LEGIF - LEG Immobilien: Tough Period Ahead With Rates Increasing

2023-03-10 11:41:13 ET

Summary

• While the company has shown consistent strong performance, there are medium-term challenges facing the German housing market, including declining values and rising future debt costs.
• Management has taken strategic steps to strengthen the company's financial position, including suspending the dividend and focusing on cash flow conservation.
• Given the high level of risk involved in the face of rising rates, I recommend investors to hold off on making any purchases for now.

Thesis

LEG Immobilien (LEGIF) provides owns and operates apartments, commercial assets, and industrial properties. LEGIF serves customers in Germany. It is a business with long operating history and offers exposure to German residential. The company is led by competent individuals, and its vision for Germany is expansive; while it has historically concentrated on North Rhine Westphalia, the company has always intended to grow throughout the country. Rising yields in both the risk-free and credit markets have me worried about the outlook for investment and the possibility of costly future refinancing. Given all of these factors lie largely outside of management's control, and I believe the wise move for investors is to set expectations right, in that it we should assume that rising yields and debt costs would reduce the capital value of the company. That said, the lucky thing for LEGIF is that there are still some time for them to solidify its balance sheet thanks to the underlying demand and supply situation (low supply but high demand) thanks to covid disruptions. As such, I could see the German real estate being resilient in the very short term, which benefits LEGIF. Nonetheless, it appears to me that investing in LEGIF at the moment is like trying to catch a falling knife. A high interest (mortgage) rate will eventually cause a drop in demand for the residential market, which will be disastrous for LEGIF. Due to the high level of risk involved, I am recommending investors to hold off on making any purchases for now.

FY22 results

Details of FY22 results revealed consistent strong performance, with free financed rents increasing by 3.7% and vacancy dropping to 2.4%. However, the improved AFFO outlook for 2023 is not attributable to operational factors, as margin, LFL rent growth, and investment outlook remain unchanged. LEG's average cost of debt rose by 10 basis points to 1.26%, and while LTV rose above the group's maximum target of 43%, management did note there is no problem with LEGIF's ability to refinance. Overall, I believe that these results highlight the commonly acknowledged challenges that the German housing sector is expected to face in the near future, such as the decrease in property values, the anticipated increase in debt expenses, and the elevated expenses related to capital. To counteract these challenges, management has taken the unpopular but strategically sound step of suspending the dividend, which is, in my opinion, a good way to strengthen the company's financial position by accumulating more cash.

Cash is better

Last year, during the company's earnings call in November, management discussed how, in light of the volatile macroeconomic climate, they were putting more emphasis on cash flow conservation, and a direct action was to halt all M&A. Management has also made clear their intention to reduce dividend, and by a large amount if underlying markets do not improve. As a result, shareholders who seek dividends to fled, sending the stock's value plummeting. As the devil's advocate, I believe this is the best course of action, given that cash is king in this setting. Particularly, LEG's exposure to residential markets is negatively correlated with mortgage interest rates (eventually). Therefore, I respect management's bold action in reducing the dividend and reinvesting the proceeds in delevering the balance sheet. Because of this, I anticipate a gradual re-rating of valuation to levels close to NAV (currently depressed due to the high debt level). In my opinion, it is difficult to underwrite investing in LEGIF based on management's guidance for a 2023 dividend due to the lack of visibility ahead.

Financing

According to management, a large portion of the debt due to mature in 2023 has been extended. What particularly catches my attention in the financing plan is that management has provided a well-defined strategy up until 2026, with complete confidence in their ability to refinance and roll over the €2 billion debt maturing in 2024 and 2025 without having to resort to asset sales. Given that management has been stockpiling cash on the balance sheet and that there are numerous options available to raise cash, I do not see any reason for alarm on refinancing. Additional options also include private placements and unsecured loans. It's also encouraging that raising equity isn't a part of the plan to finance the business as a whole.

Conclusion

The current market conditions, such as rising yields and debt costs, pose significant risks to the company's future performance. While the FY22 results show consistent strong performance, the underlying challenges facing the German housing market cannot be ignored. Management's decision to suspend dividends and focus on cash flow conservation is a bold but necessary step to strengthen the company's financial position. While the lack of transparency in the market makes it difficult to underwrite investing in LEGIF based on management's guidance for a 2023 dividend, I anticipate a gradual re-rating of valuation to levels close to NAV as management continues to focus on deleveraging the balance sheet. Overall, given the high level of risk involved, I recommend that investors hold off on making any purchases for now.

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