DEMIRE — Strategic programme delivering gains

DEMIRE Deutsche Mittelstand Real Estate is a holding company for commercial real estate investment in properties located in mid-sized cities and up-and-coming metropolitan areas across Germany, with a gross portfolio value of just over €1bn. Its shares are traded on the Prime Standard segment of the Deutsche Börse. DEMIRE describes its strategic aims as “first in secondary locations” and as indicated by its name, has a focus on properties that it expects to prove attractive to a broad spread of medium-sized corporate tenants.

The current business model was established in mid-2013 after significant changes in the company’s ownership structure. It has since grown quickly through both the acquisition of individual property assets and corporate acquisitions suited to its investment objectives, while non-core assets and corporate interests have been sold. In late 2015 it acquired a controlling (77.7%) interest in Fair Value REIT (FVI), a German REIT with a similar investment policy. FVI is fully consolidated and is reported as a separate business segment, alongside what is referred to as the core portfolio and corporate functions. The remaining minority interest in FVI has, for now, increased the complexity of the group and simplifying this is a key target for DEMIRE management.

Primarily reflecting strategic and ownership changes, the composition of both the management and supervisory boards have changed considerably in recent years and continues to evolve. Ralf Kind currently represents the management board, as CEO/CFO. Following the departure of Markus Drews, who stepped down as CEO at the end of 2017, the supervisory board is planning to appoint another member, with operating responsibilities. The company indicates that this change will have no material impact on the strategic programme that was announced at last year’s AGM, known as DEMIRE 2.0. The main aim of the programme is to increase the profitability of the existing business and to grow the portfolio further, generating scale economies. The medium-term target is to expand the portfolio value to c €2bn while maintaining the focus on secondary locations in Germany, and to reduce the LTV ratio to c 50% (from 62.0% at 9M17).

The first nine months of FY17 showed operational progress, with increasing occupancy and rents. DEMIRE has also made significant progress in 9M17 and into Q4 in relation to its strategic programme (DEMIRE 2.0), particularly with respect to refinancing and tax simplification. The underlying earnings progress made in 9M17 is obscured by revaluation gains and continuing one-off negative restructuring impacts and can best be seen in management’s preferred measure of operating performance, funds from operations (FFO, after tax, before minorities). This measure adjusts for revaluation effects, disposal and other one-off effects, and any income effects relating to prior periods. FFO (after tax, before minorities) increased 32% to €9.2m, or a diluted €0.14 per share. Supported by revaluation gains, EPRA basis NAV per share advanced to €4.72 from €4.60 at end-FY16. The FFO improvement came predominantly from the non-FVI parts of the group such that attributable FFO earnings (after minorities) showed a much stronger advance, to €4.6m (€0.07 per share) versus €1.7m in 9M16. The refinancing and tax progress made in FY17 should have a significant positive impact on performance from FY18, while management is also preparing to return to portfolio growth. Both are discussed in later sections of this report. The highlights of the performance year to date are:

With its 9M17 results, DEMIRE increased its FY17 guidance for its operating measure, FFO (after taxes, before minorities), from €8-10m to €11-12m. In addition to the tax benefits made possible by the EGM shareholder approval, the increase reflects operational improvements; guidance for gross rental income was also increased from €72-73m to €74m. The refinancing is proceeding largely as expected and will have a significant impact on FY18 with an expected interest cost saving of c €9m and an additional c €9m benefit to cash flow from reduced debt amortisation.

Our FY17 forecasts benefit from higher net rental income and lower taxes than previously, while the higher than expected administrative and other costs substantially reflects non-recurring items that are excluded from FFO. Our revised FY17e FFO (after tax, before minority) moves to €12.0m, at the top of management’s guidance range. For FY18e our forecast FFO (after tax, before minority) also rises materially and may prove conservative as the pre-tax increase only matches the €9m pre-tax gain that management expects from financing costs. We also introduce a first time forecast for FY19 but note that this is based on the current group structure only.

We have revised our method of forecasting minority interests which means that while our FY17 forecast attributable FFO (after tax and minorities) per share increases materially, there is a small reduction in the FY18 forecast growth rate.

Our forecasts include an assumption of vacancy reduction from 9.9% at end Q317 to 7.8% by end-FY18 and 6.0% by end-FY19. We also allow for rent growth at a rate of c 1% pa.

We have included no further revaluation gains for FY17 but do assume €20m pa (€0.4 per share) in both FY18 and FY19 to be consistent with our assumed operational improvements. This may also prove to be conservative as the gross rental income (GRI) yield implied by our revaluation and operating assumptions still rises from 7.1% at end-Q3 to 7.2% by end-FY18 and 7.3% by the end of FY19. An unchanged GRI yield would imply additional revaluation equivalent to c €0.5 per share (c 9%) by end FY19.

Although management is signalling that property acquisitions are highly likely, we have not included these in our base case forecasts, given the inherent uncertainty in so doing. Rather, we discuss the potential impact on our forecasts in the following sections. We have included the completion of the sale of the €18.5m of investment properties carried as held for sale at end-Q317 within our forecasts. €9.2m of this amount was in respect of an office property in Teltow, Brandenburg owned by the c 78% owned subsidiary of FVI, IC07. The sale was completed by year-end 2017 and as this was the sole property owned by the subsidiary, it will now be liquidated, eliminating a layer of administrative expense and simplifying the group structure. The sale price was €11.5m, c 24% above the Q3 book value. The other assets held for sale have sales agreed at around their carrying value. We have assumed completion of the sales of all other assets held for sale in Q118. Another FVI subsidiary, BBV06 (c 62% owned by FVI), is also targeted for liquidation following the transfer of two of its properties into direct ownership (by FVI) and the sale of its remaining assets. DEMIRE management estimates that the eventual liquidations of IC07 and BBV06 will generate administrative cost savings of c €400k pa.

A key driver of the further strong growth in FFO in FY18, expected by management and reflected our forecasts, is lower interest costs arising from the Q4 refinancing operation. Although the average cost of borrowing has been lower in the current year, declining from an average 4.4% at end-FY16 to 3.8% at end-9M17, the reported cost of borrowing has increased from €33.4m in 9M16 to €37.3m. The reported cost includes c €13m of non-recurring costs, mostly linked to the refinancing. These include a c €6.5m early repayment penalties including c €4.0m in respect of the 7.5% coupon 2014/19 corporate bond, c €4.4m in accelerated amortisation of loan arrangement costs and accrued interest, and c €2.1m in derivative fair value movements. Since the end of Q317 the average cost of borrowing has declined to 3.0% (see Exhibit 5) and this is reflected in our forecasts with additional allowance for recurring debt cost amortisation.

In the following section we explore the potential for the acquisition of additional investment property assets or minority interests in subsidiaries to materially enhance our forecast earnings. Without making any allowance for this potential we believe that the likely growth in FFO earnings is sufficient for management to consider the commencement of dividend distributions, although this is not reflected in our forecasts.

DEMIRE’s CEO/CFO has indicated that in the coming year the group will focus on:

As discussed in the previous section, our existing forecasts include an assumption of continuing vacancy reduction and modest rent increases.

In terms of acquisitions, DEMIRE currently has several assets, with an aggregate value of c €60m, undergoing due diligence. At a less advanced stage, it has a larger pipeline of potential acquisition targets amounting to c €200m across both the office and retail sectors and spanning both the core plus and value add strategies. Towards its target of c 2bn of investment assets over the medium term, management believes that it should be able to invest c €250-350m pa through single asset or portfolio purchases while corporate transactions, less easy to predict, would have the potential to accelerate the process. Management indicates that allowing for Q4 refinancing activity and working capital needs, there is up to c €50m of surplus cash immediately available to fund acquisitions and we illustrate the potential impact of this on our base forecasts below (Exhibit 6). We show the impact on a full year basis (as if the assets were acquired on 1 January 2018), for a range of possible gross yields on the assets acquired and allow for direct property costs at a rate of 25% and show the result on both a fully taxed and untaxed basis. Our 25% direct property cost assumption is similar to the long-term trend at FVI and although the DEMIRE core portfolio has been above this level, with occupancy increasing we assume in our base forecasts that it too will fall to c 25%. Given the new tax pooling arrangements, the effective tax rate that would apply to the additional earnings is likely to be below the standard rate, at least until carried forward group tax losses are exhausted. In the near term we would therefore expect an outcome somewhere between zero and c 30% and our base forecast includes a group-blended current tax rate of c 17%. Because we would not expect any minority interest in the additional earnings, any material loss of income on the cash invested, or any additional administrative cost, the impact on our existing FY18 forecast attributable FFO (after minority) earnings per share is quite significant. We show the outcome on both a fully taxed and untaxed basis, recognising DEMIRE’s increased ability to utilise tax losses carried forward but uncertain as to how this may apply in practice. The potential uplift ranges from 11% to 20%, while the impact on forecast net LTV is relatively modest with an uplift from the forecast 58.7% to 60.7%.

We also illustrate the potential effect of a larger investment of €250m (Exhibit 7), in line with the lower end of management’s annual target. We first assume investment of the “surplus” €50m of cash and then assume that the balance of €200m of investment is funded 50:50 with new debt and new equity, in line with management’s target to reduce the LTV towards 50% over time. We have assumed that the new shares are issued at around the current market price and that the cost of the new debt is 2.875%, in line with the coupon on the recently issued long-term fixed rate corporate debt. In current market conditions we would expect DEMIRE to be able to arrange secured bank finance at a lower cost than we have assumed and so our assumption should be seen as conservative. Each 50bp reduction in the assumed cost of debt would increase the accretion by c 2%. We have similarly assumed that the investment is made within DEMIRE ex-FVI, generating no additional minority interest, although we note that within the group FVI has room to further gear its balance sheet (Q317 equity ratio 38.1%, REIT equity ratio 63.0%, and net LTV of 39.9%). The potential uplift to attributable FFO (after minority) per share ranges from 2% to 29%, which includes the significant uplift from the surplus cash investment with the marginal impact of the additional investment slightly tempered by the assumed equity issuance. The net LTV remains at a similar level to the base forecast (59.0%) but lower than in the illustration above.

Following the acquisition of a 77.7% controlling stake in FVI, minority interests exist at two levels:

In recent weeks, Ralph Kind (DEMIRE CEO/CFO) has joined the management board of FVI as CEO, alongside Patrick Kaiser (CFO). The three-strong supervisory board also completely changed in September, including replacements for former DEMIRE CEO, Markus Drews, and Ralph Elgeti. Mr Elgeti’s Obotritia Capital has subsequently reduced its holding in DEMIRE (acquired through an exchange of its prior FVI holding) from 11.89% to 9.98%. In late December 2017, FVI announced its intention to change its stock market listing from the Prime Standard to the General Standard, with an easing in listing requirements.

Any increase in DEMIRE’s ownership of FVI above 95% would trigger a costly property transfer tax liability. Moreover, for FVI to retain its REIT status, a minimum free float of 90% must be retained. However, should DEMIRE seek to increase its stake up to 95% the required investment at the current FVI market capitalisation is relatively modest (c €20m) and despite the recent narrowing of the FVI discount to NAV to c 5%, we estimate it would be very modestly accretive of DEMIRE’s EPRA NAV per share and attributable FFO1 earnings per share, if cash funded.

A more material simplification of the group structure will come from the continued reduction in minority interests in the subsidiaries of FVI, in line with FVI’s historical strategy and providing cost savings in addition to a reduced minority interest in earnings. However, the processes of acquiring the minority interests from a wide spread of investors and the liquidation of subsidiaries once they have divested their investment property assets has hitherto been relatively slow moving. In addition to the pending liquidation of IC07 and BBV06, there are two other FVI subsidiaries (BB02 and IC13) that have also disposed of their investment property assets and where liquidation is pending. Five investment property owning subsidiaries remain. Historically, FVI has offered a mixture of shares and cash to investors in the subsidiary real estate closed end funds and has been able to increase its ownership at a discount to NAV. The outstanding minority interest at end-Q317 was c €64m and we estimate that a substantial portion of this could be acquired with a mix of cash and debt at the level of the FVI subsidiary. The FVI balance sheet could support the acquisition of 60% of the outstanding minority, at NAV, without breaching the REIT equity ratio rules, or 100% of the outstanding minority at a 75% discount to NAV. The FVI net LTV would increase from c 40% to c 53% as a result. It is possible that FVI shares could be offered to minority investors in the subsidiary funds but this would have the effect of reducing DEMIRE’s interest in FVI. The exact path to funding a minority buyout is perhaps of less significance than the economic effect on the group. In Exhibit 8 we illustrate the impact of DEMIRE group (either directly or indirectly) acquiring the minorities at a range of P/NAVs.

We have made the assumption that this is funded 50% by the issue of new DEMIRE shares (issued at the current share price) and 50% by debt (at a fixed cost of 2.875%). The range of positive outcomes for pro-forma attributable FFO per share is from 5% accretive to 17%. As above, we have shown the outcome on both a zero tax and full tax basis and in reality would expect the near-term effective rate to fall between the two. It is interesting to note that there would be no positive impact on FFO (after tax, before minorities). We have measured the impact on EPRA NAV per share in relation to our forecast for end-FY18. Because of the assumed issuance of shares at a substantial discount to this, there is slight EPRA NAV per share dilution on most scenarios. Because the acquisition of minority interests has no impact on the consolidated value of investment properties, the additional debt raised does increase LTV. Depending on the size of the acquisition discount to NAV assumed, the impact on our forecast end-FY18 LTV of 58.7% ranges from 2.4% to 3.4%.

DEMIRE’s P/NAV discount has narrowed slightly since we initiated our coverage in July 2017 (c 17% versus c 19%), while the peer group average (excluding FVI) premium has increased slightly, from c 3% to c 5%. It also continues to trade at a higher FFO multiple than the peer group average but that premium has declined over the same period. This analysis uses the last published NAV data for each of the companies and for each it annualises the reported nine-month FFO. For DEMIRE we use our preferred metric of attributable FFO1 after minorities.

Looking at the FFO multiple differently, the peer group average FFO yield is c 5.85%. As discussed above, our base case forecasts for DEMIRE look for a strong growth in FFO earnings over FY18 and FY19 such that the forward looking forecast FFO yield increases to 5.80% for FY19, very similar to the current peer average. Not included in these base case forecasts is the potential, discussed above, for FFO earnings to be lifted considerably further through cash generative acquisitions, operational gearing, and the elimination of minority interests. With the prospect of significantly improving FFO earnings it seems reasonable to expect that DEMIRE will soon begin to make dividend distributions, although we have not included these in our forecasts pending guidance from management. Management will need to balance shareholder distributions with its desire to grow the portfolio substantially (to c €2bn) over time while reducing the LTV towards 50%. However, a combination of sharply rising FFO and the commencement of distributions is likely to be taken positively by the market, improving DEMIRE’s access to the equity capital that will be needed to meet its growth targets.