Written by Meyrick Barker – Investment Analyst
Real estate markets have been severely aﬀected by the COVID pandemic restrictions on the movement of people. Travel restrictions and a move to substitute business travel with online meetings have decreased the demand for hotel accommodation. An increased acceptance of flexible work-from-home arrangements has reduced the need for oﬃce space and raised uncertainty about future oﬃce demand. Retail stores have suﬀered from mobility restrictions and a greater move to online shopping, although shopping patterns are returning to normal.
Additionally, given that real estate companies are generally leveraged to enhance equity returns, tightening financial conditions squeeze distributable cash flows and refinancing debt has become more diﬃcult, especially as property asset values have declined.
One of Europe’s largest oﬃce, hotel and residential accommodation landlords, Aroundtown, has certainly not been spared the fight. We discuss why, despite these headwinds, it is a compelling investment proposition.
Growth ambitions ignite innovation
Established in 2004, Aroundtown initially focused on growing a residential and hotel property portfolio in Germany. Being privately owned, with limited financial resources, the business model imperative was to buy properties with potential for value enhancement via asset management initiatives. Once improvements were achieved, the properties were sold to generate cash to fund further acquisitions. Capitalising on the distress in property markets post the 2008/2009 global financial crisis, Aroundtown acquired numerous valuable property assets.
In 2012, the group partially listed Grand City Properties (Grand City) – a subsidiary that houses its residential assets – retaining a strategic stake. Grand City obtained the first credit rating from S&P for a German real estate company, enabling lower-priced access to debt capital markets – a key advantage for a real estate company with growth ambitions. Access to larger, more permanent financing sources shifted the business model towards holding properties for longer, although they continued selling assets on a smaller scale and recycling the capital.
Aroundtown listed in 2015, with the intent to expand into German oﬃce property ownership – a sector viewed as undervalued at the time. Using capital market experience gained from the Grand City listing, the company promptly obtained an investment grade rating and through to 2020, successfully raised consecutive rounds of funding. Good relationships with brokers, a ready supply of capital and an established deal-sourcing network presented numerous attractive opportunities to grow the property portfolio.
Property deals are sourced from a large and diverse network including banks, loan funds, distressed owners, private and institutional investors, and court auctions. This culminated with the completion of a share merger with TLG Immobilien (a €4,5 billion German oﬃce-biased landlord) in February 2020. With close on €40 billion of assets today, Aroundtown ranks as the third largest listed European property landlord.
Maximising shareholder returns
Since the onset of the pandemic and the resultant negative impact on hotel occupancies and weakness in demand for oﬃce space, Aroundtown’s share price has been very weak – trading well below its book value. This is reflective of what independent experts assess is the realisable market price of their property holdings. To date, these values have been an accurate reflection of property transaction values on sales they have made.
Aroundtown have capitalised on this disconnect over the past couple of years by selling €6 billion of mostly mature properties at above book value. Importantly, this is 40% above what they originally paid for them. The proceeds have been used to buy back their own shares at a significant discount to book value and reduce debt levels, creating value for shareholders. The chart below indicates how each share’s claim on the company’s net assets has increased due to investment decisions undertaken by management and the extent to which this has been enhanced by share buybacks.
Oﬃces comprise approximately 50% of Aroundtown’s property portfolio, located predominantly in the top cities of Germany and the Netherlands (ie Berlin, Frankfurt and Amsterdam). The tenant base is diverse, covering a host of diﬀerent industries and including multinationals such as Amazon, Siemens and Vodafone. The public sector, which has been less likely to adopt work-from-home practices or shrink its oﬃce space requirements, constitutes 30% of the tenant base.
The oﬃces, which vary in size, are largely located within the city centres. Typically, Aroundtown buys buildings that have been sub-optimally managed (either under-rented, have elevated vacancies or high building management costs) and a dedicated team determines how spaces can be reconfigured and refurbished to extract value from existing underutilised potential. This might take the form of a new development on vacant land or converting or extending an existing property. After obtaining the necessary building rights, Aroundtown either sells these rights to crystallise their value or will develop the project by contracting external construction partners.
Below is an example of an old, vacant and dilapidated brewery purchased for less than €1 000 per m2 in a good location in Berlin on the Spree River (between Berlin’s prime commercial and tourist centre and the university district of Adlershof). Together with a development partner, the site is undergoing reconfiguration into a mixed-use oﬃce and residential development at a cost of approximately €2 000 per m2. Retaining many of the distinctive features of the original building, the completed development is expected to attain sales prices of between €4-5 000 per m2.
Bring back the travellers
Aroundtown owns 156 hotels, mainly located in Germany but also in popular cities across Europe. 85% are 4-star, catering for both leisure and business travel, thereby diversifying the exposure to diﬀerent demand factors. While mainly city-based, several hotels and resorts exclusively focus on leisure activities in areas such as the Baltic Sea, the Alps and places oﬀering natural attractions like thermal hot springs.
Aroundtown does not operate the hotels. Instead, they lease them on long, fixed-term contracts to strong hotel operators that trade under well-known brands such as Marriott, Sheraton and Hilton. Various hotel operators were oﬀered significant discounts over the past two years as occupancy rates collapsed during the government-imposed travel restrictions. As travel gradually recovers, the cessation of these discounts is providing a meaningful boost to earnings.
The business has used this time to accelerate planned redevelopment work at a number of their hotels, executing refurbishments more quickly and with less disruption than is typically achievable when a hotel remains open for business and work is completed floor by floor. This included the successful €7 million refurbishment of an iconic water tower in Cologne, once the largest of its kind in Europe. Today, it forms part of Hilton’s Curio Collection and oﬀers a gym and a rooftop bar with 360-degree views of the old city, while retaining the building’s original architecture and historical aesthetic.
No place like home
Aroundtown does not manage residential properties directly but rather owns a 50% stake in Grand City – translating into a 15% economic exposure to residential real estate for shareholders. Grand City targets the aﬀordable rental housing market, with 80% of the portfolio located in Germany and the balance in London. A typical apartment is around 60 m2 in size, costing in the region of €480 per month to rent. With the average tenancy length of the German portfolio being around 10 years, tenants are evidently happy. The typical apartment building is four stories, with 2-3 units on each floor, ranging from large residential ‘towers’ to single-unit housing. A call centre is continuously available to address tenant queries.
The German residential market is highly regulated, largely favouring tenants (by limiting rental increases) but oﬀering a reasonable return for investors on existing rental stock. The main regulation impacting Grand City’s business is that rental increases are limited to 11% over a three-year period (with some exceptions) – although if an apartment is vacated, higher rentals can be charged. Housing demand exceeds supply in cities serviced by Grand City, therefore tenant turnover can lead to stronger rental growth.
Grand City follows a similar acquisitive approach to Aroundtown, purchasing properties that have been sub-optimally managed and increasing returns through various improvement initiatives. Upgrading apartments, installing playgrounds or improving access with elevators are some of the value adding measures employed. Management have estimated that rental incomes can be increased by over 20% across the existing portfolio.
Testing the foundations
Developed country central banks have suppressed the cost of credit for the past decade. Like many asset classes, the resultant fall in required rates of return and easy access to financing, lead to rising property prices. However, as inflation has materially risen, interest rates are now rising rapidly. Property companies typically utilise a fair amount of debt financing. As a result of the impact of higher interest costs on distributable cash flows and lower property asset values (and fears of further markdowns), they have seen very weak share prices.
Aroundtown, however, has a few factors that aid it in navigating the current environment, including:
- not being a real estate investment trust allows them the option to retain earnings within the business if needed to bolster the balance sheet;
- holding significant amounts of cash relative to upcoming debt maturities;
- having the flexibility to pledge their property assets as security should they decide to source bank financing; and
- having a large portion of their debt bearing interest rates fixed at low rates for some time.
Despite the uncertainties confronting the sector, Aroundtown’s astute capital allocation decisions, strong track record in repositioning properties to extract their full value, relative flexibility provided by their corporate structure and recovering revenue streams within the business – should ultimately reward shareholders over time.