AANNF - Grand City Properties: A Value Play In The German Residential Sector

2023-04-03 14:54:35 ET

Summary

• Grand City Properties reported a resilient performance during the last year due to its sound business fundamentals.
• Even though its financial position is strong, the company decided to be conservative and suspended the annual dividend payment.
• Its investment case is now geared to its depressed valuation.

Grand City Properties ( GRNNF ) has decided to suspend its annual dividend related to 2022 earnings to save cash, which means its investment case has changed to a deep value play.

As I've analyzed in a previous article , I see Grand City Properties as one of the best plays within the German residential sector, due to its good fundamentals and discounted valuation. However, while it was also a good income play, this has changed for the worse, as the company decided to suspend its annual dividend.

I was not expecting this decision given that GCP had enough liquidity to maintain its dividend, but its management decided to be conservative considering the current difficult operating environment and shifted its focus to cash preservation.

As the company released its annual figures related to 2022 a couple of weeks ago, in this article I analyze its most recent earnings and revisit its investment case.

Earnings Analysis

GCP's investment portfolio was valued at about €9.5 billion at the end of 2022, up 2% YoY. However, like what happened to its closest peers, its portfolio was revalued upwards during the first semester, while in the second semester, valuations started to go down. Indeed, its investment portfolio decreased by 2% during Q4, a better outcome than compared to Vonovia ( VNNVF ) or its major shareholder Aroundtown ( AANNF ).

This downward portfolio revaluation is mainly justified by higher cap and interest rates, given that rental growth and the vacancy rate continue to progress well. At the end of 2022, GCP's vacancy rate was 4.2%, much lower than 5.1% at the end of 2021, and a decline of 20 basis points (bps) during Q4, showing that the quality of its portfolio continues to improve, which is also supported by an increasing average in-place rent per square meter over the past few years.

Regarding its like-for-like rental growth in 2022 , GCP was able to report an increase of 2.9% YoY, supported by in-place rent growth of 2.2% and 0.7% gain from higher occupancy. Due to acquisitions performed during the last year, and in 2021, total rental income amounted to €396 million in the past year, representing an increase of 6% YoY.

Its total revenue was €582 million, up by 11% YoY, with operating and other income up by 24% YoY to €186 million, which is mainly related to recoverable operating expenses from tenants that increased due to the inflationary environment in 2022. Due to much lower earnings from property revaluations and capital gains, which amounted to €117 million in 2022 compared to close to €700 million in the previous year, plus rising operating expenses related to property management, GCP's EBITDA declined by 57% YoY to €423 million.

Its net profit was €179 million (down by 70% YoY), but on the other hand, its Free Funds from Operations (FFO), which excludes gains and losses from properties, was €192 million in 2022, up 3% YoY. While in the past its asset rotation strategy was a support for its earnings, during the past year the transaction market has been much more difficult, as investor sentiment turned more negative toward the real estate sector, explaining the big drop in the company's accounting profits.

As I've analyzed in previous articles covering other companies in the German real estate sector, while in the past these companies were focused on growth, the changing operating landscape has turned management's focus to cash preservation, and GCP has been no exception. This means that GCP's short-term strategy is to manage the balance sheet and liquidity position, waiting for a more supportive operating backdrop to focus on growth again in the future.

At the end of 2022, GCP's financial profile was good, even though like its major shareholder Aroundtown, the company has used hybrid debt to a larger extent in its balance sheet compared to its closest peers. While during the 'boom' years the market was not concerned about this type of debt, which has no maturity date and usually is not considered for debt ratios, this has changed with the rising interest rate environment and some skipped call options, both from Aroundtown and GCP.

Indeed, GCP's loan-to-value ratio, a key measure of leverage within the European real estate sector, was only 36% at the end of last year, which is below the average level of its closest peers. However, when considering hybrid instruments as 100% debt, this ratio increases to 46%, which is slightly above its peers Vonovia and LEG Immobilien ( LEGIF ).

This means that GCP's adjusted leverage position is in-line with its peers, instead of being more conservative, even though the difference is smaller than compared to Aroundtown, which has an LTV ratio of 40% while its adjusted LTV ratio increases to 55%.

This difference in the LTV ratios is, in my opinion, a key reason why both Aroundtown and GCP are currently trading at a discount to its German peers, as the market is penalizing companies with relatively high debt levels in the current challenging market environment.

Despite that, GCP's liquidity position is comfortable, and debt maturities shouldn't be an issue over the next couple of years, given that it had €429 million of cash and liquid assets at the end of 2022, plus €300 million of undrawn revolving credit facilities. This cash position is enough to cover GCP's debt maturities until Q2 2025, thus it's not expecting any cash crunch in the short term. Moreover, GCP was able to raise €135 million of new bank financing during 2022, and the vast majority of its asset portfolio is unencumbered, which means GCP can tap secure bank loans if needed over the next few years.

While GCP's financial position can be considered solid, its management decided to be conservative and suspended the annual dividend payment related to 2022 earnings. This measure enables it to save about €57 million cash outflow, which is not a significant amount during 'normal' times, but in the current uncertain environment, its management is clearly focused on balance sheet strength rather than rewarding shareholders.

I think this decision is acceptable, even though the company had enough financial flexibility to 'only' cut the dividend by 50% or less. Going forward, GCP maintained its stated dividend policy of distributing 75% of FFO, even though it only pays an annual dividend and therefore visibility regarding its dividend next year, related to 2023 earnings, is quite low right now.

Conclusion

Grand City Properties has reported a resilient operating performance during the past year, but uncertainty regarding future property valuations and its increased focus on balance sheet management led to a dividend suspension. This background has led to a weak share price recently, and GCP is currently trading at a very depressed valuation that doesn't seem to be justified by the company's fundamentals.

While the whole sector is trading at depressed valuations, GCP is even cheaper considering that it's trading at only 0.22x NAV, compared to more than 0.3x NAV for its largest peers Vonovia and LEG, being therefore a good value play within the German residential sector.

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