Once in a Lifetime Opportunity in German Residential Real Estate Stocks

Vonovia, LEG Immobilien, TAG Immobilien, Grand City Properties

About once in a decade, the listed real estate market presents investors with a truly exceptional opportunity. I am convinced that now is one of those times. This time, clearer than ever before. Low-leverage German residential real estate stocks are currently trading at a staggering 67% discount to their net asset values (NAVs), leaving about 200% mid term upside to recover to their intrinsic values. In this article, I will delve deeper into the reasons behind this undervaluation and share how I am positioned to take advantage of this setup.

The table below shows an overview of some key measures of the four German residential real estate stocks I am discussing in this article. In the following sections I will put the current pricing into historical context. I will discuss the German residential market and finally, I will discuss how I believe those companies will be able to deal with the rising interest rate framework.

Value Perspective: Buying German Residential Real Estate for One Third of its Value

According to IFRS, real estate holding companies have to reveal the market value of their properties on a yearly basis. This allows for the calculation of the net asset value (NAV), as:

NAV = Total Assets – Total Liabilities

Since the vast majority of assets of a real estate holding company are by nature real estate assets, the NAV provides a pretty accurate estimate of the current value of a real estate stock. In theory, a real estate stock should hence trade for about its NAV, and this is about in line with the actual trading behaviour of real estate stocks. There are though obviously fluctuations of the share price around its NAV. At this moment, we are at the very, very, low end of the range. The figure below shows the NAV-discounts for the four German real estate stocks I am analyzing in this article:

For the majority of the last decade, LEG Immobilien (LEG), Vonovia (VON), TEG Immobilien (TEG), and Grand City Properties (GCP) have traded close to their NAV, or in other words, their discount-to-NAV was about 0%. This is consistent with financial theory. However, today on April 20, 2023, these four stocks are trading on average for a 67% discount to their NAV. Or in other words, the current share price is just one third of the market value of the properties less the debt. If you ever thought you had missed out on buying residential real estate in Germany during the last 10 years, now you can get it for a two thirds discount.

This NAV discount is not only enormous absolutely, but also relatively, and as well historically. During the Global Financial Crisis, some stocks traded down severely, but for residential real estate as a group, the discount was at best -50%. This makes sense, as residential real estate is generally considered the safest real estate sector – in the end, we all have to live somewhere, even in a severe crisis. Not only does it strike me that the largest NAV discounts are currently found within the residential real estate sector (and not office, or retail). Moreover, it is precisely the German residential real estate stocks that show the highest NAV discounts. As a matter of fact, Germany is currently facing an enormous shortage of residential real estate across the country. I will discuss the “health” of the German residential real estate sector in a separate section below.

Takeaway 1: Based on NAV as a proxy for fundamental value, German residential real estate stocks have 200% upside.

Cash Flow Perspective: Buying German Residential Real Estate at a Potential 10% Dividend Yield

Real estate stocks are dividend stocks. Since residential real estate is generally considered safe, their dividend yields do not tend to be very high in normal times. The figure below shows the dividend yield history for the four German residential real estate stocks.

Historically, these stocks have trades for a dividend yield around 3 to 4%. For the two stocks with a complete dividend history since 2013 (LEG and Vonovia), they have traded for an average dividend yield of 3.3% until recently. While a dividend yield of 3-4% is not high, it reflected the perceived safety of residential real estate and the strong fundamentals of the underlying German residential housing market.

However, since August 2021 the share price of these stocks has been in free fall:

·       LEG Immobilien lost 61%

·       Vonovia lost 70%

·       TAG Immobilien lost 75%

·       Grand City Properties lost 69%

As a result of this drawdown the four stocks currently trade at an average yield of 10.00% relative to their 2021 dividend. Note that for the year 2022, all stocks except Vonovia have suspended the payment of a dividend as a precautionary measure to strengthen their balance sheets. Vonovia has decided to cut its dividend in half. As a result of this, Vonovia currently trades at a 4.5% dividend yield.

It is important to note that dividends have not been cut as a result of declining underlying cash flows. The funds from operations (FFO), which basically represents the free cash flow of real estate stocks (EBITDA less interest, less taxes), of 2022 was about in line with the FFO for 2021. Hence, all companies would have been able to pay at least their 2021 dividends. I anticipate that the companies will soon return to paying their normal dividends. Mid term, I believe it is reasonable to assume that these companies will again trade at dividend yields of 3-4%.

Takeaway 2: Based on their underlying FFO, German residential real estate stocks have the potential to re-establish their 2021 dividends. Based on normalized dividend yields of 3-4%, these stocks have 200% near term upside.

The underlying strength of the German real estate market

Why does this opportunity exist? A key concern investors might have is that the underlying German real estate market is in trouble. While the German residential real estate market had a good run over the last few years, inflation adjusted home prices are still at about the same level as 40 years ago. Should the German housing market experience anything like its comps in other developed nations, the upside could be easily classified as tremendous.

Looking at the international comparison in terms of rents, housing affordability in Germany is also among the best in class. In fact, Germany ranks among the most affordable countries in terms of rent. For the bottom quintile of population in terms of income, only 10% pay more than 40% of disposable income on rent. For the international average, this ratio was in the 30-40% range in 2017.

If home prices are comparatively cheap in Germany, and if rents are comparatively low in Germany, then maybe there are still cracks in the German rental market for other reasons?

The population in Germany is on a steady rise that has been accelerating recently. According to the Statistical Federal Office, 84.3 million people have lived in Germany by the end of 2022 as a result of migration. With the current left-green government in charge, I do not anticipate this trend to change anytime soon.

As a result, it does probably not come as a surprise that the German residential real estate market is hot. Vacancy rates were already at extremely low levels in 2021 and that was before the arrival of Ukrainian war refugees in Germany. According to official estimates, some 1.1 million Ukrainian refugees have arrived in Germany by the end of February 2023.

It should hence not come as a surprise that rents are on a steady rise, irrespective of interest rates or macroeconomic turbulences.

According to the recent publication of the Empirica Index, rents in Germany have increased 1.8% in Q1 relative to Q4 2022, and they have increased 5.8% year over year.

According to the online-platform Immowelt, asking rents for Berlin in Q1 have even increased 23%(!) relative to the prior quarter. This is particularly relevant, as Vonovia has about 20% of its portfolio in Berlin.

In sum, I would not bet against the German residential market. Not in terms of rents, and not in terms of housing prices. While there was a slight decline in housing prices in Germany in 2022 as a result of the rising interest rates, recent observations point towards this movement already reverting, which makes sense in light of the very strong rental market, and the very low vacancy.

At the same time, rising regulatory requirements make the development of new supply increasingly unrealistic. In essence, only truly rich people will be able to afford what little new supply comes to the market in the next years.

As a result, I anticipate that the German residential real estate stocks will be able to keep growing their rental income at about 3% for many years to come. This will be a strong fundamental cash flow tailwind. If interest rates stay high, the cash flow will be used to deleverage for a few years. If inflation keeps coming down fast and interest rates revert to their mean, I anticipate German residential stocks may be able to grow their dividends in the 3-5% range for the years to come.

Interest Rate Worries and the Balance Sheet

A central worry of concern mentioned by many market participants is the rising interest rate environment. On the one hand, rising rates might negatively impact the German housing market, and hence NAV if real estate values were to fall substantially. However, based on my explanations above, I do not see much merit in that worry. The other concern is that rising interest rates might eat up all of the cash flow. I will explain in this section why this fear is total nonsense.

Balance Sheets are Healthy

The table below shows key metrics of financial health. LTV ratios around 45% are very sound and throughout in line with long term targets. During normal times, residential real estate is easily financed with LTV ratios of up to 70%. LTV ratios of 45% imply that these companies could survive a substantial crash in residential real estate prices.

Turning to the cash flows, interest expense is well covered by EBITDA with interest coverage ratios between 4.2 and 4.8. Even if interest rates were to quadruple, EBITDA would still be more than enough to cover interest expense.

It is important to keep in mind that more than 90% of debt is fixed rate, hence the companies will only be affected by higher interest rates as they need to refinance maturing debt. With an average time to maturity for the loans of about 6.5 years, most of those refinancings are far in the future. This is important, as I anticipate a strong fall in interest rates in about 1-2 years, hence any debt refinanced afterwards, could well have the same low interest rates as the current debt. I will discuss near term refinancings in more detail below.

Debt maturing in 2023 and 2024 is well covered by cash reserves plus near term cash flow

The table below shows the total debt maturing in 2023 + 2024. The companies may either chose to refinance that debt at current higher interest rates. Alternatively, thanks to the suspension of dividends, they may chose to simply pay back the debt and hence reduce LTV and interest expense.

The table shows the cash holdings per December 31^st, 2022. Moreover, it shows the sum cash holdings plus two years of FFO at 2022 levels. This number is meant to represent how much debt could simply be paid back. Finally, I show what percentage of debt maturing in the next 2 years could simply be retired. For Vonovia that ratio is a healthy 75%. For LEG, its even more than enough with 122%. TAG could retire 67% of the near term debt, and for GCP, a whopping 202% of near term debt maturities could be retired.

I believe this clearly demonstrates that in the near term higher interest rates should not be a concern for investors in these companies. Management is well advised to be flexible with the dividend until there is more clarity about future interest rates. I believe that by 2025 the interest rate environment will have normalized. If these companies in the near term reduce debt and interest expense, they will be positioned even strong by that time and should be very well able to re-establish 2021 dividend levels, if not substantially higher.

Looking at the last three columns, I perform a sensitivity analysis for the scenario that interest rates are to stay high for the long term. Lets assume total interest payments double eventually. Of course this might take about 10 years, given that average debt maturities are about 6.5 years. Lets furthermore assume that the companies do not chose to pay down debt, but simply refinance it at current much higher rates. In this drastic scenario, the FFO would only fall about 29% to 35%, which I believe is still quite acceptable.

Nevertheless, I do not deem this scenario likely. If interest rates were to stay high, I would prefer the companies do pay down debt, rather than paying a dividend. With the 2022 level of FFO, the companies could pay back about 5% of the debt each year. After 5 years, the total level of debt could hence be 25% lower. This could actually a counteract any nominal increase in interest rates. That is not a hypothetical scenario – this is the current path that management has taken with the suspension of interest rates.

Investment Case

Short term:

I believe the short term setup is nothing short of phenomenal. Every possible negative trigger has been pulled. We had maximum fear about real estate prices, but they are stabilizing. Rents keep climbing. Inflation is coming down. Dividends have already been cut, so dividend investors have already thrown the towel.

At a minimum, I am expecting these companies to trade up to a NAV discount of only 50% short term. That would still be way too steep for every possible bear scenario. Nevertheless, if these stocks close the NAV discount to 50%, this would equate to 50% short term upside in the share price.

Mid term:

I believe these four stocks have about 200% mid-term upside to recover to their NAV per share or normalized dividend ratios. How fast this scenario arises will largely depend on the interest rate trajectory. Inflation in Germany and Europe is now also sharply trending down and I expect peak ECB interest rates soon with first cuts likely before the end of the year. If that scenario realizes, I believe these companies could deliver a total return of 200% over a time span of just 2-3 years.

Long term:

I believe this is a generational opportunity to diversify the portfolio into German residential real estate, which is as stable as it gets. Locking in this investment at just one third of the fundamental value, which is easy and objective to measure is a once in a lifetime opportunity. I have seen massive NAV discounts – for office, for malls, for healthcare during covid – there was reason to be fearful. This is different. This is German residential real estate, any fear mongering is totally off the place.

Locking in a 10% dividend yield on today’s share price alone is a 100% return over a decade. Add to that 200% from the recovery to NAV, gives a 300% return over 10 years. If things go reasonably well, rents will keep growing, the NAVs will keep rising, and dividends will keep increasing, which can all add to another 50% upside over 10 years. In total, I believe a 5-6x over 10 years, or a CAGR of 18.5% p.a. over the next 10 years is a realistic outcome. And we are not talking about unprofitable tech or overleveraged banks.

Prove me wrong that this is not a phenomenal risk / return setup.