Forward looking statement

An interesting white paper published recently by Collier International went un-noticed, while I believe it deserve some attention and reading by anyone who is interested in the European office market.

The white paper is the third issue of a series called “Generation Y: Space planning and the future of workplace design”. Below this (un)inspiring title lies an interesting tentative calculation of the future demand for space in Europe (full document: http://aox.ag/Jyf8cg)

Collier equation is quite simple. They consider office workers population trend considering population growth, and remote working trends, as well as new workspace design trends, and add up the numbers.

The result of this analysis for an office hosting 200 employee in 2012 is summarized in the table below:

Colliers come to the conclusion that between now and 2030 it is likely that we will need 2% more office space than today. This is not an annual growth number; this is the total growth expected between now and 2030. The annualized growth rate would be around 0.07%. Let’s round it to ZERO.

The methodology used by Colliers can clearly be questioned. It is rather simplistic, and I am sure any academic can come up with a much more sophisticated econometric model in order to try to assess the need for office use in the future. However, the mere fact that it is simple does not means that it is pointing into the wrong direction.

In fact this analysis fit relatively well in the empirical evidence we have been gathering for years from the market. The existing building environment for commercial office space is sufficient in all the advanced economy. We do not need to build new space, but need to improve the existing one to fit better standards. Local government will have a significant responsibility as by granting building permits to build new office space. If in parallel they do not act to remove the same amount of space elsewhere, they are slowly but surely planting the seed for future vacancy. If in doubt you can have a look at the Nederland, or certain cities in Eastern Germany…

We have also argued in the past that this trend should not necessarily be considered as a bad trend for listed real estate company. Business models will surely need to adapt. Just being there is likely not to be enough anymore. None of the existing office property company anywhere in Europe has such a dominant market share, that it actually needs a growing market in order to pursue it own growth. It is however very likely that capital alone is not going to do the trick anymore. Emphasis is going to move slowly but surely from capital to operation. Listed companies are usually better prepared to face these challenges, than any other player in the market. They usually integrate the full real estate value change and can therefore identify change earlier than others and react faster.

The move is happening as we speak. As usual in our industry it is happening slowly. Don’t be mistaken by the lack of wave on the surface, this change is fundamental. I do not know whether or not Colliers is right in estimating the numbers of sqm of office space that will be needed in the future. However I do know that whoever will do my job in 2030, will be facing a completely different industry. With hopefully a number of more professional and bigger listed real estate companies.

Point of view

Following the publication of our latest annual reports we had a number of discussions with some analysts and investors (as we did last year for that matter) with respect to the write-off in value that we have published on our short leased assets.

We usually argue that from our perspective we would offer a lower price for a vacant building than we would for the same asset with a one year lease, which in turn should be cheaper than the same building with a two years lease … We always felt it makes a lot of sense to reflect this into our valuation process, and thus devalue every year the short dated assets to reflect the shorter lease term.

A recent article published by property magazine international (http://aox.ag/Ii71mp) is bringing a new perspective to the subject, based on a recent IPD analysis (this is the IPD Press release http://aox.ag/HVdOBX).  

According to IPD (as quoted by the article), UK landlords who give tenants five years leases immediately wipe out almost 2% of the value of their building.

Quote: “IPD lease length analysis shows that signing a new five year lease leads to a fall in value of around -1.8%, despite the property being let.”

Let’s all take a deep breath and step back for a minute to look closer to what IPS is suggesting here? If I read this correctly, the valuation of building which have signed a new five year lease (so which obviously were vacant or closed to be vacant) have LOST value because of the new lease. In other word, if investors would have paid 100 for a vacant building, they would only pay 98 for the same building with a five year lease. In essence, you would be better off keeping the asset vacant, rather than signing a short term lease. I don’t know about you, but this does not pass my smell test.

I might have a very twisted mind, but I would like to suggest another explanation for the whole story. What if the initial valuation of the building was wrong? What if the asset was never worth 100 in the first place? What if the new lease has shown beyond dispute that the assumption to get to the 100 value cannot be hold on to? Can it be that if the building was initially worth only 90 or 95, then the 5 year lease did increase the value to 98?   

From where I stand, in 99% of the cases, a cash flow producing asset is going to be worth more than the same asset vacant. Regardless of the length of the cash-flow. As such, we do devalue our assets when they are close of becoming vacant and we do show an increase in value when leases are renewed.

Where do you stand?

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.

More than a thousand words

This is probably not really worth a press release, but i though I could take a few minutes to write about it on our blog. Our AltePost development project has been selected to run for the MIPIM award in two categories this year. As the best Refurbished Building, and the Best German Project.

It is a very nice recognition for what was a five year hard work for our team as well as our partners (although for them it was only three years work). This development is one of which a young company like alstria can be proud of. It demonstates that you can acheive eventually please a lot of people with divergent interest, as long as you have the right approach and the right asset.

The first stakeholders of this development where the citizen of Hamburg which were concerned about the look and feel of the area shaped around this asset. This concern was convayed to a certain extend by the Monument Protection authorities that insisted on a number of things to be done. As a developper you usually hate this, but as a citizen, they did a great job. Just looking at the people wandering around the asset, and looking at its new design is a testimony of the successful repositioning of this lamdmark asset in the heart of both the City and its citizens.

Tenant are also by definition large stakeholders, and the challenge of bringing this asset to modernity while keeping it 170 years old soul, was acheived successfully as testified by the fast leasing success of the asset and the unique quality of its tenant base.

And last but not least, our shareholders and the one of our partners also had a vested interest in this project. In essence you can easily acheive to satisfy the first two stakeholders above, if you spend enough money on the building. In the case of AltePost, the result yielded to our shareholders where also outstanding.

Theses results where only acheived through the work of the project team of this development which involved us, and our partners Quantum and Stenham. Market movements had nothing to do with the success of this project. It is also a testimony of what we stand for and what we believe in. Real estate is about work. Do not expect market to help you to grow. Growth only comes through hard, usually long, and alway exiting work.

All in all this project explains more than a thousand words how our approach to real estate management.

For the first time this year, the MIPIM is offering the public to vote for their prefered project. If you feel like it, you can vote for AltePost here (http://aox.ag/A7tYwp)

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

The inconvenient truth

The Association of German Pfandbrief Banks (Verband deutscher Pfandbriefbanken, or vdp) have started a new (welcomed) initiative publishing a German office building rent index. The first result of this index are available on the vdp website (you will find the press release http://aox.ag/mfaQxW , and the index itself http://aox.ag/kkFoxR - theses links are for the English version but the same documents are available on vdp site in German as well).