, the second-highest in the EU after Ireland, and the IMF estimating 4.2% growth in 2016, the Romanian economy continues to be one of the fastest growing in Europe. Future growth is underpinned by the availability of European funding and the current, second phase of funding, running from 2014-20, has approved €43bn of funding over the period.

The Romanian real estate investment market is active with 2015 volume at an estimated €800m, although a little lower than the post financial crisis peak of c €1.1bn in 2014. The first half of 2016 saw growth of 80% compared with the same period in 2015, rising to an estimated €340m (source: JLL). In part, this was buoyed by one of the first significant transactions outside of Bucharest, being NEPI’s acquisition of a regional shopping centre for €100m.

The main commercial property market in Bucharest is experiencing positive demand and supply fundamentals with an estimated 65,000sqm of new space entering the market in 2015 compared with uptake estimated at 240,000sqm (source: Colliers). Prime office rents are stable and are expected to remain so, while vacancy has been falling and is very much lower than the Bucharest average figure shown in Exhibit 2 in the popular central business areas targeted by GWI. GWI estimates prime office vacancy of c 5% in these areas. Demand for prime office space is being driven by companies in the information technology and communications, services, and consumer goods sectors, and GWI reports a number of multinationals consolidating their positions and expanding their operations in the market. It has experienced this trend first hand when signing leases with Deutsche Bank, Vodafone, Honeywell and ADP over the past 12 months. Bucharest offers a well-educated and relatively inexpensive workforce while prime rents are the lowest in Eastern Europe.

New supply is expected to increase in 2016 (Colliers reports that developers plan to build 360,000sqm, including c 95,000sqm developed by Globalworth), but demand is also expected to remain strong and around half of the new space is estimated to be pre-let. GWI does not expect any impact on rents or overall vacancy from the 2016 deliveries as some c 75% is either pre-let or under active negotiation between the respective landlords and potential tenants.

Prime yields contracted during 2015, from 7.75% to 7.5% for prime offices, and from 9.75% to 9.0% for logistics properties. However, prime yields in Romania continue to be higher than most other markets in CEE, making the possibility of valuation gains driven by yield compression a real possibility. Indeed, GWI management believes that global investor capital flows will gradually move from markets considered “safe havens” to more peripheral markets like Romania in search of higher yielding investments, and that GWI should benefit from an early mover advantage.

GWI was founded by Ioannis Papalekas, who is the CEO and main shareholder with a holding of 36%. He has approaching 20 years of real estate experience, of which 15 years has been gained in Romania. The founder is supported by an experienced senior management team, including:

During his 15 years of operating in the Romanian commercial real estate market, the founder has built up a strong track record. This is detailed in the GWI admission document (link) and summarised in our previous research. Before founding GWI he was responsible for the development of more than 400,000sqm of commercial space and 1,000 residential units, investing more than €70m of proprietary and third-party capital. The combined realised IRR was 175%, generating total capital gains of €270m, with distributions to investors at 4.7x. Excluded from this realised return are unrealised projects in Romania and other South-East Europe countries (including interests in two hotels in Sofia and Belgrade).

Overall, GWI has built a team of more than 65 real estate professionals. All are based in Bucharest, which we believe is advantageous to the company’s operations, allowing closer relationships with existing and prospective tenants and a better understanding of the local market. In addition to the investment and strategic functions of the group undertaken by the six-strong senior management team and the necessary administration, finance and accounting and IT infrastructure (26 members in aggregate), GWI also has internal teams in the areas of project management (five), asset and facilities management (13), commercial sales & leasing (six) and legal (two members).

The board of directors has a majority of non-executive directors and comprises the non-executive chairman (Geoff Miller), two executive directors and five additional non-executive directors. Brief biographies of key board members are shown on page 14.

We give a brief overview of the financial developments in FY15 along with some key updates from the unaudited Q116 release.

In FY15, underlying EBITDA (that is excluding fair value movements and bargain purchase gains) was c €1.3m ahead of our estimate, primarily explained by lower than forecast expenses. However, the refinancing of the relatively expensive short-term corporate loan took longer than we had allowed for and finance expenses were c €2.3m higher than we had allowed for. Our estimate of the normalised PBT loss was c €1.0m less than the c €4.0m outturn. EPRA NAV per share exceeded our forecasts due to higher property revaluation gains than we had allowed for, largely the result of faster recognition of valuation uplifts on development properties in the external property valuation.

We have updated our FY16 and FY17 forecasts and have introduced an FY18 forecast for the first time. The main difference to our FY16 forecast results from the recent bond refinancing. Our previous assumption was that the c €100m short-term mezzanine loan (interest rate c 12%) would be replaced with short-term bank debt at a cost of c 4%, a similar cost to the current bank debt, and that near-term additional funding needs would be similarly financed. Instead, we estimate the cost of the three-year bonds at c 7%, which leads us to increase our net finance cost estimate. We have also pushed back our estimate of the timing, completion and letting of Globalworth Campus phase B slightly (completion from late FY16 to late FY17), which defers related NOI from FY17 to FY18.

At the end of FY15, the current NOI on let standing properties reported by GWI was c €37.7m (€43.7m including the subsequently completed Globalworth Tower) higher than the total FY15 NOI reported in the P&L of c €28.4m. The difference is accounted for by properties acquired during the 2015 year that did not contribute fully to the annual income, and rent incentives. We estimate that by the end of FY18, the €37.7m will rise to €78.3m, primarily due to development properties completing and being let. We assume no property acquisitions. To get to the income reported in the P&L we have averaged the contribution of each property on a quarterly basis and we have allowed a 10% deduction for lease incentives. Annualised P&L income in H218e is thus €70.2m and our estimate for FY18 is €78.3m. The implied average occupancy at the end of FY18 is 97.5%.

Of the estimated increase in gross NOI of €30.6m by the end of FY18, c €12.0m is attributable to occupancy and rent changes on existing let assets, and the balance, €28.6m, to the estimated Q4FY18 contribution from recently completed or current developments upon completion (Globalworth Tower €11.4m, Globalworth Campus, phases A & B, €15.1m, and Gera Herastrau €2.1m).

The only fair value movements that we have allowed for are to recognise the €21.4m revaluation uplift indicated by the external valuation report in respect of development properties, at or around the time of expected completion. In Exhibit 7 on page 12 we show an estimated sensitivity of property values and NAV to changes in valuation yield.

We have allowed for 4% pa growth in administrative expenses

Finance expenses equate to an average cost of debt of 5.2%, the weighted average of bank debt at 4% and bond debt at 7%.

The group is domiciled in Guernsey where the current effective tax rate is nil. Subsidiaries in Romania, the Netherlands and Cyprus are subject to local taxes in respect of local sources of income. The tax expense recorded in the P&L in FY15 represented mostly deferred tax (in respect of valuation gains on the investment portfolio) and a small amount of current tax. The effective tax rate excluding deferred tax was 0.3% and we assume negligible current tax in our forecasts.

Our forecasts show cash flow from operations after financing continue to increase, from the €3.0m reported in FY15 to €33.2m in FY18. During this same period, we expect capex to complete the existing development projects of €131.3m. As a result we estimate net debt will increase further, peaking at c €450m in FY17, with the ratio of net debt to investment properties at 41.7%, well below GWI’s self-imposed maximum LTV of 60%.

GWI has indicated an intention to pay out up to 90% of available free cash in shareholder distributions. Available cash flow depends on acquisition and development opportunities, but our starting point for available free cash is operating cash flow after financing costs. In per share terms our estimates show this at 51.9 cents per share in FY18. Although management is yet to indicate the commencement of dividends we have assumed that as free cash flow builds and capex approaches its end, this will happen.

We assume that GWI will commence dividend payments during the forecast period, and we have allowed for a relatively modest €0.10 per share dividend to be declared in respect of the current FY16 year, and be paid in FY17. We had previously thought this possible as early as FY15. There are continuing development financing needs over the FY16-18 period (€131.3m in aggregate), but as these fall away we expect that dividends will build from the modest starting position. For FY18 we assume a DPS of €0.30 to be declared and paid during 2019, representing a c 60% payout of the estimated FY18 operating cash flow after financing. At the current share price of €5.5 this would represent a yield of c 5.5%.

In September 2015 GWI issued equity at €6 per share to part fund its investment programme. The minimum €35m subscription was oversubscribed by €18.8m. Since that time, the shares have drifted lower, opening up a wider discount to NAV even though the balance sheet was strengthened and the portfolio has continued to develop favourably. Our updated EPRA NAV per share for FY18, when the current development projects should be complete and largely reflected in the balance sheet, is €10.21 and at a price of c €5.5 the shares are trading at a discount of c 46%. While it is true that large discounts to NAV are not uncommon among listed real estate companies investing in CEE and SEE, we continue to note that few are focused on Romania to the same extent as GWI, where market conditions remain favourable.

We have previously referred to New Europe Property Investments (NEPI) as an interesting comparator. It is listed in Johannesburg with a secondary but less active listing on London’s AIM market. Like GWI, it is focused on commercial (both retail and office) property development and investment in Romania (80% of rental income) and is internally managed, and combines property and asset management with development activity. Since it listed in 2007 it has built a consistent track record of NAV growth while distributing at least 90% of its net rental profits, semi-annually, mostly satisfied by the issue of new shares via a scrip alternative. Clearly, compared with GWI it is larger and considerably more liquid, with a market capitalisation of c €3.5bn (GWI c €350m market cap, a free float of 23.5% and an average daily volume of 32.5k shares over the past year according to Bloomberg). And the NEPI valuation appears high; at a price of c €10.75 it is valued at over twice 2015 adjusted NAV per share of €5.25 (up from €4.63 in 2014), while the 2015 distribution of 35.34c represents a yield of c 3.3%. Given the differences is size between GWI and NEPI, and given the latter’s longer track record and more advanced stage of development and cash generating ability, we would not argue that GWI should also trade at 2x book value. However, we do consider the NEPI valuation to be a positive indicator of the direction of travel in GWI’s valuation as it continues to develop.

€1,065.6m of the FY15 expected portfolio value at completion (the last external valuation) applies to what are, or will become, income-producing assets excluding land plots. On this management expects a contracted NOI of €78.5m (this includes pre-lets, but is very similar to our expectation of the occupied position at the end of FY18) or an NOI yield of 7.39%. In Exhibit 7 we update our sensitivity analysis of the estimated movement in EPRA NAV per share for a range of possible valuation yields.

A decline in the NOI yield to 7.0% is estimated to lift our existing FY18 NAV per share estimate from €10.21 to €11.16. At 6.0% the forecast NAV would increase further to €14.14 per share. We also illustrate the result assuming full conversion of the warrants that have been granted to the founder and certain key managers. The warrants vest in three tranches, when the weighted average share price exceeds the trigger level for 60 consecutive days (1.8m warrants at a €7.5 average price, 1.4m at €10 and 1.4m at €12.5). In total, a potential 4.6m shares would be created at a subscription price of €5 per share (generating c €23m of new capital). In the estimate that allows for warrant dilution, we have assumed that the additional equity generated by the conversion increases operating cash flow at a yield of 2%; this is a balance between the alternatives of paying down debt at a cost of c 4% or holding a higher cash balance with a negligible return. The potential upside in NAV per share is clear in both scenarios.

In addition to the usual development and funding risks, we would highlight the significant role played by GWI’s founder and major shareholder, as well as Romania’s past reputation for weak political and business transparency. The country is still subject to special monitoring by the European Commission (the “Co-operation and Verification Mechanism” or CVM) to check its progress in the fight against corruption. The issue has received a great deal of government attention and the most recent CVM report makes note of the country’s willingness to fight corruption and to protect the independence of the judiciary. However, it also notes that further steps to tackle general corruption are needed to address it as a systemic problem.