Cromwell European REIT - DBS Research 2019-03-15: Expanding Its Boundaries

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CROMWELL EUROPEAN REIT (SGX:CNNU)

Cromwell European REIT - Expanding Its Boundaries

• Cromwell European REIT (SGX:CNNU) deepens presence in Netherlands, Italy and France and maiden entry into Finland and Poland. 
• Acquisition of 22 office and logistics properties for EUR377m on a net initial yield of 6.2-8.9%. 
• Impact from rights issue but acquisition to strengthen portfolio and accelerate medium-term growth. 
• FY18 results in line with expectations excluding impact of recent rights issue. 

Attractive yield on offer.

• We maintain our BUY call on Cromwell European REIT (SGX:CNNU) with a revised Target Price of EUR0.59.
• We continue to be bullish on Cromwell European REIT’s prospects, given an attractive 8.5% FY19F forward yield with further upside to our DPU estimates should Cromwell European REIT execute its previously announced asset recycling of disposing some of its smaller and lower-yielding properties into better quality properties.

Where We Differ: More positive than most.

• While most investors are generally cautious on Cromwell European REIT prospects given the more downbeat Eurozone macro outlook coupled with the overhang from the impact from a recent rights issue, we believe that the 16% correction in Cromwell European REIT’s share price will have reflected most of these negatives.
• With a recapitalised balance sheet, we see investors’ confidence returning over time as management set out to establish a track record of value accretive acquisitions to drive earnings and NAV.
• The portfolio WALE of 4.6 years coupled with a forward yield in excess of 8.0% offer comfort that dividends yields are relatively secured and as management delivers on its value enhancing acquisition strategy over time, we see a steady rise in Cromwell European REIT’s share price.

Delivery of acquisition benefits.

• We believe if Cromwell European REIT delivers a 17% y-o-y jump in DPU in 2019 as per our forecast, it will help demonstrate to investors the benefits from the recent acquisitions.
• In the longer term, the opportunity to reposition 10-hectare Park des Docks St Ouen (EUR 114m,6% of AUM) site into a mixed-use commercial site offer significant upside to distributions and NAV in the longer term.

Valuation:

• After incorporating the recent acquisition and rights issue, we lowered our DCF-based Target Price to EUR0.59 from EUR0.66.

Key Risks to Our View:

• The key risk to our view is lower-than-expected rental income, arising from loss of tenants or slower upturn in rents/inflation.

WHAT’S NEW - Why remain bullish

Our positive investment base for CERT

• We remain positive on Cromwell European REIT’s prospects over the year despite the correction in Cromwell European REIT’s share price in late 2018 (which has since partially recovered year to date due to strong equity market backdrop) and downward revisions to the economic outlook in Europe.
• We believe Cromwell European REIT’s long WALE of 4.6 years with in-built rental escalations should help smoothen any potential negative drag on rents in Cromwell European REIT’s key markets.
• We do not question the merits to Cromwell European REIT’s decision to acquire 22 properties in Netherlands, Finland, Poland, France and Italy, namely the diversification benefits and upside to income from driving an improvement in occupancy. However, we believe the 16% fall in Cromwell European REIT’s share price late last year was due to the market's disappointment over Cromwell European REIT’s maiden equity funding exercise being conducted via a rights issue.
• Looking ahead, Cromwell European REIT should benefit from the full-year contribution from the acquired buildings and the REIT's attractive 8.5% yield. We believe the majority of the disappointment has been priced in.
• Moreover, if Cromwell European REIT enacts its strategy of selling some of its smaller and lower-yielding properties and recycling the proceeds into higher-growth or higher-yielding properties, this should not only show investors the ability to realise its NAV but also accelerate its medium-term growth potential, which in our view should act as a re-acting catalyst.
• Thus, we reiterate our BUY call with a revised Target Price of EUR0.59.

Executes inorganic strategy

• On 30 October 2018, Cromwell European REIT announced the execution of its first large portfolio acquisition, after its maiden acquisition of Vodafone’s headquarters in Irvea, Italy for EUR16.9m on a net initial yield of 8.4% in June 2018.
• Cromwell European REIT proposed the purchase of 16 predominantly office properties in the Netherlands, Finland and Poland (“New Properties” portfolio) from a fund managed by its Sponsor for EUR312.6m and 6.2% net initial yield. This acquisition was subject to unitholder approval which was subsequently obtained.
• Concurrently, Cromwell European REIT also announced the acquisition of four logistic properties in France (French Properties) for EUR28.2m and on an 8.9% net initial yield, as well as two Italian office properties for EUR36.0m on a 7.4% net initial yield.
• These six properties were bought from a third-party vendor and thus, not subject to unitholder approval.
• To fund these acquisitions, Cromwell European REIT conducted a 38-for-100 rights issue (rights price of EUR0.373) raising gross proceeds of c.EUR224m.
• The acquisitions of the 22 office and logistics properties were completed over December 2018 and February 2019. Cromwell European REIT originally intended to acquire a DIY home improvement centre in France but owing to further due diligence on the property, it decided not to proceed with the purchase.

New Properties, Italian Properties and French Properties overview

• The “New Properties” portfolio consists of
  1. two office buildings in Utrecht and ‘s-Hertogenbosch, Netherlands (40.8% by purchase price),
  2. 11 office buildings in Helsinki and Kuopio, Finland (36.2%) and three office properties in Warsaw and Gdansk, Poland (23.0%)
• Total lettable area for the “New Properties” stands at 53,901 sqm with WALE of 4.7 years. Average occupancy stood at 84.5% as at 31 August 2018.
• The two office buildings in the “Italian properties” portfolio have a total lettable area of 27,211 sqm and are fully occupied. WALE as at 30 September 2018 was 5.0 years.
• The “French Properties” portfolio of four logistics properties has a total lettable area of 37,342 sqm and 100% occupancy.

Diversification benefits and acceleration of medium-term growth

• A key benefit from the proposed acquisitions is a further diversification of Cromwell European REIT’s portfolio. Post the acquisitions, Finland and Poland which are new markets for Cromwell European REIT will contribute 6.3% and 4.0% respectively to the enlarged portfolio by value. Meanwhile, contribution from Denmark, Italy, France and Germany will drop from 5.9%, 30.1%, 22.6% and 7.8% to 4.5%, 25.5%, 19.5%, 6.3% respectively. However, The Netherlands will remain the largest contributing country at 33.9%, up from 33.8% previously.
• Another benefit of this acquisition is to further accelerate Cromwell European REIT’s medium-term growth. Specifically, there is an opportunity to improve the “New Properties” net initial yield from 6.2% to 7.4% by driving an improvement in occupancy from the 84.5% level.
• Furthermore, the markets that Cromwell European REIT is expanding into offer stable, if not rising rents.

Potential investors' concerns over transaction

• With Cromwell European REIT’s move into Finland and Poland for the first time, some investors may be cautious on this exposure given the lack of familiarity with both countries.
• Furthermore, during the IPO process, Cromwell European REIT removed the Polish retail asset from the portfolio given concerns over exposure to a developing country as compared to the remainder of Cromwell European REIT’s portfolio which is focused on Western Europe.
• In addition, rents in the Warsaw office market in Poland have been under pressure and vacancy rates have been elevated due to an increase in supply.
• Nevertheless, we believe some of the concerns over Poland should be partially allayed by the fact that Poland has now been classified as a developed market in the FTSE Russell equity index. In addition, according to Cushman and Wakefield, as well as Cromwell European REIT’s own on-the-ground market research, due to healthy demand, the new supply is expected to be absorbed which should translate into higher rents especially in the central areas over the next 1-2 years.
• On Finland, based on Cushman and Wakefield's analysis, strengthening demand should result in higher market rents.

FY18 results in line with expectations

• Cromwell European REIT reported FY18 (1 January to 31 December 2018) DPU of 3.69 EURcts or after applying the rights adjustment factor DPU of 3.53 EURcts
• Stripping out the impact of the rights shares, FY18 DPU would have come in at c.4.3 EURcts which is in line with our original estimates before the announced acquisitions and rights issue in late 2018.
• The dilution to FY18 DPU was mainly on account of the additional shares from the rights issue in late 2018 and less than one month’s worth of earnings contribution from the acquisition of 15 properties with the completion of another seven properties to be completed over January to February 2019.
• Since its listing on 30 November 2017 to 31 December 2018, excluding the impact of the rights issue, Cromwell European REIT delivered a DPU of 4.70 EURcts which is 1.4% above IPO forecast. The ability to beat IPO projections was due to 1% higher revenue of EUR135.3m (slight higher rental income) and better cost control translating into better NPI margins of c.67% versus c.65% and 3.7% higher NPI of EUR90.2m. This should give investors’ confidence over Cromwell European REIT’s ability to drive its asset performance despite the disappointment over the impact the recent rights issue on its 2H18 DPU.
• For 2018, while occupancy for the office portfolio averaged around 96% versus IPO forecasts of c.97% (lower-than-expected occupancy for the Netherlands properties), occupancy for the light industrial/logistics largely tracked expectations. Nevertheless, overall portfolio occupancy had increased to c.91% by end- December 2018 from c.88% at listing in 2017.
• In early 2018, Cromwell European REIT generally reported healthy positive rental reversions. However, for leases that were renewed in 4Q18, Cromwell European REIT reported 15% and 2% declines in rents for the office and light industrial/logistics portfolios respectively. While this is disappointing, short-term volatility in rental reversions from quarter to quarter is to be expected.
• Following these renewals, around 10.7% and 7.2% of leases are set to expire in FY19 and FY20 respectively.

Drop in gearing post revaluation gains before rebounding, once remaining acquisitions are completed in 1Q19

• Following a modest EUR60.1m worth of revaluation gains (mainly due to higher income) and additional equity raised, Cromwell European REIT’s aggregate leverage fell to 33.0% from 34.9% as at end-September 2018 due to the impact from the equity raising. However, following the completion of the acquisition of another seven properties in January and February 2019, Cromwell European REIT’s aggregate leverage is expected to climb to c.35.6% which still provides the REIT with some debt headroom to pursue acquisitions.
• Meanwhile, Cromwell European REIT’s average cost of debt remains low at c.1.4% with the proportion of fixed rate debt expected to recover to 87.4% post the drawdown of new debt for the acquisitions in 1Q19. The proportion of fixed rate debt had dropped to 71.2% from 84.4% as at end-September 2018.
• Despite the revaluation gains, due to the impact of the recent rights issue, NAV per unit fell to 51.3 EURcts from 52.5 EURcts and 55.3 EURcts as at end-September 2018 and December 2017 respectively.

Reversion to DPU estimates and lowering of our Target Price to EUR0.59

• After incorporating the additional shares from the recent rights issue and acquisition of 22 properties, we lowered our FY19-20F DPU by 5-8% and cut our DCF-based Target Price to EUR0.59 from EUR0.66.
• Despite the downward revision to our DPU estimates, we still expect Cromwell European REIT to deliver a healthy 3-year DPU CAGR of 6.5% per annum.

Maintain BUY

• With 19% capital upside, we reiterate our BUY call with a revised Target Price of EUR0.59.
• We continue to like Cromwell European REIT for its attractive 8.5% forward yield and expected 6.5% 3-year DPU CAGR.

Mervin SONG CFA DBS Group Research | Derek TAN DBS Research | https://www.dbsvickers.com/ 2019-03-15

SGX Stock Analyst Report BUY MAINTAIN BUY 0.59 SAME 0.660