Vonovia issues bonds to raise €2.5b to finance projects, but is there still a problem?

ANNOUNCEMENT
The news from Vonovia is that it has issued its first two social bonds with terms of 3.85 and 6.25 years as well as its first 10-year green bond under the new EU taxonomy. This is a premiere in the property industry, stated the company. The bonds worth €2.5bn have a coupon of 1.875% and were oversubscribed by a multiple of 4.7.

‘The bonds demonstrate our social responsibility and our strategy of sustainability. This is precisely what investors expect from companies today,’ said Philip Grosse, CFO.

‘In turn, we as a company benefit from social bonds and green bonds as an opportunity to expand our investor base.’

Just recently, on February 2022, Vonovia adjusted its sustainable financing to the new EU standards (EU taxonomy) and added social components.

The two social bonds will be used for the financing of social projects. This includes housing set aside for holders of state subsidy entitlements and thus low-income households. But it also includes privately financed flats in Berlin as a way of providing access to affordable housing, with rental fees that are at least 15% below the officially determined average local reference rent. Furthermore, the funds from social bonds will be used for low-barrier housing and for modernization that will cater more effectively for the needs of an ageing society.

The 10-year green bond provides Vonovia with additional cash, which the company also wants to use for refinancing sustainable projects in Germany, Austria and Sweden. This includes investments in new builds and upgrading existing buildings to an energy efficiency class of at least B (in Austria: at least A). Above all, Vonovia is promoting renewable energies, such as the installation of solar panels.

‘We still have buildings that go back to the 1950s and 60s and which have not been modernized,’ said Grosse. ‘This is why we’ve been working steadily since 2015 on a reduction of the carbon footprint of our buildings through energy upgrades. Today’s rising energy prices show how important it is to reduce the cost of heating for tenants. We also ensure high standards in energy efficiency in new builds, and so we often give preference to wood as a building material.’

GREEN STREET’S MESSAGE
Yet, in a typically robust message, Green Street's note on Vonovia entitled “Rethinking the Business Model” was not altogether flattering. The firm has a “buy” rating on the stock. However, there are several messages from the firm via its pan European residential head.

Having listened into Vonovia’s conference call, Green Street's Toome said a ‘notable observation’ was that management is frustrated with the public market’s steep ascribed discount to asset value, and here is the rub: ‘However, they did not provide an actionable plan that would help close that discount, so this report serves as a roadmap management could follow that should yield tangible results over a relatively short period of around 12 to 18 months’.

Before getting into that, Toome explains that German residential was once the darling of capital markets offering attractive return prospects via relatively high starting yields, a long and clearly visible runway of internal growth – positive on a real basis – along with reasonable capex requirements. What’s more, the sector’s high embedded NOI growth – in-place rents typically 10-25% below market – in conjunction with its well-below-replacement-cost valuations earned the business its “bullet-proof” character.

Vonovia, the bellwether of the sector, traded broadly in line with its close peers in the first eight years following its 2013 IPO. However, the public market, enamoured of the sector for so long, is pricing in a different future now. Gross Asset Value (GAV) percentage discounts in the high-teens to low 20s have become the norm and imply a ‘dire view’ of declining private market values.

WHAT CHANGED?
In Green Street’s Toome's opinion, the massive yield compression binge in the private market that frontloaded German residential’s total returns has pushed net initial yields (NIY) in top markets close to, or even below, the 2% level.

‘That is proving impossible for the public market to stomach when multiples in other parts of the equities space are nowhere near as stratospherically high,' he said. 'At the same time, rent regulation in Germany has tightened over the years, meaning that internal growth potential has moderated, whilst capturing embedded reversion is taking longer.’

Finally, with higher inflation expectations helping nudge long-term BBB bond rates upwards recently, razor-thin cap rates will have a hard time to compress further. Along with the realization that capex requirements, including “green”, are proving to be materially higher than was believed only a couple years ago, the public market is unequivocal in its assessment: it believes the appropriate cap rate for German Residential should be around 70 basis points above what direct investors are currently ascribing, which is around 2.6%.

NEEDS
With investment needs on the rise and not enough free cash flow available post capex, higher debt has been the sector’s ‘piggy bank’ to fund dividends to shareholders, argues Green Street's Toome. ‘Vonovia is the poster child of this theme,' he wrote.

Group Funds From Operations (Group FFO), a Vonovia-defined metric including profits from merchant development and single-unit disposals, is guided at €2bn-€2.1bn for 2022. However, Vonovia’s total capex envelope in 2022 amounts to €1.4bn. That includes around €400mln of regular capex and a €1bn modernisation programme), whilst 70% of Group FFO of around €1.4bn is earmarked for next year’s dividend.

‘The combined €2.8bn funding need is well in excess of the guided Group FFO – the shortfall being made up by valuation growth either crystallised via disposals or unrealised via new borrowings. In recent years Vonovia has used scrip dividend to alleviate cash need for dividend distributions, but large GAV discount impairs this assumption. However, even with a 40% scrip dividend, free cash flow after fully loaded capex falls short to cover the cash dividend component. In addition, Vonovia is actively investing in ground-up developments with its own funding requirements, which is another €1bn in 2022.

SUGGESTIONS
So, what does Green Street's Toome suggest? As deep discounts persist, he suggests a capital allocation roadmap for Vonovia envisaging a significant slowdown in the pace of external growth. As a first step, acquisitions should be off the table.

Secondly, selective asset disposals should take priority, with proceeds used to deleverage the balance sheet. Some funds could be used to also instigate share buybacks in a leverage neutral manner.

Thirdly, Vonovia should focus exclusively on energy modernisation initiatives and consider a spin-off of its merchant development business. 'It is not being rewarded for owning it by the public market and the business demands large amounts of working capital while the land bank and in-process developments push up the PropCo’s sky-high Debt/Ebitda to levels of around 16X that now put off many prospective equity investors, generalists or REIT specialists.’

IF ALL ELSE FAILS – A FUND MANAGEMENT BUSINESS?
But what if all the above doesn't work? The Green Street head of residential in Europe wonders if there is any way to meaningfully speed up the process of shrinking the asset base? Toome asked: 'Could Vonovia launch a fund management business, whereby it opens its portfolio of assets to minority investors via joint venture structures?'

The analyst said there were many examples in the European Reit space where this had been successfully executed, with the right checks and balances in place that ensure no material conflicts of interest arise between Reit and fund investors, citing Segro, Unite Group, Prologis, and VGP.