FCR Immobilien — Rental income improves on growing portfolio

In FY19, FCR Immobilien adopted IFRS reporting for the first time (replacing German accounting standards, HGB), which resulted in the recognition of revaluation gains on its investment properties. Previously, these were accounted for as constituents of property, plant and equipment and gradually depreciated over time rather than being revalued. Even though the first-time valuation uplift for FCR’s current property portfolio was directly reflected in equity in the FY19 accounts, the company recognized a c €8.3m gain on investment properties revaluation in the comparable H119 figures in its H120 report. At the same time, in H120 FCR reported only €0.9m of revaluation income, which affects earnings comparability between both periods, with FCR reporting H120 EBIT of €7.9m and net income of €3.8m, against €9.3m and €4.7m recorded in H119,respectively.

FCR managed to improve its rental income from investment properties to €11.6m in H120 from €8.0m in H119, on the back of further portfolio expansion. This already reflects the initial impact of COVID-19, which was relatively limited. We believe this is due to the company’s focus on the German market (96% as at 30 June 2020) and retail sector (76%) as FCR has high exposure to tenants in defensive sectors (food retail in particular which make up close to 40% of FCR’s portfolio). Management indicated in its press release on 30 July that until that date, the company was able to sign 36 new and early extended lease contracts representing rental income of €5.7m (including €3.3m since end-March 2020). At the same time, it waived rents amounting to €200k in the case of its existing tenants. Higher rental income was driven by portfolio expansion (to 83 properties at end-June 2020 vs 64 at end-June 2019) and certain asset management successes.

H120 revenues totaling €13.8m (vs €9.6m in H119) were also supported by one-off (€1.3m) other income related to the sale of goods/merchandise from FCR’s hotel business, which was not recorded in the previous year. Through its subsidiaries, the company is operating two out of three hotels held in its portfolio (Il Pelagone and Westerburg) for which it posted a c 47% y-o-y revenue decrease to €0.8m in H120. We assume that this resulted primarily from safety measures imposed to limit the spread of COVID-19, which included lockdown and limitations on personal travel.

While FCR has been scaling up its business, it managed to reduce its material expenses (which primarily consist of property management costs, property taxes and material expenses related to its hotel operations) and personnel expenses by c 14% each in H120 (to €3.6m and €2.3m, respectively), with the latter driven by average headcount reduction in the period from 126 to 102. Management believes that the recent development of its digital solutions (for instance in the area of vacancy rate optimisation and liquidity planning) should allow the company to grow its business without the need for headcount expansion.

While portfolio growth allowed FCR to record higher rental income, it also resulted in a 22.8% y-o-y rise in financial costs to €3.6m on the back of additional bank borrowings (the company’s targeted leverage at property level sits at 70–80%) as well as a €30m bond offering launched last year. However, it is worth noting that in FY19 FCR also repaid its 2014 bond, which paid an 8.0% coupon, well ahead of the current weighted average for the company’s outstanding bonds at c 5.9%, according to our calculations. Furthermore, in March 2020 FCR launched a new bond placement with a volume of up to €30m and a 4.25% coupon.

Finally, FCR’s enhanced operating efficiency resulted in its FFO1 (which excludes disposal and revaluation gains) reaching €2.2m in H120. We note that while the H119 FFO1 figure was not disclosed, it stood at -€3.7m in FY19, based on our estimates. While we consider this a positive sign (as FCR is able to cover its operating and financial expenses with rental income), we also note that FCR has so far been more of a total return rather than a pure income play. Its strategy is based on ongoing portfolio rotation aimed at opportunistic purchases followed by measures to enhance rental income and subsequent disposals to realize added value. Consequently, its FFO1 to NAV ratio is relatively modest at c 2%. FCR’s FFO2 (accounting for property disposal and revaluation gains) was €2.8m in H120, of which €1.8m was reported in Q120, which illustrates the coronavirus-driven disruption to transaction activity.

In H120, FCR acquired another 10 properties, but sold only three as transaction activity in the German property investment market stalled in Q220. Management expects to accelerate portfolio expansion in H220 on the back of its full investment pipeline. Having said that, we note that its earlier target to expand property portfolio value to €500m at end-2020 (vs c €300m at end-2019) has been cut to €400–450m in response to COVID-19 (as disclosed on the release of its FY19 annual report). This target was not explicitly reiterated during the H120 report release. In the first six months of 2020, the company’s portfolio value expanded marginally to €309m. At the same time, during the recent capital markets conference in Munich, management announced its intention to sell its portfolio of development and ‘opportunistically held’ properties, including three hotel properties and three development projects in Bamberg (student living), Frankenberg (retail) and Spain (residential).

Management currently guides to rental revenue of €28.3m in FY20 (up 31% y-o-y). This is based exclusively on its existing portfolio, which at end-June 2020 generated annualised ‘cold’ rents of €20.5m (ie excluding pass-through of property-related costs, which we believe may add c 15% to this figure). We understand that the €28.3m also includes FCR’s revenues from the two hotels it operates (€2.6m in FY19), as well as one-off €1.3m revenue from sale of goods/merchandise reported in H120. At this stage, given the uncertain macroeconomic environment, which translates into limited visibility with respect to FCR’s portfolio performance in H220, it is difficult for us to assess whether this guidance will be met. Our current base case scenario assumes rental and hotel revenue of €27.9m in FY20 after accounting for 19 net acquisitions during the year. However, we note that our confidence in these forecasts is lower than normal and that the actual results could be materially higher or lower in several respects.

In early 2020, the COVID-19 economic slowdown started to spread across all business segments, including the German real estate investment market, which was initially well-placed to carry momentum forward from 2019 (transaction volume at a record-high of €91.8bn), according to Jones Lang LaSalle (JLL). The Q120 figures reflected limited impact from the coronavirus, with the €27.9bn overall transaction volume constituting the second-best quarterly result historically and a more than 81% y-o-y improvement. Even though the €14.7bn recorded in Q220 is just 15% below Q219 figure, it fell 47% against Q120, which illustrates the magnitude of the slowdown. Interestingly, while around 40% of transaction volumes in 2019 were recorded in the office segment, this was down to 22% in H120 as residential property deals made up 35% (vs 24% in 2019). The share of other segments remained broadly stable, including retail (FCR’s primary focus), ie 14% in H120 vs 12% in 2019.

Although the number of sale transactions has been declining, it is attributable to limited supply rather than subdued demand, with the German property market remaining an attractive investment location as it is perceived as relatively resilient in the current environment. Consequently, prime yields in the office, logistics (benefiting from accelerated e-commerce expansion) and specialist retail segments remained strong in both Q120 and Q220 in the seven largest German cities, according to JLL. The yield in the office segment fell slightly over H120 from 2.93% to 2.91%, while the yield in logistics stabilised at 3.75%. The situation in the retail sector varies, with speciality properties with a food retail focus (which form an important part of FCR’s portfolio), local supply centres and hardware stores being still in demand, while yields for shopping centres continued to increase to 4.75% in Q220 against 4.20% in Q219 (and 4.50% at end-2019), according to JLL.

The COVID-19 crisis has also affected the commercial rental market, with retail take-up in inner city locations falling by c 24% y-o-y to just 190.9k sqm in H120, while the number of transactions decreased by almost one-third, according to JLL.

We have maintained our portfolio assumptions in terms of property acquisition/disposals, and rental revenue and the average occupancy rate are broadly unchanged compared to our previous note published in July 2020. However, we have reduced our operating expenses assumptions for FCR and, as a result, raised our FFO1 forecast as highlighted in Exhibit 2. This translates into slightly improved NAV TR expectations in our base scenario at 9% for FY20 and 11% in FY21.

In Q220 FCR paid a dividend of €0.30 per share from 2019 earnings, which currently constitutes a 2.6% yield. As the last reported EPRA NAV per share stood at €11.05 at 30 June 2020 vs €10.93 as at end-December 2019, we calculate that the NAV total return was 3.8%. The company is currently trading at a P/NAV multiple of 1.04x, which represents a 19% premium to the broader peer average (including Demire, Deutsche Konsum REIT, Defama, Hamborner REIT and Deutsche EuroShop) of 0.87x. However, FCR trades at a 20% discount to the average multiple for its closest peers (Deutsche Konsum REIT and Defama) based on the last reported NAV per share.

To further enhance our analysis, we have looked at the implied net rental yield for these three companies in more detail (see Exhibit 4). FCR’s yield is broadly in line with Deutsche Konsum REIT, but below the yield for Defama. We note that the calculations for Deutsche Konsum REIT do not account for already notarised but not yet finalised property acquisitions (as at the balance sheet date), which would bring the net annualised rent to €65.1m (and the implied yield to 7.0%).