The #GRESB Conundrum

We have been asked by a number of investor the reason why we have decided not to submit our data to GRESB this year (the data itself is available on our website www.alstria.com/sustainability ).

In order to better explain our position we have used the following presentation.

We are obviously happy to discuss, so please feel free to send us feedback.

The gresb conundrum from alstria office REIT-AG

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

 

 

 

 

Life Insurance

The say on the street is that there is a funding gap in the European property market. The say is also that new players are coming along to fill, or benefit from this gap. These new players are called debt funds, or insurance companies. Reports are piling up announcing the raise of new funds, or the billions that this or this insurance company is planning to invest in the new yield Eldorado. Advisors are warning about banking regulation risks looming on the new sector, and offering advice… And journalist have been writing about it (for instance here http://aox.ag/12tjxdn, here http://aox.ag/12tjw9c and here http://aox.ag/TbXMdh )

I have been wondering how much of all of this is actually for real, and how much is there to help us sleep at night. The white knights are coming to save our industry from its own cliff.

The fact is that there are a number of high profile loans which have been put together by insurance companies (not so much by funds so far). The Deutsche Bank and the Silber Towers in Frankfurt, some prime assets in London… So there is some action going in there. But is that really new? In the syndicated facility of alstria back in 2007 we also had AXA as part of the consortium with one of its debt fund (alongside with 25 banks). Today we do have a fund from Deka as part of our banking syndicate.

We also hear that unlike in the US, insurance companies have never really be involved in the financing of real estate in Europe. This is not exactly true. The lion share of the Pfandbrief bonds (the German cover bond market which finance real estate across Europe) are actually sold to insurance companies (although we could not identify any statistic in that respect). According to the Vdp, the total amount of Pfandbrief loan outstanding in Europe at the end of 2011 was around EUR 297 billion. The pfandbrief banks granted EUR 90 billion of new real estate loan in 2011. This compares with, for instance, Allianz target of EUR 5 billion loan book by 2015 ( http://aox.ag/UhbZHW )or the total EUR 2 billion of new loans by insurance companies in 2011…

From my perspective, the key question in this debate is not really whether or not insurance companies will step in the lending business. But are they going to do this with new capital, or is the lending business just part of the existing real estate allocation. GE Real Estate for instance (which I appreciate is not an insurance company, see here http://aox.ag/T3EytC ) is stepping out of equity, and coming back into debt. Net net, the move is neutral… No new capital.

    

There is clearly something going on in the field of new debt providers. It is however too early to say if this is going to be a game changer, or just a capital reallocation, which will leave us as naked as we were before. The only certainty I still have is that there is still too much leverage in the system. It will take us more than just a life insurance to secure the future of our industry

Green Lanterns

IPD has started an interesting new index in the French market, called the IPD Green Real estate index. It basically analyses the performance of Green buildings and compares it with both recent non-green buildings as well as with the general IPD index (http://aox.ag/KdpWzJ)  

As far as I know, this is the first time such an indicator is put together. This is more than welcome initiative as it might once and for all stop the rhetorical debate about whether or not Green adds value to the asset.

On the face of it, it looks as if it does add value. Total return last year for the green building stood at 7,4%. That is 1,1% higher than equivalent non green building which showed a total return of 6,3%. However devil is in the details.

Here is how this performance is broken up:

The green building performance is solely driven by a (theoretical?) capital value improvement. It relative performance is very poor in turns of Income Returns with assets yielding around 2% less than the rest of the market.  More interestingly the IPD data reveal that there is no rent difference between Green and non-green buildings (average ERV is at 356 EUR/sqm/year for non-green vs 361 EUR/sqm/year for green building).

These data allow for an interesting (theoretical) analysis about the benefit of investing in the green building.   Let’s assume a green office building which is worth 100. According to IPD data, this asset will generate around 4,2 of rent. Let’s now assume a non-green building asset generating the same rent. According to IPD this asset is yield 6,3% ie. is worth 66,7. From there you can derive the actual value as described in the following table.

As a result of the IPD data, you can determine in a few minutes that the market offers a 71% premium for the value of a “Green” construction over a non-green construction.  At this stage it become clear what you want to build if you are a developper. The only economical explanation for such a premium would be that a green building will depreciate much slower than a non-green building. It would therefore deserve a premium as it would deliver returns on a longuer period of time.  

The table below, summarizes the number of years needed to collect enough rent in order to pay for the construction cost at a given unlevered expected return (the NPV of the cash flow is equal to zero).

What the previous table show is that If you expect a 5% return from a non green building, assumes no terminal value, no rental growth, no capex... you need to collect the rent for 16 full years. For a green building for which a 71% premium was paid, you need to collect rent for 54 years. Another way to say this is that the premium reflect the belief that the green building life will be 3,3 times longuer than the non green building.   

So now, here is the question: Which assets do you think is going to generate the most sustainable returns over time? I am not going to take position. However I have lost faith long ago in Hal Jordan and the believe that “Green is the color of will”

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.

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

Some pictures of the Mundsburg Construction site.

The good, the bad and the ugly

In a recent paper, signed by Joseph Harvey, President and CIO of Cohen and Steers (disclaimer, Cohen and Steers is as far as I know one of our shareholder), the investment manager argues about the merits of allowing European REIT to execute capital increase excluding subscription rights. (The document can be read at the following address http://bit.ly/flBlrP)

Having executed a recent capital increase for alstria with the exclusion of subscription rights, I wanted to share my thought on the matter, and explain how we have looked at the issue from a company perspective.

Japanese’s whispers

I have put on a paper some thoughts while I was in roadshow in Asia, following meeting with investors and investment analysts. As a disclaimer, I am writing this in the middle of a jetlagged night, and I clearly do not pretend to know what I am talking about here.

1- In China, it seems that it is more reasonable to invest into less known secondary cities, than in the majors. Rational being that a lot of speculation is driven by some cities names, not by economics. Ring a bell in Germany as well. Except that Frankfurt is by no way a major city by Chinese standards

Real Life

Picture from the construction site of the New Ohnsorg Theater.

Honi soit qui mal y pense

In the foreword to a green supplement in the magazine House and Garden (in 2008), the Prince wrote: "Why, I must ask, does being 'green' mean building with glass and steel and concrete and then adding wind turbines, solar panels, water heaters, sedum roofs, glass atria - all the paraphernalia of a new 'green building industry' - to offset buildings that are inefficient in the first place?

 

"That many of these add-ons are mere gestures, at best, is now clear, as their impacts on home energy consumption can now be measured and usually offer scant justification for the radical nature of the design." (see http://bit.ly/bjibZy for more on this)

We (almost) made it happen

News that I felt went through pretty much un-noticed in the last month was the publication of the latest Jones Lang LaSalle transparency index (you can register for free on JLL website and download the study here). For the first time since inception, the German market is part of the “tier 1” countries, along side with the UK, Australia, France and 12 other countries. More precisely Germany is quotes by JLL as the 10th more transparent market among the 81 markets covered by the study, and 6th more transparent among the 34 European market surveyed.

Evolution

Real Estate Investment Trust or REIT, is a global trademark which started in the US in the 1960’s, and is now spread across the globe. When a company define itself as a REIT, it mean that it adhere to a number of simple concept. Its is usually a listed company, its business must be real estate investment it is tax transparent, and it pays most of its profit as dividend. Although the local legislation differs here and there, those are the main characteristic of REIT worldwide.

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.

Qui va piano va sano

A few weeks ago, following our annual press conference, we got this interesting question from a real estate equity sales desk: “I have one particular question on current disposal talks. If pricing is not very much of an issue and the buyers are mostly equity buyers and have little constraints regarding the debt financing, what is currently holding up the process?”

Apples and bananas

For real estate listed companies like for other industries, March was the month of FY08 earning season and we did publish our numbers on the 31st of March (a replay of the webcast of alstria result presentation can be found here).

In the credit crunch, the credit might have already left, but the crunch still has to come

In November 2008 a panelist at the ninth annual European Real Estate Opportunity & Private Fund Investing Forum had the following remark: “Is CMBS dead? It can't be dead--there's no other place to get [that money] from” I guess it is relatively fair to say that if CMBS is not clinically dead, it is in a very deep coma.

European real estate markets were less relying on the CMBS market than the US markets. Nevertheless the share of the CMBS market has been constantly growing and it is estimated that more than 20% of the commercial real estate financing was financed through these markets. That still leaves us with a significant number of billions of commercial real estate financed in the CMBS markets…