VONOY - Vonovia: The Bears Are Capitulating

2023-12-31 22:34:21 ET

Summary

• Vonovia is hugely benefiting from lower interest rates, and the bears are capitulating.
• I expect it to trace back to book value in the medium term.
• The shortage in supply of German properties and rapidly rising rents could drive FOMO for prospective investors and homeowners.
• In the medium term, I expect Vonovia's book value to grow strongly.

In my prior article on Vonovia SE ( OTCPK:VONOY ) ( OTCPK:VNNVF ), I argued that the bears are completely wrong and presumed risks are completely overblown. Since then, the stock has performed strongly on an absolute and relative basis.

Whilst the recovery in the stock has already picked up steam, it is still trading at less than ~0.6x of Net Asset Value ("NAV"). Traditionally, Vonovia traded around its NAV, albeit in a period where interest rates in the eurozone were significantly lower. Having said that, Vonovia is also expected to benefit from accelerated rental growth in the next few years due to the unique Mietspiegel system that regulates rent in Germany. Given the acute supply shortage of residential apartments in Germany (especially in the large cities), increased demand from immigrants (e.g., Ukraine war refugees), and high construction costs - I expect property prices in Germany to increase strongly in the medium term. Especially so, as interest rates decline and prospective buyers start experiencing FOMO due to a lack of supply and ever-increasing rental rates. Given the embedded leverage in Vonovia's balance sheet, this may drive NAV back up strongly.

In 3 to 4 years, I expect Vonovia's share price to trade around the 70 euro mark. It is currently trading at ~28.50 Euros and a book value of 50.51 Euros.

Background

Vonovia is Germany's leading residential real estate company. Vonovia currently owns and manages ~550K residential units, mostly in Germany, but with some apartments in Austria and Sweden.

While rental income from holding residential apartments is its main business, Vonovia also has additional segments that include:

1. Property development segment
2. Recurring sales (disposal of non-core apartments)
3. Value-add services (e.g., craftsmen, media, etc.)

The Bear Case Debunked

The bear case was all about forced deleveraging of the balance sheet. The bears have managed to drive the valuation to as low as 0.3x NAV. The rationale was straightforward enough, the bears expected the German property prices to drop quickly and in turn manifest in fears that Vonovia will breach various metrics in its bond covenants (Q3 earnings deck) .

Whilst German property prices fell ~10%, they still needed to fall an incremental 22%+ for Vonovia to breach its covenants. Given the supply/demand situation, I correctly presumed that this magnitude of decline (>30% from peak to trough) would be a remote risk. The bears also assumed that Vonovia would be unsuccessful in deleveraging by selling non-core assets.

The bears were wrong about this as well, and by the Q3-2023 report, Vonovia already signed EUR3.7 billion of assets (outstripping its communicated target of EUR2 billion by a mile):

Furthermore, all the rating agencies confirmed Vonovia's stable investment ratings and outlook, and unsecured funding maturities are now fully covered at least until the end of Q1 2025.

German Property Prices Are Stabilizing

The German Europace house index is showing that property prices are now stabilizing following a decline of ~10%. The recent decline in interest rates should most certainly be supportive of firming property prices as mortgage rates decrease and the FOMO effect should start to play out.

The light blue, gray, and black lines represent the price index of new homes, single existing homes, and apartments, respectively.

Lower Interest Rates Are Strong Tailwinds

Lower rates are significant tailwinds for Vonovia for the following reasons:

1. Lower rates should translate to more buyer demand for both investors and homeowners (lower rates on mortgages)
2. Enhances the ROE for the modernization of apartments. The gross regulated yield allowed on modernization is between 8% and 10%, with lower rates meaning that the spread Vonovia retains on capital investments is wider.
3. Lower funding costs as Vonovia refinances debt maturities
4. Vonovia stock is seen as a "bond proxy" for many investors who are after the dividend yield. All else being equal, lower risk-free rates in the eurozone enhance the attractiveness of the dividend yield provided by the Vonovia shares.

Final Thoughts

Vonovia is on the cusp of turning from a debt deleveraging story to an equity buyback narrative. The inflection point will manifest when it is clear that German property prices have stabilized (or even better increasing). Lower interest rates are likely to be a material catalyst as these are such strong tailwinds to its business model. I expect Vonovia management to soon start contemplating buying back shares and/or the Apollo JV's common minority equity participations.

Thereafter, I expect Vonovia's share price to retrace back to its book value in line with its historical multiples. The pace of retracement will likely be driven by how quickly interest rates decline as well as FOMO by prospective buyers as they realize property prices have bottomed and rents are continuing to climb rapidly.

Vonovia remains a top conviction of mine for 2024 and beyond. I also expect it to perform strongly, on a relative basis, even in a recessionary environment as I expect rates to decline faster and deeper in an economic downturn.

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