Phoenix Spree Deutschland — Stress-testing the challenges

In this note we review the FY22 results and business trends as well as stress-testing our forecasts for a range of assumptions on property valuation and asset disposal proceeds. The market appears to be discounting significant challenges to the market environment and business model from the end of the ‘zero interest rate world’. However, despite the near-term headwinds, there are a number of positive indicators that appear not to be recognised in the current valuation. In particular, we highlight:

Berlin rents have risen strongly in recent years, but federal laws significantly restrict the pace at which market rental growth can be passed through to tenancies already in place. This has built up reversionary potential within the portfolio such that even if free market rents were to weaken, rental income should continue to increase. Refurbishment and subsequent re-letting of vacated units at a premium to existing rents, and closer to market rent levels, will remain the key driver of reversionary capture.

Across the portfolio, average gross in-place rents were €10.0 per square metre per month at end-FY22, up 3.9% versus end-FY21. Despite the cost-of-living pressure on tenants, PSD says that rent collections have remained broadly stable, a function of conservative rent to income levels for new tenants and German federal support initiatives. While the income statement impairment charge increased from €0.4m to €0.8m, this reflected write-off of provisions while gross outstanding receivables were only modestly higher at €0.9m versus €0.8m.

During 2022, new leases were signed on c 13% of all occupied units, achieving an average rent of €13.0 per square metre, 6.6% above the previous year, and an average 29.1% premium to passing rent. Excluding assets in Brandenburg acquired in 2019, where rents are lower than those achieved in central Berlin, the reversionary premium to previous passing rents was 32.3% (FY21: 33.7%). The premium to previous passing rents varies from period to period, mainly determined by mix, but the average re-letting premium for the whole portfolio in the three years to end-FY21 was c 27%.

During FY22, PSD invested €16.4m in property refurbishment and in bringing new residential condominium projects to market,1 an increase from €9.5m in FY21. The increase included a step-up in the refurbishment of vacant assets for re-letting following the repeal of the Mietendeckel rent cap in April 2021,2 increased renovation expenditure on the Brandenberg asset acquired in 2019,3 and further work on bringing assets into a position to be sold as condominiums. PSD expects a positive return on these investments in 2023 and beyond from condominium sales and rental uplifts. FY23 investment is expected to be materially lower as condominium projects complete and we forecast €7.6m in each of FY23 and FY24.

Condominium market prices are typically 30–35% higher than rental-based valuations The division and subsequent resale of selected apartment blocks as private units (condominiums), with vacant possession, at market valuations, provides cash flow to support the core refurbishment and re-letting rent reversion strategy and accelerates the release of significant value embedded within the portfolio.

Condominium sales during 2022 were heavily affected by a significant deterioration in buyer sentiment as a result of cost-of-living pressures, higher borrowing costs and uncertainty surrounding the macro-economic environment caused by the crisis in Ukraine. During the year, 13 condominium units were notarised for sale for an aggregate value of €4.7m (2021: €15.2m). More positively, the average achieved notarised value per square metre for the residential units was €5,502, representing a gross premium of 22.4% to carrying value and a 34.8% premium to PSD’s average Berlin residential portfolio value as at 31 December 2022. The sales premium in any period is specific to the mix of assets (different locations, floor space, etc) but the 22% premium achieved in FY22 was slightly above the three-year average of 20%, albeit on significantly reduced volume.

At the time of reporting FY22 results in late March, a further three condominiums had been notarised for a total consideration of €0.8m, at a 62% premium to carrying value, and a further three units had been reserved, with the combined value of €0.6m reflecting an average 80% premium to carrying value. PSD cautions that these condominiums are smaller than the average across the portfolio and that the premium achieved should not be viewed as representative of future condominium valuations. The company says that buyer confidence in the condominium market remains very fragile, particularly for occupied units and as a result it is focusing on plans to bring additional unoccupied condominium properties to market. Bulk condominium sales are under active consideration, potentially taking advantage of the high (77%) share of Berlin units that are legally designated as condominiums,4 a differentiating feature of PSD versus listed German peers.

This strategic advantage is highlighted by recent federal government legislation, which has placed significant restrictions on the ability of landlords to split their properties into condominiums in the future. The measures will inevitably increase the scarcity of condominiums available for sale, further exacerbating the demand-supply imbalance.

Within the portfolio valuation, only six properties, with an aggregate value of €30.1m, are fully valued as condominiums and sales values are typically well ahead of this.

Alongside the condominium disposal programme, during FY22, PSD committed €29.7m to acquisitions and agreed an aggregate €12.1m of disposals. The company plans no further acquisitions for 2023, pending an improvement in market conditions, the resumption of dividend payments and a significant narrowing of the discount to NAV. A number of additional properties are being marketed, although market conditions remain challenging for disposals and offers have been at levels significantly below carrying value, and at prices that would release limited cash after repayment of associated debt.

The single largest acquisition commitment was the March 2022 acquisition by way of a forward funding agreement of a portfolio of 17 environmentally efficient, new-build, semi-detached residential properties (34 houses), well situated in Erkner, in Brandenburg, for a purchase price of €18.5m. PSD has acquired the land site, is funding the costs of construction and will acquire the property at the agreed price on completion, expected in H224. The projected fully occupied rental income is €0.7m pa (3.1% of end-FY22 gross in-place rents), which reflects a prospective gross yield of 3.5%. At end-FY22, €5.5m of the purchase price had been invested.

In May 2022, PSD announced the acquisition of four multi-family houses, located in Hoppegarten Neuenhagen, consisting of 24 residential units for €6.3m.

In September 2022 it exchanged contracts to acquire a multi-family house with 22 residential units and three commercial units in Berlin-Neukölln for €4.9m. Completion is expected in Q223.

In August and September 2022, PSD exchanged contracts to sell two non-core properties for an aggregate consideration of €8.6m. The sale of the property at Margareten Strasse (€4.9m) completed before the end of FY22 and that of the property at Argentinische Strasse completed in January 2023. The aggregate sale price was for the properties was slightly below the end-FY21 carrying value of €9.0m but well ahead of the aggregate acquisition prices of €3.9m in 2008 and 2017.

In December 2022, contracts were exchanged on another non-core property (Putlitz Strasse) for €3.5m, with the sale completing in Q123 The agreed sale price was again a little below the end-FY21 carrying value of €3.9m but well ahead of the 2008 acquisition price. The sale completed in February 2023.

PSD has borrowing facilities with Natixis Pfandbrief (‘Natixis’) and Berliner Sparkasse (‘Berliner’), amounting to €365m.

The main facility with Natixis is a €240m seven-year non-amortising interest-only facility that matures in September 2026. It comprises two tranches, a €190m refinancing facility and a €50m acquisition facility, both fully drawn. Also with Natixis, PSD has a €60m non-amortising facility comprising a €45m acquisition facility and a €15m capital expenditure facility. This matures alongside the existing Natixis facility in September 2026. The majority (81%) of the floating rate interest cost for the Natixis facilities has been hedged to give a blended effective rate of 2.4% at end FY22.

With Berliner, PSD has an amortising facility that matures in October 2017. The facility has been fully drawn and after loan amortisation, €61.2m remained outstanding at end-FY22. Just over 70% has been fixed at rates in the range of 1–3%, and most of the balance has been hedged, to give a blended cost of 1.8% at end-FY22.

At end-FY22 PSD had gross borrowings (nominal value, including unamortised loan arrangement fees) of €315.8m, and including cash of €12.5m, net debt was €303.3m. The net LTV ratio of 39.1% (FY21: 34.7%) remained well below the long-term target of 50% (with a 60% maximum).

At end-FY22, the interest cost on 83% of drawn debt costs were fixed or hedged with swap and the blended effective rate of all drawn debt was 2.2%. The end-FY22 average remaining debt duration was around four years, closely matched by the swaps.5

Financial covenants relating to the Natixis loans include a projected interest cover of at least 150%, minimum debt yield of 4.3% and a maximum LTV of 67.5%. There are no financial covenants relating to the Berliner loans.

While rental income is relatively predictable and should continue to grow, property valuations and disposal proceeds are uncertain. For this reason, alongside our base case/central scenario we show the impact of alternative assumptions for property revaluation movements and the scale of condominium sales. Revaluation movements primarily affect the income statement and LTV ratio but have no impact on cash flow. Condominium sales have a relatively modest direct impact on the income statement but drive the cash flow available for investment and determine borrowing requirements.

Compared with our last published FY23 forecast, the change to ‘recurring’ profit before tax and property valuation movements is a modest €0.7m or 2.5% of revenues, driven by increases in administrative expenses and the net finance charge. Our unchanged forecast 4% pa like-for-like rental growth is slightly offset by recent disposals.

We have assumed a 7.5% like-for-like decline in property valuation (taking the full occupancy gross yield to 3.2% vs 3.0% at end-FY22). The negative pre-tax valuation movement is partly offset by a positive deferred tax movement. Property disposals are assumed to amount to €8.5m, comprising completion of the €3.5m non-core sale exchanged in H222 (see below) and €5.0m of condominiums. The realised gain on condominium sales is more than offset by disposal costs on the total disposals.

At €4.4, FY23e EPRA NTA per share is c 10% lower than previously forecast and c 12% lower than reported in FY22. Net LTV increases to 44% versus 39% in FY22. For FY24 we forecast no change in valuation with a flat EPRA NTA per share and LTV stable.

Reflecting the current low running income yield on the portfolio, EPRA has historically been negative and returns have been driven by capital growth, including the positive valuation impacts of reversionary rent capture and PSD’s condominium strategy. Although the spike in inflation had a negative impact on FY22 EPRA earnings, we forecast a positive trend, driven by continuing rent growth.

Condominium disposal proceeds have thus been a key source of cash flow to fund portfolio investment and dividends. While dividends have been put on hold until market conditions become clearer, we expect PSD to continue to invest in the portfolio, to support rental growth and selected condominium disposals, as well as its development assets in Brandenberg. In the following section we illustrate to sensitivity of PSD’s borrowing requirements and LTV to a range of outcomes for property revaluation and asset disposals. Before that, we discuss our expectations for capex, acquisitions and disposals in detail.

Our forecasts allow for the completion of previously disclosed acquisitions and disposals, future condominium sales, and development capex for the Brandenberg forward funding development.

On this basis, the net cash outflow from investment is €8.6m in FY23 and €8.4m in FY24, which we have assumed is funded by a mix of cash resources and, in FY24, from further debt drawings. If it chooses, PSD has the flexibility to draw additional funds from its capex and investment borrowing facilities (see below). On this basis LTV remains well below the company’s long-term target of 50%.

Our central assumption of a 7.5% decline in valuations in FY23 (and flat in FY24) generates an LTV of 44.0% (FY22: 39.1%). In Exhibit 11 we show the sensitivity of LTV to what we consider to be a reasonable range of alternative assumptions for property revaluation movements. The actual outcome may of course fall outside this range.

With most of our forecast investment already committed, it is the assumption regarding condominium sales that drives a change in funding requirements (cash or debt drawdown). As we show in Exhibit 10 above, based on €5m of sales in FY23, the funding requirement is €8.5m, which we assume will be provided by cash drawdown. With sales of €2m, the funding requirement increases to €11.4m, well within our forecast cash balance and undrawn debt resources (€39m at end FY22). The condominium sales assumption has no material impact on LTV as it reduces both net debt and portfolio value.

Market expectations, reflected in the Euribor forward curve, are that policy rates will increase to around 3.6% by the end of this year before falling to c 2.5% in 2026, when PSD’s debt facilities mature. Exhibit 13 shows our existing rental income and interest cost forecasts for FY23 and FY24, including like-for-like growth in rents per square metre of 4% and a slight increase in occupancy. As an illustration, assuming rental income growth accelerates to 4.5% pa through FY25–26, the change in rental income from that reported in FY22 to FY26 would be c €4.4m. Assuming a full refinancing of debt in FY26, on annualised basis, at a 1.5% margin and 2.5% Euribor rate, FY26 cash interest cost would be €5.7m higher. The net negative impact would be €1.3m, which we believe would be manageable, especially if condominium sales recover as interest rates decline. However, without a decline in interest rates there would be a persistent negative spread between the gross asset yield and funding costs, before taking account of corporate expenses. Including corporate expenses, the operating margin (before valuation movements) was 27% (of gross rental income) in FY22 (five-year average: 26%). In such circumstances we would expect PSD to consider an accelerated unlocking of the value that is embedded in the portfolio, currently reflected in the new letting premium and condominium sales at a premium to book value.

Share price performance across the quoted German real estate companies has been weak over the past year, with our selected peer group down by an unweighted average of almost 50%. PSD shares have modestly outperformed peers over this period and have been noticeably more resilient over the past three years. As a result, PSD shares trade at a P/NAV of 0.46x compared with the average for German listed peers of 0.30x.

The discounts imply that investors continue to anticipate material further market pressures to an extent that none of the companies operating in the sector, including PSD, expects to be the case given the fundamental imbalance of demand and supply in the residential market. The key sector risks and concerns reflected in valuations across the sector primarily include the impact of higher interest rates on financing costs versus asset yields, asset values, compliance with existing debt covenants and refinancing risks at debt maturity.

The investment property valuation update that was published in early February had provided details of the portfolio valuation performance, condominium sales and estimated NAV. Among the detailed information contained in the FY22 results that were published in late April was confirmation of the positive performance of the core recurring income activities but also the announced pause in dividend distributions.

Key features of the FY22 results were: