ESS - LEG Immobilien Vs. Vonovia: Which Should Value Investors Consider Right Now?

Summary

• We believe the market has overreacted to the headwinds facing the European real estate industry, leading to very low valuations for companies like Vonovia and LEG Immobilien.
• Both companies have a strong presence in the German residential real estate market and offer attractive yields, but have some differences to consider.
• We believe at current prices, both companies are a 'Buy', but we like one of them slightly more.

Be fearful when others are greedy and greedy when others are fearful - Warren Buffett

An industry where there is a lot of fear right now is in European real estate. The combination of high inflation, exorbitant energy prices, and rising interest rates have really affected the prices of many real estate companies. Two in particular that value investors might want to take a look at are Vonovia ( OTCPK:VONOY ) and LEG Immobilien ( OTCPK:LEGIF ). Their share prices are down for good reason, but we believe the market has overreacted and overly punished both. The market seems to have realized that the worst case scenario is not very likely, and the share prices of both have started to recover. We believe there is still a lot of value in both at current prices, as their valuations continue to be quite low.

Both companies have a strong presence in the German residential real estate market and offer attractive yields, but there are some key differences between them that investors should be aware of before choosing one over the other.

Vonovia has a larger and more diverse portfolio than LEG Immobilien, with investments in affordable housing and luxury homes, while LEG Immobilien has more concentration in affordable housing. LEG is also more focused on a specific region of Germany, that of North Rhine-Westphalia (NRW). This is important because this region has some interesting characteristics. First, it's Germany’s economic powerhouse generating approx. 21% of German GDP. In fact the GDP of this region is larger than Sweden's, Poland's, or Belgium's. About one third of the largest companies in Germany are based in NRW, and it has the most start-ups in Germany. It also has a robust labor market with a decreasing rate of unemployment (-40% since 2006). Meanwhile Vonovia is not only more diversified across Germany, it also has around 20% of its portfolio outside of Germany, mostly in Sweden, and a small portion in Austria too. While we appreciate Vonovia's diversification, we actually like LEG Immobilien's focus on an attractive region more. Particularly when markets like Sweden are experiencing a lot of headwinds, we like that LEG Immobilien does not have exposure to that market. This is what legendary investor Peter Lynch would call "diworsification", basically adding investments to a portfolio in such a way that the risk-return tradeoff is worsened. We believe Vonovia has done this to a certain extent.

Balance Sheets

Given the headwinds that both companies are experiencing right now, it is critical for them to have a solid balance sheet. LEG currently has a loan to value ratio of ~42.3%, net debt to EBITDA of ~15.2x, and a Moody's corporate rating of 'Baa1' with a stable outlook.

Meanwhile Vonovia has a slightly worse loan to value ratio of ~43.4%, net debt to EBITDA of ~15.4x, and also a Moody's corporate rating of 'Baa1' with a stable outlook. In other words, both companies have decent balance sheets, but Vonovia is slightly more leveraged.

LEG Immobilien does not have any significant maturities until 2024, while Vonovia does have some debt that will have to be refinanced during 2023, but its debt is still very well laddered. LEG's average debt maturity is 6.8 years with an average cost of 1.26%, while Vonovia's weighted average maturity is 7.5 years, with an average cost of 1.3%.

Strategy to face the headwinds

Both companies are deeply aware of the headwinds they will be facing in the short/medium term, and as such they are being more careful with how they manage their cash and liquidity. LEG Immobilien is actually saying that in this environment cash is king, and they are taking several steps to increase their cash position and cash generation. Some of the moves they are making include rent increases, cost reductions, run-off of new developments, no more acquisitions and instead it is now looking to be a net seller of properties.

Vonovia is taking similar steps, recognizing that in this environment the cost of capital is higher, and as such they are also reducing significantly their investment program.

Resiliency of the German residential market

There are several secular tailwinds supporting the German residential real estate market, and that is why we believe property prices will hold-up better than investors fear. The German residential market has been facing a shortage of supply, due to a lack of new constructions and limited availability of land for development. At the same time demand is growing thanks to population growth and immigration. This is particularly true for the affordable housing segment in which LEG Immobilien concentrates.

During previous economic crises, the German rental price index kept going up, showing how resilient the German residential market can be.

Valuation

As a result of the headwinds we discussed at the start of the article, shares have fallen to what we consider to be very attractive valuations. Based on price to book value Vonovia looks a little bit cheaper, but it actually has some intangibles on the balance sheet.

Using tangible book value it is actually LEG Immobilien that is a little bit cheaper, trading at roughly 61% of its tangible book value, while Vonovia is at ~68%. Taking leverage into consideration, this means investors are expecting a ~20% decline in property prices in Germany. We would be surprised if prices actually fall this much, in particular given the secular tailwinds previously discussed.

To give an idea of how cheap these multiples are, we can look at popular equivalents in the US market such as AvalonBay Communities ( AVB ), Essex Property ( ESS ), and Equity Residential ( EQR ), all of which trade at more than 2x tangible book value. Of course, they are not facing the same headwinds, and operate with fewer regulations. Still, the valuation difference is quite remarkable.

Both Vonovia and LEG have attractive dividend yields of more than 5%, but investors should be aware that the dividend could be paused or reduced if conditions deteriorate further. In fact LEG Immobilien has already said that its dividend will depend on the market environment. Still, even if the dividend were to be paused or reduced for some time, we believe that it would eventually be restored to the previous level and start growing again.

The Verdict

If we had to choose between the two we would currently go with LEG Immobilien given that it is trading at a slightly lower price to tangible book value multiple. We also like that it is more focused on Germany, and believe the exposure to Sweden could cause troubles for Vonovia. That said, Vonovia is a larger company, it is better known by investors and has more analysts following it, and has exposure to the luxury market as well.

Risks

Both companies are currently experiencing significant headwinds from the rising interest rates environment, complicated credit markets, and a weakening economy. Given the current market conditions investors should not be surprised if one or both of these companies decides to pause or reduce their dividends.

Conclusion

We believe Vonovia and LEG Immobilien both present an opportunity for value investors, given the significant discount to tangible book value with which they are trading. There are significant headwinds and risks to consider, but we believe the market is being overly pessimistic. As such, we believe this can be a great opportunity to be greedy when others are fearful. Of the two companies, we prefer LEG Immobilien, but can understand why some investors would prefer to go with the better known Vonovia. In any case, at current prices we believe both companies are a 'Buy' for courageous investors willing to put up with the risks and volatility.

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