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A few months ago, I’ve analyzed Vonovia (OTCPK:VONOY) and have recommended it as a good income play due to its attractive and sustainable dividend yield. Since then, there have been some good and bad developments for the company and the real estate industry in Germany, but Vonovia remains an interesting income play within the European real estate sector.
Vonovia is the largest residential real estate company in Germany, which has benefited strongly from a supportive market backdrop in the past few years. Property values and rent prices have risen steadily throughout the country during the past decade, leading to higher revenues and profits for landlords.
On the other hand, the tight supply-demand situation in the German residential market has led to higher housing costs for tenants, making housing much less affordable for lower income households than a few years ago. This is an issue in especially major cities, of which Berlin was one of the German cities with higher rising rent costs.
Due to this situation, on 30 August the Senate of Berlin published a proposal for a five-year rent freeze in this city. The law permits annual rent increases of 1.3% beginning one year after the law entering into effect, with rent ceilings based on the age of the property but independent of location within Berlin.
This means that rents can increase to a certain extent, provided that such increase do not cause rents to exceed the relevant ceiling. For landlords, this proposed law is negative because it will restrict future rent growth, limiting the future like-for-like rental income growth for the properties in Berlin. Note that rent growth was around 4% year-on-year in 2018, thus this new law can have a considerable impact on rental income growth in the coming years.
Even though Vonovia is the largest listed landlord in the German residential sector, its competitor Deutsche Wohnen (OTCPK:DTCWY) is the company most affected by rent freezes in Berlin because it has the largest residential real estate exposure in Berlin. Indeed, some 77% of its properties are located in Greater Berlin, while other players with exposure to the city are Covivio (OTC:FNCDY), with a weight of 28% of the company’s property value, and Grand City Properties (OTC:GRDDY), with some 21% of its portfolio in Berlin.
Vonovia’s property portfolio in Berlin only represents 17% of its total value, being therefore less exposed to rent freezes than some of its peers. Nevertheless, Vonovia’s rental income growth was 4.4% in 2018, thus this new regulation is expected to have a negative impact on future growth, given that rental income growth will decrease.
Another risk is that other federal states may follow the Berlin example, depending on past rent increases and political motivations in each state. This risk is higher in states with similar government coalitions as in Berlin, but the company’s diverse location of units enables it to mitigate the negative impact of the regulation. Indeed, more than 80% of Vonovia’s portfolio is expected to be unaffected by Berlin and other potential states rent freezes, as can be seen in the next graph.
The Senate of Berlin is expected to publish a final draft of the law by mid-October and potentially the law will enter into effect in the beginning of 2020. There is also the possibility that the Federal Constitutional Court to rule the Berlin legislation as unconstitutional, like Vonovia expects, but a decision will certainly take some time.
This has led to some negative sentiment towards German residential real estate companies, but Vonovia doesn’t seem to be much affected by this issue and therefore it should continue to report strong fundamentals in the near future despite regulatory headwinds in some of its markets.
Since my last article on Vonovia, the company has reported its earnings related to the first half of 2019, maintaining a very good operating performance with all of its four operating segments reporting revenue growth compared to the first half of 2018.
Vonovia’s rental income (its major source of revenue) increased to more than €1 billion ($1.10 billion), representing an increase of 13.9% year-on-year (yoy). This was driven by acquisitions and organic rental growth and the company is well positioned to keep strong top-line growth in the next few years due to its diversified housing portfolio, its strategy of expanding additional income streams and the internationalization of its business.
The company’s profits also increased markedly, both measured by its EBITDA (+22% yoy) and FFO (+13%), showing improved operational efficiency and its push to value-add business (services to internal and external tenants) that is highly complementary to its property portfolio.
Vonovia’s net asset value (NAV) increased by 5.8% in the first six months of 2019, while its balance sheet remains strong with a loan-to-value (LTV) ratio of about 40%. This LTV ratio is at the lower end of its target range (40-45%), which means that Vonovia has room to continue to grow by acquisitions without increasing its balance sheet leverage beyond its desired level in the short-term.
Most likely the company will continue to invest outside of Germany, which currently accounts for some 11% of its property portfolio (Austria represents 6% and Sweden 5%). Vonovia considers that France has good long-term potential and is also open for opportunities in the Netherlands, thus the weight of other countries in its portfolio is expected to increase in the future even though Germany should remain the dominant market in the foreseeable future.
Regarding its guidance for the full year 2019, Vonovia confirmed earlier projections and still expects strong growth in rental income and higher EBITDA compared to the previous year. Indeed, it expects adjusted EBITDA to rise by more than 20% and free funds from operations (FFO) by at least 6% in the second-half of 2019 compared to the same period of 2018.
This is largely justified by Vonovia’s strategy of diversifying its revenue streams beyond rental income which continues to increase the contribution to the company’s overall EBITDA and FFO. Its FFO per share is projected to be between €2.15-2.24, while its dividend should be around 70% of group FFO. This means that Vonovia’s dividend should be around €1.51-1.57 per share, which means that Vonovia at its current share price offers a forward dividend yield of about 3.6-3.75%.
Vonovia is an attractive income play within the European residential real estate sector and recent developments in the industry and earnings from the company didn’t change its investment case.
Indeed, Vonovia’s dividend yield is higher than compared to its closest competitor Deutsche Wohnen, while the company is much less exposed to the potential rent freeze in Berlin which is leading to negative sentiment towards the sector. This creates a good buy opportunity for long-term investors as Vonovia’s valuation below NAV doesn’t seem to reflect the company’s strong fundamentals.
Disclosure: I am/we are long VONOY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.