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European S-REITs: Odyssey with different challenges and opportunities

Goola Warden
Goola Warden • 11 min read
European S-REITs: Odyssey with  different challenges and opportunities
CEREIT outperforms IREIT in both price and operations following CEREIT's recycling strategy vs IREIT's acquisition strategy
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Following Manulife US REIT’s recapitalisation plan that was voted through in December 2023, Singapore now seems “the place to be” compared to US-focused S-REITs for investors. 

How about Europe? Two European S-REITs — IREIT Global UD1U -

, which was listed in 2014 at 88 Singapore cents, and Cromwell European REIT (CEREIT), listed in 2017 at EUR0.55 — are still trading and reporting distributions per unit (DPU), albeit lower y-o-y. Of the two, CEREIT has performed better by a mile, in large part because it has stopped asking unitholders for more money, preferring instead to recycle properties. Although down 5.7% over one year, it is up around 4.9% this year. 

IREIT, on the other hand, has fallen by 15% since the start of the year and has lost 29% over one year. IREIT had an equity fundraising each in July 2023 and July 2021. The FTSE REIT Index is down 11.1% y-o-y and down 8% this year-to-date.

Despite being S-REITs with European assets, the two REITs have different challenges and opportunities. Their portfolios are also in different parts of the property cycle. Moreover, Europe, while less diversified in terms of economic cycles than Asean, is made up of different countries at different stages of economic development. 

IREIT is committed to “western Europe” and its properties are located in Germany, Spain and France. Its sponsors are Tikehau Capital and City Developments (CDL), both of which have supported the REIT in capital raising. That has helped support IREIT’s cost of capital. Despite a poor showing in its FY2023 DPU, which collapsed by 30.5% to 1.87 euro cents, its historic DPU yield is 7.8%. However, units in IREIT are trading at a P/NAV of 0.56 times.  

The DPU decline was caused by two reasons. Units in issue rose to 1,344.8 million as at end-FY2023 compared to 1,155.9 million units as at end-FY2022. During the year, IREIT acquired the 17 properties anchored by B&M (B&M portfolio) which were subject to an EGM. The B&M portfolio was added to IREIT in September 2023, and IREIT will experience the full impact of the additional net property  income (NPI) this year. 

See also: Unearthing value in property stocks and REITs

A Tikehau fund owned a stake in the B&M portfolio. As a result, Tikehau Capital and CDL abstained from voting. In addition, both sponsors gave an undertaking to take up the pro-rata share of an equity fundraising exercise, and CDL announced it would take up excess units in the preferential offering up to a maximum of $40 million of new preferential units. 

As it is, the preferential offer was oversubscribed. 

Reducing concentration risk 

See also: Asset disposals ‘worth the wait’, even with penalty fee: MUST chairman

The second reason that DPU declined goes back to the way the portfolio was structured at IPO back in 2014, with four campus-style properties where Deutsche Telekom was the main tenant, contributing some 79% to gross rental income (GRI), giving rise to significant concentration risk.

At the time, the major unitholders of IREIT were Tong Jinquan with 45% and Lim Chap Huat. The latter is also the major shareholder of Soilbuild Group, which was once the sponsor for Soilbuild Business Space REIT (eventually privatised). They have largely exited IREIT.  

Deutsche Telekom vacated the Darmstadt Campus in December 2022 and it was empty till a new federal tenant entered in August 2023, taking up 7,600 sq m. IREIT’s manager is having discussions with a few potential tenants for new leases totalling 7,000 sq m. Deutsche Telekom also exited the Munster Building. However, IREIT’s manager has signed a 10-year lease with a major mobile roof antenna provider. 

“The strategy is to continue diversifying the portfolio because that’s where we see the strengths, to have recurring income over the years, while at the same time working on repositioning the portfolio,” says Louis d’Estienne d’Orves, CEO of IREIT’s manager.  

As IREIT’s long leases with Deutsche Telekom and Deutsche Rentenversicherung Bund or DRB (a pension fund) run down, d’Estienne d’Orves and his team are reinvesting in buildings like the Munster and Berlin Campuses to enhance the yield. 

For the Berlin Campus, DRB is the main tenant, and it is vacating this year. The refurbishment was planned well ahead of the potential departure of the main tenant and it should provide long-term income and value upside but would have a near-term impact on earnings during the refurbishment period, according to d’Estienne d’Orves.

CEREIT’s manager steadies the portfolio 

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CEREIT’s manager has also spent time and money to reposition its portfolio since the IPO. When CEREIT was listed in 2017, its portfolio comprised 47% of office by value, and 43% light industrial and warehouses, with others at 10%. As at end-December 2023, light industrial had overtaken office at 51% of value compared to 45% office, with others shrinking to low single digits. 

Since its IPO, CEREIT has had two placements, in 2019 and 2021, for acquisitions. Since then, it has relied on asset sales to reconstitute its portfolio. CEREIT’s manager has a planned asset sale programme to fund redevelopments and to keep aggregate leverage within the 35% to 40% range. Since FY2022, CEREIT’s manager has announced EUR237 million ($346.8 million) from eight divestments at a blended 14.6% premium to valuation. The REIT’s manager plans to divest a further EUR170 million in the next two years. 

In a recent interview, Simon Garing, CEO of CEREIT’s manager, says: “We have … reduced debt and brought our gearing to lower levels in contrast to other REITs. We will continue to reduce our debt and we have a development pipeline. Our belief is we have very well-located, older assets that can be rejuvenated to achieve higher rents and deliver consistent returns.” 

Investors are aware that income growth can drive prices higher, Garing says.  He believes that e-commerce and supply chain onshoring will continue to drive demand for warehouse space. “And we will continue to pivot to logistics,” he adds. 

As for offices, vacancies in European Grade-A cities are a low 3%. There is a bifurcation between Grade-A-certified buildings. In Europe, only 22% of office space is Grade-A-certified. Another driver of tenant demand is green buildings. “We have 70% green-certified buildings. Our office occupancy rate went up and we delivered 9.5% rental reversion growth. We showed a decrease in vacancy and positive rent growth,” Garing says.

Nonetheless, the rise in interest rates, discount rates and capitalisation rates have offset income growth, and CEREIT’s portfolio declined by 10.7% to EUR2.24 billion. However, on a like-for-like basis, the portfolio was down just 0.5%. NAV fell by 12.4% to EUR2.12 per unit with CEREIT’s trading price, translating into a P/NAV of 0.69x. 

“The capitalisation rate increased by 100 basis points but we managed to grow the underlying income and release [divest] 20% of the portfolio in the last six months. The risk has been removed,” Garing says. 

In terms of unit price, CEREIT was listed at EUR0.55. In 2021, five units became one. Hence the equivalent price currently would be EUR0.294 with a historic DPU yield of above 10%. 

Officially, CEREIT’s sponsor is Cromwell Property Group but Garing acknowledges that the REIT does not have a pipeline. Moreover, Cromwell Property Group underwent a tussle for control back in 2019, causing the founder Paul Weightman to retire in 2020. ARA Asset Management, which wrested control of the company from Weightman, was sold to ESR Group in 2022 and ESR’s management has confirmed its intention to divest of Cromwell Property Group.  

“Our board is ok for us to take on development risk, and we have a policy of 5% of AUM for development,” Garing says. The Collective Investment Scheme does not allow S-REITs to take on more than 10% of deposited property worth of development risk. S-REITs can take on a higher portion of development risk under certain conditions.

“If we own an asset that is income-producing, and if we want to [renovate] the building, there is a two-year window where there is no income from the building,” Garing says. The purpose of renovating a building is to generate higher rents. As a result, the upgrading of the portfolio has to be done thoughtfully.

Tenant incentives? 

In FY2023, CEREIT spent EUR33.6 million on capex, EUR46.0 million on development expenditure and EUR1.1 million on capitalised interest.

A CEREIT unitholder says: “S-REITs capitalise a lot of operating expenses including regular AEIs [asset enhancement initiatives], which is not right. They are overpaying DPU. Then they have a huge fundraising exercise.” 

CEREIT pays out 100% of its distributable income, unlike IREIT, which pays out 90%, keeping 10% for AEIs. However, CEREIT has EUR31 million in retained earnings from capital gains. Garing blames the current problems faced by S-REITs on the effects of higher interest rates. As cheap Covid-19 era debt falls off, S-REITs are paying more for new debt. “We all had debt and hedges and there is a higher borrowing cost impact on DPU. For us, it was 1.5 euro cents off DPU. But unlike other markets, European leases are long and they have annual indexation. So, if we can generate inflation-linked growth in our rents, we get some income to offset the rise in debt costs,” Garing says. 

“The income benefit on capex is between 6%–7%. That doesn’t take into account the valuation uplift. So we will be delivering 30%–40% [ROI]. This is not maintenance capex and valuers give us the additional [uplift] by lowering the capitalisation rate,” Garing continues. 

With all the controversy surrounding tenant incentives for US office S-REITs and how well or not they were articulated to investors, Garing is quick to clarify that tenant incentives in Europe are rent-free periods. “For logistics, it is one month [rent-free period] for a year of rent and for office [rent-free period] is two months for every year. Tenant incentives are not the 30%–40% in US cities because our vacancies are lower and the landlord is in a better position. The landlord does not fund the fitout. We do in Poland, and the incentive levels in Poland are higher,” Garing explains. 

The other boost to occupancy is a green building. Savings are likely for energy-efficient buildings in Europe. “We have enough data that investors are differentiating between pricing buildings that are BREEAM or LEED-certified,” Garing says. “If your buildings are not green-certified, they could end up being stranded assets.”

German assets face challenges 

As part of a restructure and exit for the original owners of IREIT’s manager, in 2016, Tikehau acquired an 80% stake. In 2019, CDL took a stake in IREIT’s manager and IREIT itself. Since then IREIT has diversified away from concentration risk in its German portfolio. Initially, the REIT acquired a modest portfolio of offices in Spain. This was followed by the acquisition of 27 retail properties with Decathlon as the tenant. IREIT has also divested a Spanish office building for EUR24.5 million, a 6.1% premium over valuation. 

Since Tikehau and CDL took over the manager, the three major acquisitions were funded with a mixture of debt and equity. While initially accretive, the tenant movements in its German campuses caused challenges on the income and NPI front. The loss of major tenants such as Deutsche Telekom in a couple of campuses and DRB in Berlin, coupled with new units, impacted DPU.    

Nonetheless, the current management has de-risked the portfolio. Imagine what would have been the impact on DPU if the portfolio was not diversified, market-watchers point out. “Professional management is useful. REITs should not be managed by the people who get together to form a REIT and have no idea what’s going on,” notes the CEREIT unitholder. 

As IREIT’s portfolio faces challenges on the occupancy front, interest expense rose a modest 14.4% y-o-y in FY2023, compared with CEREIT’s 32.8% y-o-y increase. As a comparison, CapitaLand Integrated Commercial Trust C38U -

’s (CICT) interest expense rose 33% y-o-y in FY2023 while CapitaLand Ascendas REIT A17U - ’s (CLAR) interest expense was 36% higher in FY2023. Both CICT and CLAR have European assets, although the largest part of their portfolios are Singapore-centric.  

For IREIT’s debt, 97% is hedged and the all-in cost is 1.9%. “The next refresh refinancing is not before January 2026,” d’Estienne d’Orves says. 

European S-REITs are not the only ones facing challenges. For CICT, Gallileo, an office in Frankfurt’s CBD, was revalued downwards to $338.8 million as at end-December 2023, before the anchor tenant, Commerzbank, vacated in January this year. Gallileo was acquired for EUR356 million, which was $569.6 million at the time. In CICT’s FY2023 results briefing, the manager guided that it would be spending $265 million on AEI for Gallileo but could not provide further details. Last month, CICT announced that it has secured the European Central Bank as the anchor tenant for 93% of the space. So, there is some light at the end of that tunnel.  

 

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