TAGOF - TAG Immobilien: Liquidity Improvement Makes It An Interesting Cyclical Play

2023-11-01 00:33:15 ET

Summary

• TAG Immobilien has improved its liquidity and is in a better financial position than before, making it an interesting play in the European real estate sector.
• The company has made asset disposals and raised bank loans to address its liquidity needs.
• TAG Immobilien's leverage ratio is increasing and it needs to reduce debt to maintain a strong balance sheet.

TAG Immobilien ( TAGOF ) has improved somewhat its liquidity and is now in a better financial position than it was some months ago, making it an interesting cyclical play in the European real estate sector.

As I’ve covered in previous articles , while TAG Immobilien has reported a resilient operating performance in recent quarters, its liquidity issues were a major concern and a key reason to avoid its shares. Indeed, in my personal portfolio I own Vonovia ( VONOY ) in the German residential sector, given that its larger size has enabled it to raise funding with alternative investors, such as private equity, something that may be harder for smaller companies to do.

In the current tough market environment for real estate companies to refinance their debts, having access to alternative financing sources is a key advantage for larger companies, justifying significant valuation discounts for smaller players that may have issues to refinance upcoming loan and bond maturities.

TAG Immobilien has some sizable refinancing needs ahead and in this article I analyze its most recent financial performance and its liquidity needs in the short term, to see if its shares remain a value trap or if its financial position is stronger than it was some months ago and offer now value for long-term investors.

Financial Overview

As I have discussed in previous articles , the rising interest rate environment in Europe has been quite negative for the European real estate sector, due to relatively high debt levels and lower property valuations. This had led to negative investor sentiment toward real estate companies, with the credit markets practically shut for these companies for most of the past eighteen months.

Also, funding costs for senior unsecured debt has increased a lot compared to the past few years, when interest rates were negative and real estate companies could borrow money for less than 2%, a situation that has changed dramatically since the beginning of 2022.

For instance, TEG Immobilien raised €125 million bond in 2018 at an annual cost of only 1.75%, while this bond is currently yielding more than 5%, showing that if TEG would refinance this bond today it would increase significantly its interest expense and would be probably higher than its rental income yield, which is not economically sustainable.

Additionally, this landscape also led to much lower volume in the property transaction market, as most players were net sellers of properties to raise cash, putting further pressure on property valuations and leverage ratios across the sector.

Considering that TAG is a relatively small company in the European real estate sector, this puts more pressure on its refinancing needs, particularly in the capital markets.

Therefore, not surprisingly, TAG has made several disposals in recent months to raise cash, namely more than 1,000 units during H1 2023 for total net cash proceeds of €143 million. These transactions are expected to lead to a net book loss of less than €4 million, which is a quite good outcome considering the real estate market landscape in Europe.

Beyond asset disposals, the company has also resorted to banks to raise new loans, being able to raise €490 million since July 2022 to the end of June 2023. During 2023, bank loans had an average interest rate of 4.38% and an average maturity above 6 years, which was possible to do by using its properties as collateral (mortgage loans).

However, as property valuations continued to decline over the past few months, TAG reported a portfolio devaluation of 7.3% in the first half of 2023, a higher decline than compared to its closest peers given that its portfolio is not much concentrated in prime property, leading to a higher leverage ratio. Indeed, its loan-to-value (LTV) ratio, a key measure of leverage in the European real estate sector, was 47.5% at the end of June (vs. 46.7% at the end of 2022).

This is still an acceptable leverage ratio, but its increasing trend is worrisome and TAG clearly needs to reduce debt in the near future to maintain its balance sheet in a strong position.

Indeed, the company’s desired LTV ratio is below 45% and to maintain an investment grade credit rating it needs to maintain leverage below this threshold, or a credit downgrade to high yield may happen in the coming months. This would be another headwind for the company to refinance its bonds and loans in the next few years, at least at reasonable costs that don’t put in jeopardy its business model.

From an operating perspective, the tight supply-demand situation in the German residential market remains quite positive for these companies, leading to higher rent prices despite the more challenging economic environment. In H1 2023, TAG’s rental growth (like-for-like) was 1.6%, or 2.1% including reduced vacancy, a very good development compared to recent years.

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However, its vacancy ratio was 4.7% at the end of last June, an increase of 30 basis points (bps) in the semester, which is explained by the sale of properties with an average vacancy rate of only 2%, pushing the overall vacancy ratio to a higher level for the remaining properties in the company’s portfolio.

In H1 2023, its net rental income amounted to €145 million, an increase of 5.2% YoY, due to higher rents and lower property expenses. Due to valuation losses of €455 million during this period, its net loss was €304 million, but adjusted for this non-cash expenses its Free Funds From Operations (FFO) amounted to €89 million, down by 7% YoY, due to higher interest costs.

For the full year , TAG expects FFO to be between €170-174 million, down by 9% YoY, while a potential dividend payment is not completely ruled out after its dividend suspension related to 2022 earnings, depending on the company’s liquidity position at the beginning of next year.

Regarding its debt maturity schedule, TAG has refinanced most of its maturities in 2023, while or 2024 it has about €350 million to refinance and some €478 million in 2025. Given that at the end of last June TAG only had about €100 million in cash, its liquidity position is not great, but considering its annual cash generation and its pending asset sales, the company should have enough financial resource to cover loan and bond maturities over the next twelve months.

Conclusion

While I was concerned about TAG Immobilizer’s financial position some months ago, the company has been able to raise bank loans and has pending asset sales that address its liquidity needs over the next twelve months.

Given that interest rates are likely to have reached its peak in Europe, investor sentiment towards the real estate sector is likely to improve going forward, which will be positive for companies like TAG to refinance its bonds and loans in the coming months. Therefore, TAG seems now to be an interesting cyclical play on a potential rebound of the European real estate sector, as the company is trading at only 0.54x its net asset value, which seems to be quite undemanding.

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