IREIT Global (SGX:UD1U)

Germany's office real estate has been on a roll over the last few years. Judging from its share price, IREIT Global (IREIT) was deep in slumber amidst the real estate frenzy. I will examine this much unloved and non-covered REIT, as it offers an interesting, albeit long-term value proposition. This is a reversal of my usual investment thesis, where I tend to prioritise macroeconomic factors over company specific ones. 

Summary of Investment Thesis

Strengths

1. Rental rates and book value are below market rates
2. Robust office market in Germany
3. Brexit may lead to companies relocating to Germany

Weaknesses

1. EUR is vulnerable to Europe's political turmoil
2. Tenant risk concentration

What does IREIT do?

IREIT is a pure-play office REIT consisting of five office buildings located in various cities across Germany, with the largest contributor being its Berlin Campus. The REIT was listed in 2014, and the Berlin campus was subsequently injected in 2015, with no further additions since then.

The REIT's management has changed hands in 2016, when Tikehau Capital acquired 80% of the REIT manager from the previous sponsor. The previous Sponsor who carried out the IPO is an Israeli investor into European office assets. Tikehau is a pan-European Asset manager and investor and is listed on the Euronext Paris (Bloomberg Code - TKO:FP).

Change in mandate. Subsequent to the acquisition, Tikehau announced that IREIT's mandate will be broadened to include European retail and industrial assets. However, there has been no addition to IREIT since the Berlin Campus in 2015, leaving it a pure play German office REIT at present.

Shareholders. IREIT's largest shareholder is Tong Jinquan, a Chinese tycoon, with a 55% stake at present. The stake was acquired as part of the IPO, from the previous sponsor. Tong Jinquan's stake has remained largely unchanged since the IPO. On the other hand, Tikehau has gradually increased its stake in the REIT since becoming the REIT's manager in 2017. At present, Tikehau owns 8.3% of the REIT. I view this gradual increase as an encouraging sign, as it increases the alignment of the REIT manager with that of unitholders.

Macroeconomic Outlook

Germany's inflation has been stable. IREIT's leases are generally inflation-indexed, that is periodically adjusted when cumulative inflation reaches a threshold between 5-7% for the leases. The ECB’s Governing Council adopted a quantitative definition of price stability in 1998:

"Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%."

The Governing Council clarified in 2003 that in the pursuit of price stability it aims to maintain inflation rates below, but close to, 2% over the medium term.  Inflation pressure in Germany has averaged 1.5% per annum over the last 20 years, indicating that the ECB has been able to meet its goal in the long run, at least for the German economy.

German office rental market has been running red hot over the last few years, with a robust economy generating new jobs and unemployment rate hitting record lows consistently. The steady growth of jobs and workers in the economy has resulted in office vacancy rates falling rapidly in major cities.

Interestingly, though vacancy rates have been declining steadily since 2012, rental rates started to surge from 2015 onwards. This indicates that the market tightness only set in once excess supply has been absorbed. The brightly coloured lines in the charts are the cities that are relevant to the REIT, while the grey lines are for the other major cities in Germany. Reuters has highlighted the shortage of office space in Berlin.

Brexit Catalyst. Naturally, investors will be wondering, can this spike in rental rates continue? I believe that it is possible, given that German office rental rates are much lower than that of the UK and France. A key catalyst that investors have not factored in is that a hard or messy Brexit could lead to a flood of companies seeking to relocate to mainland Europe. While France is likely to be the main beneficiary of any exodus, German cities will also be a recipient of some corporates seeking to relocate. Should this materialize, this outcome will be impetus for further increases in office rental rates.

Economic Outlook for Europe and the Euro (EUR). The economic outlook for Europe is rather bleak, given the aging population, deteriorating social cohesion and political turmoil. Events such as Brexit, while may be beneficial for IREIT, bodes poorly for the grand European project and it's single currency in the long run. In my opinion, politics beyond Germany's borders is likely the biggest threat to the long term performance of this REIT, as the EUR's existence may be called into question. As shown below, the trajectory of the EUR appears to be that of a weakening trend against the SGD since the Global Financial Crisis.

Company Analysis

Given the overwhelmingly positive backdrop of the German office market, why hasn't IREIT's unit price moved positively? My answer to this question is, investors in Singapore and Asia are still oblivious, as they remain focused on IREIT's DPU, which will remain largely flat (at least in EUR terms) until 2022 at earliest, with a periodic bump up due to inflation-adjustments.The chart below captures how monotonous the REIT's revenue and NPI have been since the Berlin Campus acquisition in 2015, with any fluctuations largely due to changes in the EUR/SGD rate.

DPU rose after 2015 following the acquisition of the Berlin Campus, but declined in 2017 as the new REIT manager, Tikehau, revised the distribution rate to 90% from 100% previously. The DPU has remained stable since then, with any changes due to fluctuations in the exchange rate. Looking forward, the DPU can be expected to decline in 2019, as the EUR weakened in 2018 against the SGD. The currency hedge is expected to roll over at a lower rate, with my estimated 2019 hedged exchange rate of 1.57, as compared to 1.63 for 2018. This is a 3.7% reduction in DPU in SGD terms.

IREIT's long lease profile. At the point of IPO in 2014, IREIT's properties have always had a long lease profile. The leases for the original properties were structured with no rental escalation, save a periodic inflation adjustment. This lease structure has left the DPU relatively stable, albeit unexciting.

The bulk of the leases will start to expire commencing 2022.

Based on the table below, we can see that the Berlin Campus, with a 40% weight in the REIT, has the widest gap between market rental rates and the present lease rate for the asset.  IREIT's leases are generally far below the average market rental rate. This presents an opportunity for a bump up in DPU in 2022-2024 as the leases are renewed at prevailing market rates.


Source: Colliers

In terms of book value, the assets are likely to be undervalued. This is because the book value of real estate are commonly valued on the basis of NPI divided by the capitalisation rate. As IREIT's NPI will be adjusted upwards when the leases are renewed, the book value of the assets should be higher. Thus, the NAV of IREIT is likely to be understated.

Although there have been concerns that the REIT is highly leveraged (Sep-18: 39.1%), given my view that the assets are undervalued, the true debt-to-asset ratio is likely lower than that of the book value. In any case, the ratio has been gradually drifting downwards from the high of 43.4% reached post-acquisition of the Berlin campus in 2015.  This gradual improvement is due to the 10% retention of distributable income, paring down of debt and gradual upward revaluation of properties as Germany's capitalisation rate has been declining amid falling interest rates.

REIT Management Fee Structure

1. Management Fee-
• Base Fee: 10% p.a. of Annual Distributable Income
• Performance Fee: 25% p.a. of the difference in DPU between a financial year and the prior year
2. Acquisition Fee - 1.0% of the value of real estate investment purchased or acquisition price 
3. Divestment Fee - 0.5% of the value of real estate or sale price 
4. Trustee Fee - 0.01% p.a. of trust property value 

The performance fee ensures that the REIT manager's and unitholders' interest are aligned since the REIT manager is incentivised to pursue DPU-accretive deals. Nevetheless, despite the change in REIT manager and broadening of the mandate in April 2017, the REIT has shown little appetite for new acquisitions.

Conclusion

IREIT is a deep-value REIT, with a potentially significant upward revision of DPU in 2022 and beyond as the leases are renewed. The primary short term risk for IREIT unitholders appears to be a weakening EUR, as DPU for 2019 will be lower than 2018. IREIT remains an excellent stock to hold if you are only looking for dividends, as any DPU growth can be expected in 2022 and beyond. The stock has been trading with a dividend yield of 7-8% over the last few years.