Phoenix Spree Deutschland — Good H1 growth and return to core strategy

As anticipated by the company and its advisers, on 15 April 2021 the German Federal Constitutional Court, the highest court in Germany, ruled that the Mietendeckel was unlawful and thus void. Contrary to its objectives, the uncertainty created by the Mietendeckel acted to disrupt the Berlin residential market during the period, and significantly reduced the supply of available accommodation as rental stock was removed from the market, generating record-low levels of vacancy. Investment in new housing development and in improving the existing stock was reduced as this could no longer be justified due to the rent controls. These trends were reflected in PSD’s portfolio and repeal of the Mietendeckel leaves it free to resume its core reversionary rent strategy, based on acquiring under-rented apartment blocks at low valuations and actively managing and investing in the assets to realise reversionary rent potential, drive growth in rental income and enhance capital values. Free market rents continued to increase during H121 and condominium prices advanced further, both reflected in PSD’s H121 performance. Having structured rental agreements to revert to pre-Mietendeckel rent levels and to allow for the back payment of these higher rents, PSD has made considerable progress in collecting the amounts that are now legally due. As at end-H121, 86% of the €2.1m of back rents due (of which €0.8m related to FY20 and the balance to the early months of FY21) had been collected. By 23 September, this had increased to 92%. COVID-19 has had no material impact on rent collection with more than 97% of H121 rents collected. In common with many other city locations, it has reduced net migration into Berlin, but PSD expects this to reverse over time. Meanwhile, the acute shortage of housing in Berlin remains.

The Mietendeckel was a political response to the city’s housing shortage, which has seen rents increase sharply in recent years. However, having started from a relatively low level, Berlin rents and condominium prices remain relatively affordable in both a national and international context.

Exhibit 1 shows a summary of the H121 financial performance.

Key highlights from the H121 results include:

Until mid-2019 as anticipation of the Mietendeckel began to build, ahead of implementation in 2020, PSD shares had historically traded at around net asset value or higher. In June 2021, 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 adopted a more proactive buyback strategy2 to take advantage of the discount, while seeking to ensure that the share price better reflects the underlying net asset value. Since then, and up to 8 October 2021, PSD has repurchased a further 3.4% of the shares in issue at an average 12% discount to prevailing EPRA NTA. Over the same period, the discount has narrowed from c 30% in H121 to c 13%, still below the historical average.

H121 share repurchases of c €7m have been funded from cash resources (€28.4m at end-H121 versus €37.0m at the start of the year) with no impact on the company’s investment plans. The ultimate number of shares repurchased will depend on the continuing level of the discount and the accretion available

German Federal elections, held at the end of September, have not delivered any clear winner and as discussions between the various parties are held it may be several weeks or months before a new coalition government is successfully formed. The tightness of the result suggests the necessity of seeking consensus and common ground, making radical policy shifts less likely. One area of consensus across parties is the need to reduce CO2 emissions, of which housing will need to be a significant contributor. With private landlords representing c two-thirds of the total, their ability to support this goal will be of importance. One area of the residential property market where the federal government seems likely to act, and has introduced a draft bill, is to legally give permission to state authorities to ban the conversion of rental apartments into condominiums. With 74% of its portfolio already legally designated as condominiums, PSD is well placed for any change. It is hopeful that existing applications covering a further 11% of the portfolio can also proceed.

In the Berlin state election, the SPD took the largest share of the votes, followed by the Greens. Again, it remains unclear what form a coalition will take, but it is almost inevitable that it will include the SDP. Shortly before the elections, a non-binding referendum proposing that authorities in Berlin seize and take into public ownership more than 200,000 homes received 56% of votes in favour. It will now be for the new Berlin government to consider whether to act on this. There is no political support among the CDU (18.1% of the state election votes), FDP (7.2% of votes), or the SDP. Indeed, Franziska Giffey, head of the Berlin SPD, has declared expropriation to be a ‘red line’ and has said: ‘We need an alliance for new construction of affordable housing with all stakeholders in the city and effective protection of tenants – not expropriations worth billions of euros’. Further, any state legislation for expropriation would certainly face legal challenges at the federal level. As a result, PSD does not expect moves towards expropriation.

The external valuation of the portfolio at 30 June 2021, conducted by JLL, was €777.7m or an average €4,075 per sqm and reflecting a fully occupied yield of 2.9%. On a like-for-like basis, excluding the impact of disposals, valuations increased by 2.5% in the period, supported by rent growth, progress with condominium splitting and certain asset-specific factors. The valuation takes account of the Mietendeckel repeal whereas the end-FY20 valuation had assumed its implementation, and the resulting negative impact on rental income, for the full five-year term. The positive valuation impacts of the Mietendeckel repeal were softened by the high probability attached to such an outcome by property investors, with pricing continuing to harden despite the uncertainty.

Contracted gross rent roll was €20.2m or an average €9.5 per sqm per month. On a like-for-like basis, rents increased by 1.6% in H121 and by 4.6% compared with H120. By area, including properties under refurbishment for re-letting, vacancy was 7.7%. On an EPRA basis, excluding properties under refurbishment, vacancy was 1.3%, a very low level reflecting the continuing lack of availability for rented apartments in Berlin despite the Mietendeckel repeal.

Despite 74% of residential units being legally designated as condominiums, with positive indications for valuation, this is only partially reflected in the portfolio valuation. Just eight of the 97 properties are valued as condominiums with an aggregate value of €43.4m (less than 6% of the total valuation). Condominium market values are typically 30–35% higher than the rental-based valuations that apply to most of the portfolio. The difference between market values and carried values represents a significant value embedded in the portfolio that is not reflected in net asset value.

PSD estimates that market rents are c 30% above current portfolio average rents. In the first half of the year 102 new leases were signed, representing a letting rate of c 4.3% of occupied units. The average rent achieved on net lettings was €11.7 per sqm per month, a level that was 7.6% higher than in the prior year, and 23.5% above the previous passing rent for those apartments. Excluding assets in Brandenburg, where rents are lower, in Berlin (c 91.5% of PSD’s total lettable residential space), the reversionary premium to previous passing rents was 35.8%. The premium to previous passing rents varies from period to period, mainly determined by mix and, although lower than the 37% achieved in H120, is in line with the five-year average.

With rent increases on existing tenancies significantly restricted in Berlin, refurbishment and subsequent re-letting of vacated units at a premium to existing rents, and closer to market rent levels, is the key driver of reversionary capture. During H121, €2.7m was invested across the portfolio and, following the repeal of the Mietendeckel, PSD expects a significant increase in H221 as deferred projects are reinstated.

During H121, 13 condominium units were notarised for sale with an aggregate value of €4.3m. Although this was a c 45% increase on H120 (c €3.0m), the earlier period was significantly affected by the early impacts of the pandemic. Similarly, after a strong start in 2021, the second quarter was affected by a further wave of COVID-19, as well as the low vacancy and shortage of available apartments for sale created by the Mietendeckel. PSD expects an acceleration in notarisations as the effects of the Mietendeckel wear off and with progress in the vaccination programme. Since end-H121, a further 11 condominiums have been notarised for sale with an aggregate value of €3.9m, almost as much as the first two quarters of the year combined.

The average notarised value per sqm in H121 was €4,821, a 25.4% premium to book value and an 18.3% premium to the portfolio average value per sqm at 30 June 2021. Reflecting mix, the average notarised value in Q321 was higher than in H121, at €5,655 per sqm, a 25.3% premium to book value and a 38.8% premium to the average residential portfolio value at 30 June 2021.

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. The first project involves building out the attic space and renovating existing commercial space to create an additional seven units. Construction on this project is underway and PSD expects the first units to be available for sale or rental in H122. The total construction budget for this project is €3.9m. The second project is the construction of a new 23-unit apartment block within the footprint of an existing property alongside the creation of four additional units in the existing attic space at an expected total cost of c €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 for sale as condominiums or for rental.

Our forecasts are shown in detail in Exhibit 9 and are summarised below. The reduction in our FY21 forecast predominantly reflects our previous over-estimate of the income effect of back rent collection in that year3 but also higher occupancy (by space) as units are refurbished ahead of re-letting. The changes to our FY22 forecast are modest, and for both years we expect the accounting total return to be within PSD’s 8–10% medium-term target.

Our key forecasting assumptions are:

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 8.2% in FY21 and FY22.

The FY21e yield is 1.6% and the current P/NTA of 0.86x is below the long-term average. We estimate that the P/NTA would be significantly lower if the NTA were adjusted to include all condominium-designated assets at market values. Exhibit 6 shows the historical data for notarisations. The average notarised values per sqm 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 74% of the portfolio that is designated as condominiums (and which may increase further), and excluding those assets that are already valued on a condominium basis, would lift the reported EPRA NTA per share by c 11%, implying an underlying discount to NTA of c 23%.

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 (74% Berlin), Vonovia (13% Berlin) and Grand City (23% Berlin).

Exhibit 8 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. PSD’s trailing dividend yield is below the peer average and its P/NTA is similar to the average (and below that of Deutsche Wohnen). Vonovia has launched an agreed takeover offer for Deutsche Wohnen at €53 per share and has acquired more than 50% of the votes. The offer price is around last published EPRA NTA and the transaction represents a significant vote of confidence by Vonovia in the long prospects for the Berlin residential property market.