Wereldhave: Residential Gains To Drive Returns As Rising Rates Offset Rent Indexation

Summary

• Wereldhave marginally boosted outlook for direct result to 1.55-1.65 EUR/share on the back of higher indexation and leasing activity.
• I estimate that should the ECB raise rates by 150-200 bps, higher funding costs should largely offset 2% rent indexation.
• By 2027 direct result per share may drop as low as 1.27 EUR/share absent indexation or rise to 1.84 EUR/share absent higher interest rates.
• My base case is that direct result per share remains largely flat in the coming years, with residential gains and property revaluations driving returns.
• 88% of the debt is with a fixed percentage which coupled with gradual ECB hikes may delay the full impact of higher rates.

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Investment Thesis

I think Wereldhave (OTCPK:WRDEF) still offers decent medium-term potential of circa 10% annually for the next 3-4 years given still attractive valuation with a market-implied yield of about 6.7%, some rent indexation in the years to come, and residential gains (1.6-1.85 EUR/share) to be booked starting in 2023. However, it should be noted that once residential gains dry up, investors will be left with rents and indexation alone, which may fail to keep up with inflation given online retail headwinds. Nevertheless, I think the stock is an excellent place for the real estate portion of the portfolio despite strong year-to-date performance (+39%), which admittedly has diminished the remaining upside potential. A better short-term way to gain exposure may be via Wereldhave Belgium which trades at a market-implied yield of about 7% and a very low debt ratio of 27.3% versus Wereldhave's 40.3%.

Company Overview

Wereldhave operates 11 shopping centers in the Netherlands, ten centers and offices in Belgium (through a 65.9% stake in Wereldhave Belgium), and 2 centers in France:

Portfolio breakdown (Wereldhave Annual Report)

Operational Overview

Despite a drop in occupancy from 94.9% to 94%, management marginally raised guidance for direct result per share (DRPS) to 1.55-1.65 EUR/share on the back of higher indexation and good leasing activity. The other main takeaway is that for current redevelopment projects to be completed in 2022, construction costs are already locked in. However, I think further transformations would have to be reevaluated in light of the potential sale proceeds from the sale of the last 2 French assets, achievable yields on cost given higher construction costs and possibly higher rent levels, as well as market-implied yields the company is trading at.

Wereldhave as an inflation hedge

I think one way to benefit from an inflationary environment is to buy an asset that benefits from inflation, and at the same time finance a portion of your purchase with debt. In the ideal scenario, the asset's value grows in time while the service of the debt remains manageable. I think Wereldhave, with its focus on daily shopping and mixed use, is in a good position to raise rents in line with inflation while the debt level remains in check. Other unique contributing features include the stock being the second most shorted in the Netherlands (7.8% short interest) and a still depressed valuation level of the whole retail REIT sector coming out of the pandemic. Last but not least, Belgium and France can be classified as medium-risk jurisdictions and the Netherlands as a low-risk jurisdiction, at least as far as funding costs are concerned.

Market-implied Net Initial Yield Valuation

To calculate the market-implied net initial yield, I will take the EPRA Net Disposal Value (NDV) which stood at 22.08 EUR/share in Q1 2022:

Market-implied net initial yield = Valuation net initial yield / Division factor where:

Division factor = Price/NDV Ratio * ( 1 - Loan-to-value ratio) + Loan-to-value ratio

with the Q1 2022 parameters, namely:

1. EPRA NDV = 22.08 EUR

2. Loan-to-value = 40.3%

3. Valuation net initial yield = 6%

4. Closing price at the time of writing = 17.83 EUR

You get a P/NDV Ratio of 17.83 / 22.08 = 0.81, a division factor of 0.89 (0.81 * (1-0.403) + 0.403 ) and a market-implied net initial yield of roughly 6.78%.

For comparison, Klepierre (OTCPK:KLPEF) stood around 5.83%, Unibail-Rodamco-Westfield (OTCPK:UNBLF) delivers circa 5.4%, and Wereldhave Belgium was around 7.06%.

Valuation based on current cash flow forecasts

Despite the small outlook bump, Wereldhave is trading around 11.1 times its new 1.6 EUR/share midpoint management target. Unibail-Rodamco-Westfield remains the most attractive in terms of current cash flow multiple, at just 8.4 times its 8.2-8.4 EUR/share forecast as investors await details on US asset sales. Klepierre comes in at about 9.85 times its 2.3-2.35 EUR/share management forecast.

Impact of rising rates

Although there is a high likelihood COVID-19 makes a limited comeback next winter, I think the main medium-term risk for Wereldhave will be the normalization of ECB policy. The current consensus is that the ECB raises the rate on the deposit facility to about 1-1.5% or a move of about 150-200 bps. If we assume a parallel shift in Wereldhave's cost of debt, cost of interest in EUR should rise to about 3.5-4% from the 2% at the end of 2021:

Cost of interest (Wereldhave 2021 annual report)

I think Wereldhave is shifting funding to primarily EUR to reflect its pure European exposure. Thus, I will only focus on the ECB as my assumption is the foreign exchange debt will be rolled to EUR as it matures in the coming years.

Wereldhave ended Q1 2022 with a net debt of 782.8M EUR, which I think is the long-term neutral position since the company will have to use Q2-Q4 2022 earnings to cover the 1.1 EUR/share dividend.

The good news is that 88% of the debt was with a fixed rate as of the end of 2021. However, some 72% of the debt is due between 2022 and 2026, hence a good portion of it will have to be rolled at higher rates each year.

Below I will analyze the impact on direct result per share (DRPS) from a gradual shift to a 3.5-4% cost of debt over the next 6 years. To reflect the gradual roll in of higher rates, I will assume only about 15% of the debt is refinanced year each, with a 25% final refinancing in 2027:

Year \ DRPS	2.3% current cost of debt	3.5% cost of debt	4% cost of debt
2022	1.6 EUR	1.57 EUR	1.55 EUR
2023	1.6 EUR	1.53 EUR	1.5 EUR
2024	1.6 EUR	1.5 EUR	1.45 EUR
2025	1.6 EUR	1.46 EUR	1.4 EUR
2026	1.6 EUR	1.43 EUR	1.35 EUR
2027	1.6 EUR	1.37 EUR	1.27 EUR

Scenario analysis with no rent indexation

As you can see from the table above, a gradual shift to a 3.5% cost of debt from the current 2.3% would have a total impact on DRPS of 0.23 EUR/share. Likewise, a shift to 4% would impact DRPS by 0.33 EUR/share.

Indexation to the rescue

The silver lining is that if the cost of debt does rise to 3.5-4%, it will likely be accompanied by 1-2% inflation. With the caveat that online retail will continue to pose challenges and Wereldhave may not be able to fully index rates in line with inflation, I will explore the scenario in which Wereldhave is able to index rents by 2% in the period 2023-2027:

Year \ DRPS	2.3% current cost of debt	3.5% cost of debt	4% cost of debt
2022	1.6 EUR	1.57 EUR	1.55 EUR
2023	1.65 EUR	1.58 EUR	1.55 EUR
2024	1.7 EUR	1.59 EUR	1.55 EUR
2025	1.74 EUR	1.60 EUR	1.55 EUR
2026	1.79 EUR	1.62 EUR	1.55 EUR
2027	1.84 EUR	1.61 EUR	1.52 EUR

Scenario analysis with 2% rent indexation

Looking at the table above, we observe that indexation and gradual rise in cost of debt to 3.5% neutralize each other until 2027. However, a rise in funding costs to 4% would outstrip indexation benefits and DRPS would be marginally lower in 2027.

Last but not least, I think property values will partially rise in line with inflation which should give a boost to total returns. Alternatively, in the very unlikely scenario that no positive property revaluations are recorded until 2027 in the presence of 2% inflation annually, the net initial yield used for valuation would be about 6.6% as compared to 6% today.

The Bottom Line

Wereldhave remains attractively valued despite strong year-to-date price performance. An attractive marked-implied yield, indexation, residential gains and potential property revaluation gains, especially in the Netherlands, should help offset the cost of higher rates and a loss on the sale of the final French assets. While a peaceful resolution of the Ukraine conflict will likely reduce investors' interest for defensive stocks such as Wereldhave, I think there is still some upside left in the company. Personally, I will continue to roll my options position.

Disclosure: I/we have a beneficial long position in the shares of WRDEF either through stock ownership, options, or other derivatives. 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.