Cromwell European REIT - DBS Research 2018-04-10: European Delights

Cromwell European REIT - DBS Vickers 2018-04-10: European Delights

CROMWELL EUROPEAN REIT CNNU.SI

Cromwell European REIT - European Delights

First Pan-European S-REIT with a diversified portfolio of office, light industrial/logistics and retail properties.
Exposure to improving European economy and real estate markets with high yield spreads.
Sponsored by an experienced real estate manager with an extensive European real estate platform.
Initiating coverage with BUY and EUR0.63 Target Price .

Leveraged to an improving Europe.

Cromwell European Real Estate Investment Trust (CERT) is the first Singapore-listed REIT with a diversified Pan-European portfolio that offers investors a unique opportunity to invest in office, light industrial/logistics and retail assets located in Denmark, Germany, France, Italy, and the Netherlands.

With an improving European economy, CERT is well positioned to benefit from an uplift in rents. In addition, with European property yield spreads being above the historical 10-year average, CERT is poised to gain from increases in property values.

Long WALE with inbuilt organic growth.

With a weighted average lease expiry (WALE) of 4.9 years, CERT offers strong income visibility. With the majority of leases also linked to inflation or similar indices, the CERT has an inbuilt organic growth profile.

Upside from acquisitions.

Backed by Cromwell Property Group (CPG) which has a track record of over 15 years in Europe combined with “on the ground” presence in various European markets, in our view CREIT has the requisite support to identify DPU accretive acquisitions.
In addition, while there is a lack of familiarity with CPG by some investors, we believe ARA Asset Management a well-known real estate fund manager, taking a 19.5% interest in CPG should give investors confidence over CPG’s execution capability.

Initiate with BUY and Target Price of EUR0.63.

We initiate coverage with a BUY call and a Target Price of EUR0.63. We believe CERT offers an attractive combination of high yield of around 7.3%, strong cashflow visibility, and steady DPU growth outlook underpinned by embedded rental escalations.
In addition, CERT’s Sponsor has an established 15-year track record in Europe, which provides the REIT with the necessarily platform to identify and seek DPU-accretive opportunities.

DIVERSIFIED PAN-ENROPEAN PORTFOLIO

First S-REIT with Pan-European exposure

Cromwell European REIT (CERT) is the first Singapore-listed REIT with a Pan-European portfolio and offers a unique blend of properties spread across different countries and asset classes. Its initial portfolio comprises 74 properties located in Denmark, France, Germany, Italy and the Netherlands.
The portfolio also provides exposure to office and industrial/logistics as well as retail assets and government campuses. The initial portfolio’s total aggregate lettable area stands at approximately 1.1m sqm as at 30 April 2017.
The appraised value of the Initial Portfolio is approximately EUR1.35bn (approximately S$2.15bn) as at 30 April 2017 based on the aggregate of the higher of the two independent valuations for each of the Property conducted by Cushman & Wakefield and Colliers.

Geographically diversified portfolio.

The initial portfolio is geographically diversified across six countries, namely Denmark, France, Germany, Italy and the Netherlands.
To manage concentration risks, no single country accounts for more than 34.5% of the total appraised value of the initial Portfolio. The three largest countries by exposure are the Netherlands at 34.5% of the portfolio, Italy at 29.9% and France at 22.1%.

Properties strategically located in major gateway cities.

Another attribute of the initial portfolio is that the majority of its properties are concentrated or close to major European cities such as Amsterdam, Bari, Copenhagen, Florence, Frankfurt, The Hague, Hamburg, Milan, Munich, Paris, Rome, Rotterdam, and Stuttgart. These cities account for approximately 88% of total Appraised Value.
Furthermore, CERT’s properties are typically close to or have ready access to good transport connectivity and public transportation.

Spread over two major assets classes.

The initial portfolio is also spread across two major asset classes. Office is the largest segment at 47.4% of the initial portfolio by appraised value, followed by light industrial/logistics at 42.1%.
CERT also has exposure to government campuses, a retail asset and a hotel which in total represents 10.5% of the initial portfolio as at 30 April 2017. This varied exposure in our view provides some protection from any major downturn in any asset class in any particular country.

Office portfolio in Italy and the Netherlands.

The initial portfolio’s office exposure is largely focused on quality office buildings located in the central business districts and city fringe locations of major and regional cities in Italy and the Netherlands. Key locations include Amsterdam, Rotterdam and The Hague in the Netherlands as well as Milan and Rome in Italy. These markets according to Cushman & Wakefield have favourable demand and supply dynamics, namely rising demand but limited new inventory.

Light industrial/logistics properties across Europe.

CERT’s exposure to the light industrial/logistics segment is dominated by properties located in industrial parks and/or within proximity to key urban industrial locations across Europe. The key markets CERT has targeted for its initial portfolio include Denmark, France, Germany, Italy and the Netherlands have limited new supply.

Predominantly freehold, perpetual or continuing leasehold assets.

In our view, another key attractive attribute is that 88% of the initial portfolio by total appraised value comprises of either freehold land or ongoing leasehold land, which is classified as Continuing Leasehold or Perpetual Leasehold.
In our view, this compares favourably to other S-REIT’s who typically hold Singapore properties which have a leasehold tenure of up to 99 years.

Healthy occupancy levels but upside remains.

The initial portfolio’s occupancy remains at a healthy level standing at 87.7% as at 30 April 2017. However, with improving real estate fundamentals across the initial portfolio’s key markets, as well as active asset management initiatives to be undertaken by the Manager, with the support of the Sponsor, there remains potential to drive vacancy rates lower. To that end, we expect overall portfolio occupancy to increase to 92.6% by FY19 from the initial 87.7% level.

Good cashflow visibility with long WALE and well staggered lease profile.

We believe the initial portfolio provides investors with good cashflow visibility owing to its long weighted average lease expiry by headline rent based on the next permissible break date at the tenant’s election (WALE) and weighted average lease expiry by headline rent based on the final termination date of the lease agreement (WALT) of 4.9 and 5.8 years respectively.
This is further underpinned by having a well staggered lease expiry profile, with no more than 12.4% of leases (by WALE) expiring in each year up to FY21.

Low tenant concentration risks with diversified trade sector mix.

Income stability is also attributed to a low tenant concentration risk with over 700 leases spread across various trade sectors and locations. No trade sector and tenant makes up no more than 24.6% and 19.9% of total headline rent as at 30 April 2017 respectively. The top ten tenants represent only 44.2% of the initial portfolio’s total headline rent.
In addition, no property makes up for more than 11.7% of the initial portfolio by value as at 30 April 2017, with the top ten properties contributing 57.3% by value.

Exposure to the improving European real estate market

Improving macro fundamentals and growth outlook in Europe.

Cromwell European REIT (CERT)’s initial portfolio is well-positioned to leverage on the improving European economy and real estate markets.
Based on Cushman & Wakefield, real GDP growth in the Eurozone area has shown positive momentum in the past three fiscal years. This is evidenced by the 2.5% GDP growth in the Eurozone in 2017, up from 1.7% in 2016. Furthermore, unemployment in the Eurozone area has fallen over the last three years to its lowest level since 2009 and in their view has further headroom for improvement.
Underpinning the Eurozone’s economic recovery is the improving financial position of corporates and households. This should help drive further increases in household consumption, investment, and industrial production activity in the Eurozone from 2017 to 2020 which should be supported by improving business sentiment, strong recovery in credit growth and growth in employment and real earnings. These factors also contribute to expectations by Cushman & Wakefield that the GDP growth for CERT’s key markets are expected to be higher over the next five years compared to the preceding five-year period.

Rising rents across various asset classes in Europe.

On the back of projections of improving macroeconomic conditions in Europe, based on Cushman & Wakefield’s demand and supply analysis, rents across CERT’s key asset classes of office, light industrial and retail are projected to steadily increase over the coming few years. This should be supportive of the REIT achieving higher income going forward.

Attractive yield spreads relative to historical levels.

Beyond expectations of rising rents, European real estate as an asset class is an attractive investment opportunity based on property yield spreads. According to Cushman & Wakefield, the differential between European real estate yields to long-term government bonds and average borrowing costs are near alltime highs and well above the historical 10-year average.
Furthermore, the wide yield spreads should provide a buffer against any potential increase in interest rates. In addition, current European real estate yield spread at 4.3% compares favourably with other developed market countries such as the US, Singapore, and Hong Kong which stand at 3.3%, 1.8% and 0.8% respectively.

The initial portfolio is, and future properties will be, located in Denmark, France, Germany, Italy, and the Netherlands. As a result, Cromwell European REIT (CERT)’s Gross Revenue and results of operations depend upon the performance of the Denmark, France, Germany, Italy and the Netherlands economies. An economic decline in Denmark, France, Germany, Italy and the Netherlands, or the impact of a downturn in the overall national economy in which the relevant property is located could adversely affect CERT’s operations and future growth.

Interest rates risk.

In the event that benchmark interest rates increase over time, CERT might face higher borrowing costs which will have a negative impact on distributions. However, we understand approximately 75.0% to 85.0% of the aggregate amount under the Asset Financing Facilities will be on a fixed interest rate basis via interest rate hedging while the remainder will be on a floating interest rate basis with no interest rate hedging.

Risk of non-renewal and non-replacement of key tenants in the initial portfolio.

CERT’s financial condition and results of operations and capital growth may be adversely affected by the bankruptcy, insolvency or downturn in the businesses of one or more of the anchor tenants or a significant number of tenants of any of the Properties, as well as the decision by one or more of these tenants not to renew its lease or to terminate its lease before it expires. As at 30 April 2017, the top 10 tenants of the initial portfolio contributed 44.2% of the total headline rent of CERT. As such, if a major tenant or a significant number of tenants terminate their leases or do not renew their leases at expiry, CERT’s financial condition, results of operations and capital growth may be adversely affected.
In addition, while some of the headline lease periods for some of the REIT’s leases appear long, the tenants have the option to vacate their properties before the expiry of the lease term. Nevertheless, the weighted average lease expiry by the next permissible break date at the tenant’s election is still long at 4.9 years, only slightly shorter than the weighted average lease expiry by headline rent based on the final termination date of the agreement (WALT) of 5.8 years.

Foreign currency risks.

While the majority of the REIT’s income and expenses are mainly denominated in Euros, income and expenses for its Danish properties are denominated in the Danish Krone. Nevertheless, exposure to Denmark is small at around 5% of overall group net property income (NPI). In addition, investors who receive distributions in SGD are exposed to the SGD/EUR FX rate.

Properties might require significant capital expenditures beyond the Manager’s estimates.

Some of the properties in the initial portfolio are more than 10 to 15 years old. In order for the properties to remain competitive and relevant, CERT may require periodic capital expenditures beyond the Manager’s estimates at the time of acquisition for refurbishment, renovation for improvements and development.

Regulatory risks.

Any changes in regulations or government actions may negatively impact the REIT. For example, seven of the REIT’s Italian assets face the potential for a cut in rents in the medium term once the existing leases expire, given the Italian government’s previous decree to cut rents it pays for properties by 15%.
In addition, part of Parc Des Docks, one of the REIT’s top 10 properties, located in Paris, may be acquired by the French government at the end of 2019 for the construction of a hospital and medical university. We understand the French government is likely to pay market value for the acquired land. However, to protect the interest of unitholders, while the expropriate area is valued at EUR64m, the REIT will only pay EUR52m upfront and will pay up to an additional EUR12m subject to the final compensation from the French government and costs associated with providing rent free for tenants during the expropriation period.

SWOT ANALYSIS

Our SWOT analysis of Cromwell European REIT (CERT) is as follows:

Strengths

Exposure to improving European markets. CERT offers exposure to the improving European markets. In particular, its assets are leveraged to rising consumption, investment and production trends in Denmark, France, Germany, Italy, and the Netherlands which could potentially translate to higher rents.
Stable income from a diversified portfolio with long WALE. CERT has a stable income largely due to a portfolio that is diversified across six countries and different asset classes (office, light industrial/logistics and retail). In addition, strong cashflow visibility is underpinned by having a
1. weighted average lease expiry (WALE) by headline rent based on the next permissible break date at the tenant’s election of 4.9 years, and
2. weighted average lease expiry by headline rent based on the final termination date of the agreement (WALT) of 5.8 years.
Embedded organic growth. With the majority of CERT’s leases inflation linked, this provides for a steady increase in income over the medium term.
Predominantly freehold or ongoing leasehold land. Of the total appraised value of the initial portfolio, c.88% comprises of either freehold land, or ongoing leasehold land, which is classified as continuing leasehold or perpetual leasehold. In our view, this compares favourably to other listed S-REITs which hold predominantly leasehold properties.
Strong Sponsor in Cromwell Property Group. The REIT’s Sponsor, Cromwell Property Group, is an experienced global real estate manager with assets under management (AUM) of c.A$10.1bn. Combined with its over 15-year track record in Europe with AUM of c.EUR4.0bn, the REIT is well placed to benefit from its Sponsor’s experience and expertise.

Weaknesses

Low inflation historically. While CERT’s leases are typically pegged to inflation which provides a steady increase in rents, over the past few years, inflation in various European countries have been low or negative. While we understand CERT’s rents do not allow for negative inflation adjustments, should inflation be at very low levels, excluding any improvement in occupancy, asset enhance initiatives or acquisitions, the growth outlook for the REIT may be limited.
Potential for structural vacancy in some light industrial properties. Some of CERT’s light industrial properties may potentially have some structural vacancy due to the fact that the percentage of office space available in the properties are higher than the ideal 20% level which makes them harder to be leased, due to the lack of demand.

Opportunities

Upside in occupancy. CERT’s occupancy as at 30 April 2017 stood at 87.7%. Through active management of the portfolio, there is an opportunity to reduce vacancy and increase the REIT’s income over time to 92.6% by FY19F.
Asset enhancement initiatives. In the medium term, there is potential to rejunevate and refurbish CERT’s properties which would enhance the REIT’s income. In addition, there is a possible change in use for some CERT’s properties that are located near or within residential areas which will provide additional upside.
Upside from deploying balance sheet. CERT has an initial gearing of 36.8%. This provides debt headroom for future acquisitions including third party properties which will boost CERT’s DPU in the medium term.

Threats

Rise in capital values could result in unfavourable acquisition prices for CERT. As demand for high quality assets increases, CERT could face stiffening competition for its targeted assets in Europe, resulting in higher capital values and inability to complete acquisitions due to the risk of DPU dilution.
Changes in regulatory environment. Any changes in regulations may negatively impact the REIT. For example, several of CERT’s Italian assets face the potential of a cut in rents in the medium term once the existing leases expire, given the Italian government’s previous decree to cut rents it pays for properties by 15%.

FEE STRUCTURE

Asset management fees below peers but property management fees at the upper end of the range.

The REIT Manager of Cromwell European REIT (CERT) will take 0.23% p.a. of the value of deposited properties as base management fees and 25% p.a. of the change in y-o-y DPUs as performance fees.
In our view, even though the total asset management fee is lower than the peer average of approximately 0.44%, the REIT’s property management fee is on the high side. The REIT pays its property manager 0.67% p.a. of deposited properties, which is higher than our estimate of the peer average of 0.33%. The sum of asset management and property management fees for CERT is around 0.93% which is higher than our estimated peer average of 0.77%.

100% of fees in units.

The REIT Manager has elected to receive 100% of the base management fee and performance fee in units for FY17F-FY19F. No Performance Fee is payable for FY17.

VALUATION

Discounted Cash Flow Method (DCF)

Cromwell European REIT (CERT) generates stable income from its long leases, with portfolio WALE averaging 4.9 years (by headline rent based on the next permissible break date at the tenant’s election). As such, discounting its cashflows is an appropriate valuation method.
Given CERT’s diversified European exposure, our DCF analysis has factored in a normalised Eurozone risk free rate of 1%, European market return of 10%, beta of 0.71x (based on weighted average of European REITs/companies with comparable sector and geographic exposure to CERT), cost of debt of 2.5% and cost of equity of 7.4% and 38.0% target gearing. This translates to a WACC of 5.5%.
Coupled with a terminal growth rate of 1.5%, we derived a DCF based-Target Price of EUR0.63 per unit.
Based on our FY18F and FY19F DPU, this translates to a target FY18F and FY19F yield of 6.8% and 7.0% respectively.

Trading yield of peers supportive of CERT’s yield compression

Based on our DCF-based Target Price of EUR0.63, we expect CERT’s FY18F yield to compress from 7.3% to 6.8%. We believe this is achievable as the yield based on a constructed REIT with similar asset class and geographical exposure to CERT and using the trading yield of peers is at c.6.5%. This hypothetical REIT with a 6.5% yield is based on the funds from operations (FFO) yield of its peers given European REITs typically do not have a 100% payout ratio as compared to CERT which intends to pays out 100% of its cashflows at least for the next two years.
For CERT’s office exposure in the Netherlands and Italy, we believe NSI N.V. and Beni Stabili are the closest comparable European REITs given they predominantly hold office assets in the Netherlands and Italy.
NSI and Beni Stabili, trade on a FY18 FFO yield of 7.7% and 6.1% respectively. However, we note NSI and Beni Stabili have a higher gearing than CERT. CERT’s industrial exposure is most similar to
1. Hansteen – before the sale of assets in Germany and the Netherlands, and
2. Warehouses De Pauw.
Given there are no consensus FFO forecasts for Hansteen and Warehouses De Pauw, using consensus dividend yield forecast and assuming a 80% payout ratio, we estimate a FFO yield of 5.9% and 5.7% respectively. We have also pegged CERT’s Italian retail assets to Euro-commercial Properties which trades on a forward FFO yield of 6.9%. Meanwhile, for CERT’s exposure to the Italian government’s campus assets, given potential risk of a 15% cut in rents in the medium term for some of the assets, we conservatively pegged the yield at 7.1% (we grossed up Beni Stabili’s yield by 15%).
Some investors may compare CERT with IREIT which has a high forward yield of 7.5%. However, we believe IREIT is not a valid comparison given its smaller size and concentrated portfolio. Furthermore, we understand IREIT is seeking to expand its portfolio which is likely to result in capital raising and dilution to its current yield.

Mervin SONG CFA DBS Vickers | Derek TAN DBS Vickers | http://www.dbsvickers.com/ 2018-04-10

DBS Vickers SGX Stock Analyst Report BUY Initiate BUY 0.63 Same 0.63

Cromwell European REIT - DBS Research 2018-04-10: European Delights

Cromwell European REIT - European Delights

Leveraged to an improving Europe.

Long WALE with inbuilt organic growth.

Upside from acquisitions.

Initiate with BUY and Target Price of EUR0.63.

DIVERSIFIED PAN-ENROPEAN PORTFOLIO

First S-REIT with Pan-European exposure

Geographically diversified portfolio.

Properties strategically located in major gateway cities.

Spread over two major assets classes.

Office portfolio in Italy and the Netherlands.

Light industrial/logistics properties across Europe.

Predominantly freehold, perpetual or continuing leasehold assets.

Healthy occupancy levels but upside remains.

Good cashflow visibility with long WALE and well staggered lease profile.

Low tenant concentration risks with diversified trade sector mix.

Exposure to the improving European real estate market

Improving macro fundamentals and growth outlook in Europe.

Rising rents across various asset classes in Europe.

Attractive yield spreads relative to historical levels.

Sponsored by an Experienced Global Real Estate Manager with an Extensive European Platform

Sponsor – Cromwell Property Group.

Established European track record and “on-the-ground” presence.

Potential partnership with ARA Asset Management.

Alignment of interest with c.34% Sponsor stake.

No ROFR pipeline but liquid European property market provides a bounty of acquisition opportunities.

Exposure to improving European markets.

Attractive European property yield spreads.

Predominantly freehold or ongoing leasehold properties.

Sponsored by an experienced global real estate manager with an extensive European platform.

Long dated lease expiry profile with diversified and high quality tenant base.

Embedded rental escalations.

KEY RISKS

Country-related risks.

Interest rates risk.

Risk of non-renewal and non-replacement of key tenants in the initial portfolio.

Foreign currency risks.

Properties might require significant capital expenditures beyond the Manager’s estimates.

Regulatory risks.

SWOT ANALYSIS

Strengths

Weaknesses

Opportunities

Threats

FEE STRUCTURE

Asset management fees below peers but property management fees at the upper end of the range.

100% of fees in units.

VALUATION

Discounted Cash Flow Method (DCF)

Trading yield of peers supportive of CERT’s yield compression

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