This time it is different

It has been a while since I have not written anything on alstria’s blog. I started from time to time, but never get to finish the work. This morning however, when I read the piece about the German real estate, that was featured in the daily newsletter of Property Investor Europe (which is usually the first think I read in the morning), I knew I would get through.

 

The “Expert view”, which is called “Upward trend on the German commercial real estate market” (and available here: http://aox.ag/PIE_German_office ) gives an overview about why investors should be investing in the German office sector, which per see, should not lead to any specific comments from my side. Except that, when I finish reading the post, I suddenly felt younger by 7 to 8 years. If you want a list of all the bad reasons to invest in the German office market, this post is definitely the right place to start. It is making 5 assumptions that should lead a decision to invest in German office space.

Assumption 1: Economic growth in Germany is resulting in increasing demand for office space

This is a graph that was published on this blog four years ago (and would lead to the same result if extended to 2014).

I am amazed to see that some commentators are still arguing about the fact the GDP growth correlate with office rental growth. This might have been the case 30 years ago, but it is clearly not the case anymore. The way tenants are learning to optimize their office space, and the efficiency gain they are realizing are by far outstripping any additional need of space created by GDP growth. Do not expect any substantial rental growth in the German office sector, nor substantial vacancy reduction.  It is unlikely to happen anytime soon.

Assumption 2: Financing of commercial real estate is becoming cheaper

That is absolutely true. Financing is cheap. I would have thought that I would never again hear this as an argument for buying  real estate (nota: alstria always underwrite assets based on unlevered returns), but apparently I was wrong.

Assumption 3: Rising demand for office premises with a positive impact on rental markets

See point one above. This has never happened in the past, and I see no reason why it will happen in the future. Absorption in the market is at best neutral, more realistically negative.

Assumption 4: Ongoing investment pressure is driving transaction volumes and is reducing risk aversion

The first part of the assessment is absolutely correct, investment volume is going up, and has accelerated drastically over the last weeks (mainly on long term leased assets, driven by yield seekers). But I am not sure that risk aversion is reducing. Short term leased assets, or other assets with potential operational risk/leverage are not so much in demand. Not sure though that the risk aversion is reducing, but clearly the risk return profile of some of the assets which are being considered for trading is deteriorating.

So what is the German office market all about then ?

Obviously we all have our views on the market and how it is going to develop, and mine is as good as any other. The fact of the matter is that our position is based on an educated guess, not a crystal ball. We believe that the German office market is going to be driven by operational excellence, vs. financial engineering. That real estate needs more operators and less financial sponsors.  that driving returns should come from increased market share, better scaling of costs, operational excellence, better services to the clients (some call them tenants). That expectation of market rental growth driven by macro factors, should not be considered, and will only enhance returns if its happens. 

In my last roadshow meeting, when I was discussing the state of the investment market and the increased transaction volume we are seeing in Germany, I was asked by an investor if I felt any similarity with 2006-2007. My answer at this point was that I did not, as I believed most of the players in the market still have the deep scares and bad memories of what happened then. I think it is Mark Twain who once said "History does not repeat itself, but it does rhyme". Well PIE this morning was rhyming very strongly with 2007 (and if in doubt here are the same arguments put together in 2007:  

Deutsche Bank research: German office Market (April 4, 2007) 

At that time DB concluded as follow:

"The greatest risk in the years ahead therefore lies not in a downswing on the property markets, but in exorbitant expections on the part of investors and project developers"

I guess this last point is still up-to-date

 

 

 

 

To go please !

I have been trying to figure out how to improve the utility management process of the company for quite a while now. This topic is important for us for a number of reasons, and I am deeply convinced that we need to find the right way to address this while time is still on our side. Not only managing utilities is the main way to improve sustainability credential of an asset, but utilities represent the bulk of our tenant costs. Any extra cents going to utility providers is a cent that we cannot use to increase the rent. On a longer timeframe consideration, I do believe that the future of leasing will be (as it is already in some Nordic countries) in the full service rent were utility costs will be borne by the real estate owner, rather than by the tenant. 

The existing “In Use” certification systems remain relatively weak and rely on little evidence of operation excellence. We have recently acquired a Bream in use certified asset, and I still struggle to see, what was better in this asset than in other non-certified assets. As far as I can tell (and I do not pretend to know all of these certification tools), having an “In Use” certification, could compare to changing the regular windshield cleaning lotion of your 4x4 SUV (18 liters/100 km) into an environmental friendly lotion, and argue that thanks to this new lotion on your SUV is “Green in Use”.

One of the bigger hurdles commercial real estate is going through with respect to improved utility management is in my view the “short” average ownership/management continuity that drives of industry. As I have argued before, real estate time is much slower than capital market time. Short ownership for a real estate is in my view anything between 5 to 7 years. Most of the investment that would be needed in order to measure and understand what is going on with a building would have a longer payout period. Without such measurement, and understanding, there is little you can do. More importantly, it is very unlikely that any buyer of the asset would pay for this specific piece of technology. The likelihood that a new owner system would be compatible with yours is very close to zero. The result is that most real estate owners underinvest into modern tools that would allow a better grasp on utility bills of building, as they will not capture enough benefit of the investment over its holding period. I am still confused, that I am able to know instantly that Lady Gaga changed its dress (@ladygaga on Twitter), our buildings are not able to communicate real time data. Not that the technology is lacking, but the cost of the technology is prohibitive within our potential ownership timeframe.

What we would need is a technology that would allow us to plug something into an existing metering system, and then be in position to take that something away with us whenever we would sell the asset to someone else. This would ease the investment decision, as the lifetime of the investment would not be tied up to a single asset but to the “plug and play” device itself. The good news is that there are a bunch of start-up companies out there that are developing just that. It is early development stage, lot of progress to be made, but definitively going into the right direction. We will be looking into that closely to see if it can really work. Monitoring “to go”, is what we really need.

I love it when a plan comes together!

European leaders might or might not be putting together CDO² in order to save (or kill for that matter) the Eurozone. The ECB might or might not become a large hedge fund. European banks might be under-capitalized (from what we can see it is fair to say that at least their real estate loan book is nowhere close where it would need to be). The US are facing huge budgets constrains while US politics seem just as reliable as Europeans. Maybe, or maybe not, but there is nothing much we can do about all of this.

The capital market sentiment seems to be back in 2008. Sell side analysts are focusing (again) on debt covenant, short tern refinancing, and other liabilities on companies balance sheet. We hear that this time it is different. This time banks have learnt their lessons, and will call loans…

The key question is shall or shouldn’t be worried about all of this. Well clearly the Eurozone uncertainty and lack of political leadership is something that we feel relatively worried about. As a German company solely investing in Germany alstria’s fate is link to Germany’s fate. We knew that, and have no intention to change this.  On the positive side, we feel that on a relative basis, we should be (at least in the beginning) doing better than other European countries. Being German is not so bad after all (being French citizen I feel I know what I am talking about here).

If you forget about all the macro noise, then it is fair to say that the market is exactly where we thought it would be by now. We have been openly communicating (including on this blog) and acting on the assumption that the years 2012 to 2014 would be tough real estate years. Mainly as a consequence of the amount of debt still in the system to be refinanced. In the beginning of 2011 we have written to our shareholders:

“The years 2011 to 2014 are still going to be challenging years for a number of real estate owners. Debt overhang, overleverage, lack of equity capital: there are still a number of issues that need to be addressed one way or the other in the market. These tensions will, however, provide significant market opportunities for well capitalized companies with strong operational focus. We have been working for the last three years to position alstria for this exact moment. Now will be the time to reap the benefit of this work”.



So from this perspective the current situation and the concern around debt availability should not really come as a surprise.  We have successfully used the three previous years to reduce debt level on the company’s balance sheet, and reinforce its operational capability. We were expecting a bumpy ride. So we are very confident when it comes to sailing into the bumpy weather.  

I used to love the A-tean when i was a kid. Even when it all looked very bad, every episode ended with Hannibal saying : "I love it when a plan comes together!". It all come down to how good the plan is...

No excuses

You do not have enough time to read alstria's blog? You can access it now from your iphone via alstria's app. It available following this link http://itunes.apple.com/us/app/alstria-reit-ag/id451830672 or look for alstria in the appstore directly on your iphone...

A preview of what the app does is available at the following link: http://alstria.webuda.com/

So from now on, there is no excuses.

What is wrong with rights?

ISS is one of the leading corporate governance solutions to the global financial community. Their home page claims that they want to “enable the financial community to manage the governance risk for the benefit of shareholders”. As part its governance approach ISS is currently conducting a review of its voting policies and have launched a public consultation available on their website (http://aox.ag/qI6t2v).

We have been engaging with ISS with regard to their voting policy in respect to shareholders approval of capital transaction excluding subscription rights. From that perspective we do strongly support Cohen & Steers view (for more information see our post “the good, the bad and the ugly, http://aox.ag/pcYyHI)

As a result of Cohen and Steers paper on the subject, ISS did take on board the subscription right issue; however, the way it is considered in the ISS document does raise eyebrows on the extent to which they have understood the topic.

On page 20 (question 33) of ISS questionnaire, the question is the following: What is an acceptable level of dilution for an issuance of equity without preemptive rights (for General Corporate Purposes)? (5%, 10%, 20%...).

Considering the little room for answer I thought it would be helpful to illustrate the way we are looking at the issue, and try to contribute to the debate.

I believe there are two perspectives that management has to take when looking at dilution concerns: The company perspective and the shareholder perspective. Let’s start with the easy one, the company view.

1 . Right. What right? (Please keep on reading before shouting at me)

The two important dilution factors that we do consider as management are, the NAV per share dilution/accretion, and the earnings per share dilution/accretion. None of these factors is influenced by the existence or not of preemption rights. The NAV/earning per share dilution or accretion is driven by the number of shares you issue as well as the price at which you issue them. Providing shareholders with rights or not is (on the face of it) irrelevant from the company view. What we will always try to do, is to issue the minimum numbers of new shares for the maximum possible proceeds. If we did not have to look at shareholders interest on top of the company interest, there is no argument that would make us consider preemptive rights. End of the story for the company side of life.

2- Don’t fight the market

If we will ever be in position to make a case for the preemptive rights it needs to be from the shareholder perspective.

In order to better understand why right could matter to shareholders let’s take a small example (I know this is not very academic, but I am not a teacher). Let assume a company that have one share, which market value of EUR 10. This company decides to double its share capital (so to issue another share) at a price of EUR 7.

The table below illustrates what would happen in the case of the existence of preemptive rights:

Table 1: Capital increase with subscription right.

As you can see, at the end of the transaction, the shareholder wealth have not changed (it is still equal to 10), and therefore he is deemed protected by the right. The new shareholders have paid EUR 8,5 for a share which is worth EUR 8,5. So far so good. Well not really. This reasoning is fundamentally flawed, and here is why.

Let’s take a look at the company perspective again. The management wants to issue the minimum numbers of shares (in this case one), AND maximize the proceeds. In the example above, there is someone who is ready to pay EUR 8,5 for the share, so there is no reason why the company would issue at a price below EUR 8,5.

Take this a step further. Someone is willing to pay EUR 8,5 for the new share, and the company wants to capture all the proceeds. Let’s see what happens to the wealth of the new and existing shareholder in this case (no subscription right is offered):

Table 2: Capital increase without subscription right.

The result is very bad for the old shareholder, which have lost EUR 0,75 of value in the process compared to the right issue. So it is true after all that rights do protect shareholders… Well again flawed reasoning.

If you look closely to the situation of the new shareholder, he actually got himself a EUR 0,75 free lunch in the transaction (on the back of the old shareholders). Shouldn’t we assume that someone out there is going to be willing to pay EUR 8,75 for the share and make only EUR 0,5 free lunch. And even then isn’t someone going to pay EUR 9 for the share and make only EUR 0,25 free lunch You can run the iteration, but eventually you are going to end up finding someone willing to pay EUR 10 for the shares. And if there is someone willing to pay EUR 10 for the share, then this is exactly the price at which the company is going to issue the shares. At EUR 10, the existing shareholders rights are worthless.

3- You would not do that would you?

Let’s consider the following transaction now. The same company decide to do the following: (i) pay a dividend of EUR 1,5 and then (ii) issue a new share at market (EUR 8,5 which is EUR 10 less the dividend). Here what the previous tables would look like:

Table 3: Dividend payment followed by capital increase

 

You will notice that the table 3 looks exactly the same than the table 1 above. It illustrates that the subscription right has the exact same effect then paying a dividend. It is basically a transfer of resource (and not wealth) between the company and its current shareholders. I am assuming that a lot of you would find it very odd to pay a dividend just before you raise new money (I know we just did that but we have no other choice as we are a REIT forced to pay by law). Well really offering a subscription right is economically the exact same think. If one does not make too much sense, why would the other do?

What I have tried to illustrate above is that in essence subscription rights do not provide shareholders with any kind of protection and do make a lot of sense PROVIDED that the shares at issued at their market price. This is usually the case when you offer the shares in an accelerated placement on the market in a book building process. Although in these processes the price achieved is usually lower than the screen price (the “infamous” discount) during the book building period the screen price is not very relevant. Considering the relative volumes of the market vs. the transaction, the screen does not drive the book. It is rather the book that drives the screen.

4- A solution that needs a problem

In all fairness to the subscription right, there is one instance where it is actually a very valuable feature to protect shareholders. This is usually when a capital increase is done at a given fix price (usually underwritten by a bank). This feature is usually used by issuers who are looking for a “certainty of funding” but cannot price the issue immediately. As much as issuer try to guess what the right price is (remember it wants to maximize proceeds) there is an almost certainty that the issue price is mispriced. Not the least because the bank underwriting the process is taking a “security margin” to avoid being stuck with the shares (another name of theses transaction is “deep discounted”). Being able to sell, or exercise its subscription rights does allow the shareholders to avoid offering a free lunch to a new subscriber. The obvious question that comes to mind is why would the issuer use such a process and not issue share overnight? Why does it take the risk to announce price weeks in advance, knowing that it is sub-optimizing its transaction? Any guess? Funnily enough the main reason why issuers do this is because of the subscription rights themselves. You need to give times to your shareholders to decide if they want to exercise them or not… In other words, if you do not have preemptive subscriptions rights, you will not need them either.

I am sure that I will have a number of strong discussions with some of alstria’s shareholders following this post. Although it has been drafted overnight, it is the result of long and intense discussions at alstria. Ever since we are public, we have tried to understand the preemptive right concept. So far we were unable to find any instance were the preemptive rights added value. We have in fact refused to use the deep discounted process while advisors where arguing that “it does not matter for your shareholders as they can use their rights”. It may be that we are biased. Considering the sensitivity and importance of the subject, I am this time more than for any of our other blog post, happy to open the floor to public or private comments.

Olivier

Real Life

Picture from the construction site of the New Ohnsorg Theater.

Flat Lines

The new value of the IPD/alstria DMX index which measures the reversion potential of German office rents shows for the second consecutive year that, on average, there is little reversion to be expected in the German rental market. (Full IPD study and result can be found here).

This does not come as a surprise to me and hopefully will not surprise any of the investors we are used to speak to, as this is one of the base case assumptions we have been working on since inception.