Vonovia (OTCPK:VONOY) (OTCPK:VNNVF) is Germany’s leading residential real estate company. Vonovia currently owns and manages around 550,000 residential units, mainly in Germany, but with some apartments also in Austria and Sweden.
While rental income of owning residential apartments is its core business, it also has additional segments which include:
1) Real estate development division
2) Recurring sales (transfer of non-essential apartments)
3) Value-added services (eg artisans, media, etc.).
Vonovia is currently trading at less than ~0.5x of net asset value whereas historically it has been trading around its book value. Also note that the forward dividend yield is expected to be around 6%.
Vonovia’s main roster is on Germany’s XETRA. I recommend buying from the German market rather than the much less liquid ADRs.
The stock price over the past year has fallen precipitously, as seen below:
Even though the underlying business momentum is strong and FCF and dividends per share are expected to grow at a double-digit rate in 2022, the share price has fallen.
(All graphics in this article are from the Vonovia Investor Relations website)
What explains the decline in the share price?
In short, it’s interest rates and inflation, and the market’s perception that its business model is beyond repair (more on that later).
As can be seen below, the German Bund has gone from unprecedented negative rates to ~+1.7% in a few months.
The same goes for Vonovia’s cost of funding, which is currently between 3.5% and 4.5% compared to its current cost of debt of 1.1%.
In the past, Vonovia’s business model was based on debt-financed mergers and acquisitions and the acquisition of apartments (including apartments to be built). This has enabled industry-leading scale and profitability per unit and margins, as shown in the graph below.
Since the gross initial yield of apartments in Germany is around 3.5% to 4%, this no longer makes economic sense. The old model of debt-financed apartment acquisition is no longer economically viable.
In addition, Vonovia also invests in the modernization of apartments, the initial return on which (according to Vonovia) is 5% to 8%. These are reasonable yields, but still with a cost of debt of around 4%, they are not so accretive if financed with debt (therefore, in the future, Vonovia intends to finance from free cash flow).
So, in a nutshell, this is the main problem and the culprit for the decline in the stock price. The rising cost of debt makes its current business model simply unsustainable.
Management needs to pivot to another business model and/or get out of debt (but we’ll get to that later).
The debt structure
Vonovia’s debt structure is shown below:
Even though Vonovia’s cost of debt has increased significantly, the short-term impact seems quite manageable.
The 2022 refinancing needs are financed by existing cash on the balance sheet. The 2023 refinancing events will also likely be covered (at least partially) by the disposal of the non-essential healthcare portfolio (which is not factored into the projections above).
So the takeaway is the next few years, the impact of rising interest rates is not expected to be significant.
Management has also made it clear that it will not take on any additional debt either. To put it simply, organic (ie build to hold) or inorganic (M&A) purchases are over, given the prohibitive cost of debt for the group.
Rental income growth and inflation
The German residential real estate market is highly regulated.
Rental contracts are permanent and are not renewed periodically and are mainly governed by the Mietspiegel system. Mietspiegel are rent indices published every two years and calculated on the basis of agreed rent levels for comparable apartments over the past six years.
The main conclusion is that inflation is taken into account in the rent, but with a lag. In the past, the Mietspiegel typically led to rental growth of around 1% to 1.5% per year, given the very low inflation in the Eurozone. However, the recently released Mietspiegels point to a much larger upward revision in the rental market (as seen below).
Vonovia can also accelerate the taking into account of rental income inflation by applying the Index rents method (also applicable in Germany alongside the Mietspiegels). Under this method, rents are adjusted annually based on the consumer price index (“CPI”). In the past, this was not advantageous for homeowners given low inflation, but that has obviously changed now. Vonovia estimates that around 140,000 of its German apartments would benefit from being on index rates and will therefore, over time, seek to switch to this methodology on an opportunistic basis.
Thus, the main conclusion is that Vonovia should experience significantly higher rental income growth than before, but with some lag.
The current composition of rental income growth for Vonovia is as follows:
Going forward, the contribution from new construction will likely dissipate as newly built apartments will no longer be retained (due to the high cost of debt). However, the market component (ie organic rental growth) is expected to accelerate and more than offset the loss in new construction. The contribution to modernization will remain, but financed by free cash flow rather than debt.
In the first quarter of 2022, Vonovia’s net tangible assets (“NTA”) are calculated at EUR 63.55 per share. The current share price is hovering around ~31 EUR.
However, a large portion of the NTA includes the deferred tax liability on the fair value of investment properties. In other words, the tax payable if all the properties were sold at their book value instantly (more on this later).
The fair value of assets is underestimated on the balance sheet
Vonovia regularly sells apartments at a premium of around 40% over book value. This can be seen in the table below:
It is quite clear that the value of assets (apartments) is understated on the balance sheet due to its conservative valuation methodology.
So the obvious question is why wouldn’t Vonovia sell more units at a premium to book value and then buy back shares at less than 0.5x NTA?
I believe this is a possible outcome given the current stock price situation and could be announced in the coming months.
Of course, the other thing to consider is tax liability and some insights can be gleaned from the recurring sales segment:
In the first quarter of 2022, Vonovia sold 661 units with a fair value (i.e. book value) of €94 million and generated free cash flow (after tax and selling costs) of 126 million euros. In other words, its conversion into cash from asset disposals is much higher than the book value (the cash generated is equal to 1.34x the value of the asset).
I don’t know if this can be extrapolated to the rest of the portfolio as the assets being sold may have specific tax attributes (e.g. high cost base) that made them attractive for disposal. Nonetheless, it demonstrates the value that can be generated by a more aggressive recurring selling program that can be used to arbitrage the capital structure (sell assets above book value and buy back shares at a 50% discount to to book value).
Vonovia management understands that it needs to reinvent the business model. The current cost of debt is prohibitive and forces the question.
Immediate actions are simple and ensure that Vonovia no longer funds capital markets or increases debt.
Short-term actions are deeper. Vonovia is exploring a capital-light model in which it manages properties on behalf of others. Vonovia has a significant cost advantage given its large scale and its AUM percentage cost is estimated to be only 0.2% compared to the typical industry standard of 1% AUM.
The most interesting aspect is the potential for JV partnership with insurance companies and pension funds. The main advantage is the possibility of disposing of assets (or part of them) within the framework of a major transaction, but above all which does not crystallize a tax debt. This should enable Vonovia to raise significant cash for both share buybacks and debt repayment. Importantly, Vonovia will continue to manage the properties and generate ongoing management fees and retain its key competitive advantage of scale and efficiency.
Mr. Market is spooked by the high cost of debt and has concluded that Vonovia’s business model is completely and utterly broken and beyond repair. This is the main reason why it is trading below 0.5 times its NTA.
The market is also skeptical about the forthcoming manifestation of organic rental growth.
Management was also caught off guard. It took them a while to figure out what inflation really means for their business model and to react. After all, for a decade or so they had been so used to exceptionally low inflation.
It’s a brave new world for analysts and management. The good news is that Vonovia has a lot of flexibility and plenty of levers to pull to handle this.
It is clear that it needs to dispose of assets given the cost of its debt, but it has the time to do so optimally given the limited refinancing in the coming years.
The JV option is clearly optimal if it is viable. The fallback option is to selectively sell more units at a premium to reserve and recycle capital towards higher return opportunities (modernization investments, share buybacks and debt reduction).
He is also in a very good position to lead a small cap asset management/services business given its scale and efficiency.
Mr. Market is clearly overreacting (partly driven by the Bridgewater short sell). I’m very optimistic and consider this a strong buy right now.