A stark difference between the two European-focused REITs, IREIT Global UD1U and Cromwell European REIT (CEREIT) CWBU is their yield. Based on their historic distributions per unit, as at May 9, IREIT is trading below 8%, while CEREIT is priced at 11%.
Interestingly, based on their FY2022 operating metrics, CEREIT came out better, with higher occupancy rates of 96% versus just 88.3% for IREIT. CEREIT announced positive rental reversions of 5.7% in FY2022, compared to IREIT’s rental reversion of a more modest 5.2%.
So what gives? For one thing, trading prices can be notoriously volatile. Yet, both REITs are trading at around 0.63x price to net asset value (P/NAV).
Some market observers put it down to sponsor support. Time and again, sponsor support has made the difference between REITs that trade at a lower cost of capital and those with higher cost of capital. IREIT’s sponsor is Tikehau Capital (in which Temasek is believed to have a stake) and City Developments (CDL). These sponsors supported IREIT when it announced a rights issue in 2021. Tikehau, CDL and AT Investments gave irrevocable undertakings to subscribe to their pro rata share, and also to take up any excess rights. As a consequence, IREIT Global’s rights issue - which was dilutive - was not underwritten by any financial institution.
CEREIT on the other hand, has limited sponsor support to the extent that it has announced a divestment programme to the tune of EUR400 million. “The divestments will be staggered over the next two to three years to fund EUR250 million developments and maintain gearing in 35% - 40% range,” the REIT’s manager says in a presentation. The focus is on asset recycling in the near term, it adds.
CEREIT’s pivot to logistics
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When it made its debut on the Singapore Exchange (SGX) in November 2017, CEREIT began with a Pan-European portfolio that was predominantly focused on offices.
In its FY2018 annual report, the REIT reported that it had 97 primarily freehold properties of which 56.9% of them were offices as at Feb 14, 2019. Light industrial/logistics buildings made up 35.4% of the portfolio while the remaining 7.7% comprised “others”. At the time, the REIT’s portfolio spanned seven countries in Central Europe, the Nordics and Western Europe and was valued at EUR1.8 billion.
CEREIT continued with asset growth, but in 2020, during Covid, the manager switched to a focus on logistics assets.
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In his letter to shareholders, Simon Garing, CEO and executive director of the REIT manager, noted that the pivot was due to the sector’s “strong fundamentals”. The pivot would see “further rebalancing away from the office sector” and “result in an even more diverse portfolio,” said Garing at the time. Unlike Singapore’s logistics properties which are mostly leasehold, European logistics properties are largely freehold.
In FY2022, of the over 110 properties it has, 46% of them are from the light industrial/logistics sector, which is close to the REIT manager’s target of 50%. The REIT’s office properties now make up 49% of its total portfolio while its other properties remain at 5%. The 110+ properties, which span 10 countries in Europe – the UK being the latest addition – are valued at EUR2.5 billion.
The reasons behind CEREIT’s pivot are clear, with two key reasons - the rise of e-commerce during Covid-19 and the rise of global disruption, says Garing in an interview with The Edge Singapore.
Thanks to the rise of e-commerce, there is a low supply of logistics spaces, explains Garing. Low vacancies are also due to the global supply chain disruptions that saw a shift in European companies wanting to do more at home, which led to them bringing more goods in.
“Now companies need months of inventory, not days. So that means they, therefore, need more space. Vacancies are already low. It's not like there's a lot of available space… [companies] were effectively competing for space,” he adds.
In terms of income growth, pivoting to the logistics sector has worked well for the REIT, reveals Garing, with CEREIT’s income growth — on a like-for-like basis — delivering 5% to 7% growth y-o-y. Occupancy rates have also continued to increase for the sector, he says.
That’s not to say that the REIT is giving up on its office portfolio. During the interview, Garing clarifies that the REIT will be also be focusing on rejuvenating its office portfolio. As at Dec 31, 2022, about 22% of the REIT’s portfolio are made up of Grade A offices. Another 13% of its portfolio are made up of well-located but older assets. The REIT intends to conduct asset enhancement initiatives (AEIs) on these.
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These AEIs will be partly financed by the EUR400 million worth of properties that the REIT has earmarked for sale.
The properties that are intended for sale make up about 19% of CEREIT’s portfolio and comprise the REIT’s B and C-grade offices and its ‘other’ portfolio.
“The older, non-strategically-located B and C grade offices are not worth upgrading but they are worth selling because they can be developed into student accommodation, a hotel, or something else,” says Garing, stressing that the REIT is focused on its skills on offices and warehouses. In the same vein, the “other” portfolio that’s made of one hotel, a shopping centre, as well as campuses that are leased to the Italian government, which are not relevant to the portfolio, were always going to be sold, he adds.
“When it’s done, we end up with a really high-quality logistics and office portfolio. So we’re not saying that [the] office [segment] is dead. We’re saying… that for Grade A offices, there’s a demand for them. This is unlike Singapore where most of the buildings are brand new, while there is less supply of Grade A office space in Europe.”
How then, will the REIT maintain its distributable income during these AEIs which will generate no contribution from its tenants? One example cited by Garing is the REIT’s property, Via Nerversa 21 in Milan. The REIT conducted AEIs on the building when its tenant vacated in FY2021.
“[In that year,] we topped up distribution by EUR2 million, where the payment came out of realised capital gains from previously sold assets at a profit, which was then distributed,” says Garing. The assets were sold within the last two years.
The REIT aims to rejuvenate around EUR250 million of its assets by FY2026, starting with Via Nervesa 21 and then Maxima in Rome (formerly Via dell’ Amba Aradam 5).
As the AEIs will be staggered, the REIT is also looking to sell its assets cumulatively over the next few years.
On the energy crisis in Europe, the REIT’s distribution isn’t affected as much as the costs are passed down to its tenants.
“The tenant has to pay for the space and also for electricity, heating, security, local taxes, maintenance etc. Typically, the rent bill will be 60% to 70% and the operating charges will be 30% to 40%,” says Garing.
“The rest go to the suppliers of the building. Other than Finland, we can pass on most of the increases to our tenants except where we have the vacancy of that floor then it's the REIT’s responsibility to pay our share for that floor,” he adds.
Factoring in the impact of the increased inflation and energy prices, the REIT recorded EUR4 million in non-recoverable service costs from its vacant spaces, which is about 4% of its distribution of roughly EUR100 million.
“We would’ve seen close to 10% DPU growth if not for us absorbing those costs,” says Garing, although he notes that one of the vacant spaces in FY2022 will see a new tenant coming in August. That tenant, which is for one of its properties in The Hague, will be paying a rental rate of about 36% higher than the property’s previous occupant.
The REIT is also hedged against inflation as its leases for properties in Europe have what they call “inflation lease escalators”. That is, most leases will go up with the inflation rates, says Garing.
The rates refresh every year. For some countries, the inflation rates will be refreshed at the start of every calendar year while other countries recognise the change in rates on the anniversary of the lease when it started.
“In some countries like Italy, 75% of the inflation number gets passed through. Some countries like the UK and Netherlands will have a cap. So if inflation’s above 4%, rent growth won’t go higher than this. But generally speaking, we get good growth,” he adds.
When it comes to mitigating the risks of having big tenants, Garing says the team engages its top 20 tenants in each country at least once a quarter. This was increased to once a month during “tougher times” such as Covid-19 where the REIT also put in tenant engagement programmes where they find out if their tenants are happy with the service and so on.
“A lot of the office leases in our bigger buildings in the Netherlands are expiring in 2025, which is the biggest year of expiries in our office portfolio. [Our team] is already working with tenants now. With larger leases, you have about two to three leases to plan (whether they’re leaving or not),” says Garing.
He adds that his team’s work is a good indicator that they are doing a good job as the REIT, for example as at Dec 31, 2022, has visibility of 61% of its leases up to June 30.
IREIT diversifies
When IREIT was listed, it had four campus properties in Germany, all with long leases, but with concentration risk in terms of tenants and leases. Three of these properties, Darmstadt, Munster and Bonn Campuses were fully leased to Deutsche Telekom.
In April 2020, IREIT’s initial sponsors divested 80% of the manager to Tikehau Capital. Its largest unitholders who were formerly Tong Jinquan and Lim Chap Huat (chairman of Soilbuild Group) sold out later in 2020. These changes brought City Developments into the manager with a 50% stake. Tikehau and CDL took significant stakes in the REIT as well. As at April this year, Tikehau holds 29.1% in IREIT and CDL 21.2%.
By 2020, IREIT owned five campus properties in Germany. Also in 2020, IREIT, with support from Tikehau and CDL, diversified by acquiring five office properties in Spain. In April 2021, IREIT further diversified by acquiring 27 suburban Decathlon-focused retail properties in France.
“Our priority is diversifying the portfolio, and continuing diversification of the portfolio from a tenant, asset and geographical point of view (POV). More or less 40% of the income wasn’t around three years ago,” notes Louis d’Estienne d’Ovres, in a recent interview, adding that the REIT will stay in Western Europe geographically.
“If we’d kept exposure to the German assets, the drop in Darmstadt would’ve been a mess,” he gripes. To put the German properties in context, the Darmstadt Campus was occupied by Deutsche Telekom, which vacated the entire property in November last year.
On April 23, IREIT Global announced an anchor lease with a German federal government body to take up approximately 6,200 sq m of office space and 1,400 sq m of storage space at Darmstadt Campus, which is around 25% of the property’s NLA. The new tenant is a 100% owned agency of The State of Hesse that performs construction and property/facility management on behalf of The State of Hesse.
The lease will commence on June 1, has a long lease duration of 15 years, with two extension options of five years. With rents secured at market levels, the new lease will generate an annual rental income of approximately EUR1.2 million. IREIT’s occupancy would rise to 89% and its weighted average lease expiry would extend to 5.2 years with the State of Hesse as tenant.
Rents at Darmstadt are slightly lower than expiring rents, but higher than market rent, d’Ovres indicates. The rent per sq m is just below EUR13 while the market rent is EUR12.5. This is lower than Deutsche Telekom’s exit rent. “But that’s after 10 years with indexation. Here we are going to get indexation. We are at a pivotal point of IREIT. We’ve started a diversification. Here, we’ve been through the original assets of the portfolio and now we’ve repositioned. We are currently working on a multi-tenanted approach,” d’Ovres says.
IREIT’s Berlin Campus is the highest-valued property in the portfolio. The tenant expiry in this property is in June 2024. “If the tenant decides to vacate, what is important is to look at the fundamentals. In Berlin, our rent is currently EUR12 psm pm. The market rent is EUR25 psm pm. So there's value to be created for the unit orders. We may need to spend some capex on that, but we're not in a place where we would struggle to find a tenancy,” d’Ovres explains.
The Berlin Campus is just an 8-minute walk towards the north-east of the major public transport hub Ostkreuz, Berlin's second largest station, which forms the Eastern outer boundary of the central Friedrichshain office market with the Media Spree. Media Spree recently developed into a major CBD sub-district in east Berlin with many high-profile tenants and developments focusing increasingly on east Berlin going forward .
In Spain, the manager clinched a 12-year major lease for approximately 5,300 sq m of data centre space at Sant Cugat Green, and had a lease renewal at Delta Nova IV while retaining two tenants at Parc Sugat for three and five years.
“We have been able, last year, to secure a data centre operator for our San Cugat Green property for a 12-year lease. It was only 70% occupied when we bought it,” d’Ovres says. At the end of Dec 2022, in Spain, Illumina and Sungard vacated space. “We’re confident that we’re able to re-let this space,” he adds.
In sum, on the investment front, the strategy is to diversify assets, geography and tenants and on the leasing front it’s to raise occupancy.
Interest rate cycle
By far the most consequential challenge for REITs is the interest rate cycle, and in particular for S-REITs as on average their aggregate leverage is in the 37% to 40% range. Interest costs are their largest expenses. While the Federal Reserve appears ready to pause its hike cycle, the European Central Bank’s policy may contain at least another hike. Most recently in May, the ECB raised all rates by 25 bps taking deposit facility rates to 3.25% and MRO (main refinancing operation) rates to 3.75%.
IREIT’s aggregate gearing in 1QFY2023 stood at 32.3% and the REIT has no debt expiry till 2026 when EUR281 million matures. Of this, part of the debt expires in the beginning of 2024, and the manager plans to look at renewing in 2025. The average all-in cost of debt is 1.6%, and 96.9% of the bank borrowings have been hedged with interest rate swaps and interest rate caps.
CEREIT’s aggregate gearing is at 39.4% and its interest cover ratio is at 4.9x (IREIT’s is at 7.6x).
More than just gearing is the alarming trend of DPU. CEREIT’s DPU was on a declining trend shortly after its IPO. In 2019, DPU was 4.08 EUR cents; and in 2020 3.484 EUR cents. In 2021, CEREIT’s units were consolidated into the equivalent ratio of 5-to-1. Hence FY2022’s DPU of 17.189 EUR cents (+1.3% y-o-y) is the equivalent of 3.4378 cents.
IREIT’s DPU has also declined — from 3.39 EUR cents in 2015 to 2.69 EUR cents in FY2022, but this includes a rights issue. However, its NAV has risen from 0.48 EUR cents to 0.54 EUR cents.
Looking ahead, IREIT’s portfolio, sponsor and the sponsor support system has somewhat stabilised after the turbulent years when the sponsor was held by different parties and the REIT owned by high net worth individuals rather than institutional investors such as Tikehau and CDL.
Interestingly, ESR Group’s chairman, Jeff Perlman announced during its FY2022 results briefing that ESR plans to divest of Cromwell Property Group. CEREIT has always been somewhat independent of its sponsor, remarks a market observer, which is why the manager has announced management fees to be taken in cash. In addition, the focus on acquisitions and divestments will help to boost fee income.
Unitholders can choose whether they prefer a REIT backed by committed sponsors or one with an interesting portfolio.
