VNNVF - Vonovia Is Likely To Benefit From Undersupply In Germany

2023-10-19 05:56:00 ET

Summary

• Housing supply is falling due to high construction and energy costs and regulation.
• Demand is rising due to immigration and two other trends.
• I discuss why the German market is guaranteed to experience housing under-supply and how this will benefit Vonovia.

Dear readers,

Vonovia ( VNNVF ) is one of my favorite stocks to write about and one that occupies the biggest position in my real estate / REIT portfolio. I've studied the stock quite extensively over the past two years and have tried to convey my thoughts through a series of articles here on Seeking Alpha.

Most recently I shared an update following Vonovia's Q2 2023 earnings - here , reiterating my BUY rating at EUR 22 per share for the native shares (ticker VNA).

I'm now more than 20% in profit (excl. dividends) on my position with a break-even under EUR 18 per share with no intention to sell before my EUR 40 price target. That leaves 80% of upside to a price target, which really is quite conservative, making Vonovia a worthwhile investment even at today's prices.

I think that the one thing that often keeps people from investing in Vonovia is lack of knowledge of the local German market. The focus here is on the supply and demand dynamics and especially on rent regulation, which I believe is a key piece of the puzzle here.

Today I want to show you why I have no doubt that Germany will experience substantial under-supply of housing over the next 5 years which will inevitably benefit Vonovia and other residential landlords.

German Residential Market

Just as any other market in the world, the German residential market is driven by supply and demand (with a sparkle of regulation) over the long term.

Let's start with supply of new apartments. There's only one reason why developers build new housing - to make money. When input construction and energy costs increase, developers are faced with a choice. They can try to pass through these input cost increases onto the final customers by increasing the sale prices or they can halt their development plans.

In tough economic conditions with high inflation and a weakening consumer, it's quite unlikely that new apartments would sell at higher prices. In fact, housing prices have already started coming down from their peak in early 2022.

Chart: Germany Housing Price Index

Faced with no other choice, this has led many developers to postpone their construction plans which has led to a significant drop in the number of issued building permits (one of the best proxies for future new supply).

Note that the data below is monthly, so in normal years about 300,0000 units are permitted per year. This year that number is likely to be below 250,000 and unless the economy improves drastically, I expect no more than 200,000 permitted units in 2024.

Chart: Germany Building Permits for New Dwellings

The result is that only about 250,000 new units are expected to be delivered to the market this year. In the following years, this number may fall somewhat lower before recovering closer to the 300,000 unit long-term average. But even 300,000 units per year isn't nearly enough to cover the demand which is expected at 500-700 thousand units per year!

That may seem like a high number so let's break it down.

Demand for housing is first and foremost driven by population growth. The natural population in Germany has been declining for a long time, but immigration has been high and has resulted in a 0.4% annual population growth over the last 10 years. Recently, this growth has been accelerated by (1) the government passing immigration reform laws in an effort to increase immigration to fight labor shortages and especially by (2) the Russian invasion of Ukraine which has resulted in unprecedented 1.3% population growth in 2022. Going forward the population is expected to grow by 022. Going forward the population is expected to grow by 0.5-0.6% per year.

On top of population growth, there are two trends worth mentioning. Firstly, urbanization which isn't stopping any time soon and is likely to disproportionately benefit Vonovia whose portfolio is located primarily in places that are seeing population growth. Secondly, the downsizing of households. Back in 2011, there were on average 2 people in every household. That number has dropped to 1.94 today and is expected to decline further to 1.89 by 2035, adding additional 0.2% of demand per year.

Between population growth and these trends, it is estimated that demand for housing will average 500-700 ths. units per year which is a far cry from what will be constructed. And because you cannot simply pull new apartments out of a hat, under-supply is basically guaranteed for the foreseeable future and will only be magnified if the ruling party manages to pass its proposal for more stringent rent regulation which would only discourage more developers.

Implications for Vonovia

What does all this mean for Vonovia?

Firstly, as the housing shortage keeps prices high a large portion of the German population will rent out of necessity which is likely to result in ongoing near perfect occupancy of 98%+. Secondly, with fewer apartments on the market, existing real estate will be more valuable leading to higher prices which should help get the stock closer to its NAV of EUR 40+.

In the short-term the stock price will continue to be driven by interest rates expectations and sentiment. But over the long term the value of the company's assets acts as a very strong magnet and the valuation will eventually reflect this. Severe undersupply is one of the key reasons why I don't mind being overweight Vonovia at these depressed levels and reiterate my BUY rating for the stock.

Stay tuned for an update of my cash flow model following Q3 earnings.

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