Valuation Worries Rising Interest Rates Hit Real Estate Shares

The apartments owned by Germany's big four corporate landlords are gaining value fast. But with rising interest rates the high valuations are being questioned, hitting share prices.
Apartments in Berlin are shooting up in price.

In a few days, Germany's apartment rental giants will present excellent figures for the last fiscal year to their shareholders. The reasons are simple: The four firms, Vonovia, Deutsche Wohnen, LEG Immobilien and TAG Immobilien, are benefiting from a housing shortage that makes it easier to rent apartments. At the same time, this scarcity increases the value of their properties.

This means that healthy revaluation surpluses will be reflected in the financial results of the companies, all of which are listed on either Germany's top stock index, the DAX, or its smaller cousin, the MDax.

But there’s a problem. Revaluation surpluses are not compatible with interest rates that have been rising since the election of Donald Trump as the new U.S. president. Vonovia Chief Executive Rolf Buch, for example, constantly finds himself having to explain to investors why higher valuations are still justified. Real estate values are the key factor.

Another problem is that even though portfolio values are rising, share prices have been falling since August.

From a purely mathematical standpoint, the conventional valuation model holds that the value of apartments should decline when interest rates rise. This is because future rental yields are reduced to the current value. It normally declines when interest rates rise.

Although rising interest rates will not put a strain on balance sheets this year, share prices will.

But this rule is suspended in the current climate, because market development has a stronger impact than higher interest rates. "Apartment values do not decline when interest rates go up," said Mr. Buch, citing studies going back to 1992. "Location is far more important in the development of real estate value." Price rises are particularly likely in metropolitan areas, because apartments are scarce there.

But Vonovia, Deutsche Wohnen and others don't just use their own expertise to determine the value of their portfolios. Their results are regularly examined by appraisers, who compare real estate values against prices achieved in the sale of apartments in comparable locations.

Using press reports, private investors can perform rough estimates on whether the appreciation of these companies seems plausible to them, because all four companies publish the number of apartments they own in their most important markets.

For instance, a shareholder of Deutsche Wohnen can find out that 70 percent of the roughly 160,000 apartments the company owns are rented in the Berlin metropolitan area. A few days ago, brokerage firm Engel & Völkers published an incredible price growth rate of 18.8 percent, based on sales offers, for residential and commercial buildings in core city neighborhoods for 2016. This prompted Deutsche Wohnen to announce valuation gains of at least €2.2 billion ($2.4 billion) for the past year.

Figures by group vdp-Research are a better fit for Vonovia's portfolio of about 340,000 apartments located throughout Germany. The analyst reported that the cost of multi-dwelling buildings in Germany had increased by 7.1 percent by the end of the 3rd quarter of 2016, compared with the same quarter in 2015. Newer figures are not yet available. The vdp figures are based on actual transactions. Vonovia has held out the prospect of "significant gains in value" when it present its 2016 consolidated financial statement on March 7.

LEG shareholders can expect the company's apartments, which are rented almost exclusively in the western state of North Rhine Westphalia, to appreciate by €420 to €450 million. TAG Immobilien reported a €164 million increase in the value of its real estate portfolio last September.

The financial and quarterly reports also provide information on how much a square meter of residential space is worth, and about the rent multipliers in the portfolios. The multipliers indicate the value of apartments in terms of the number of net annual rents or, conversely, the rent yield. For example, if an apartment is valued at 20 times its annual rent, the rent yield is 5 percent.

Even these numbers can be difficult to interpret. LEG is a case in point. Despite the increase in apartment prices, the company's third quarter 2016 report shows a lower apartment value per square meter than in late 2016. "The decline in this key indicator results from the acquisition of inventory with a below-average valuation per square meter," LEG explained. On the other hand, a rising rent multiplier can also mean that apartments with high rent yields were sold.

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In any case, appreciation drives up the net asset value of real estate. There is a good reason why shareholders pay close attention to the NAV per share. It enables them to determine how much their assets are worth, regardless of the company's share price. NAV per share has risen for all four companies, even though their share prices have declined since mid-August 2016.

This could change after the reappraisal of apartments for last year and the resulting rise in NAVs. The market rule that applies here is that a stock is considered fairly valued if it is traded at prices around the NAV per share. But Mr. Buch wants more than that. "Of course, it's in our interest that our shares are traded at a premium above the net asset value per share. After all, we generate additional value with our services."

Goodwill is also reflected in property value. Goodwill is the intangible value, or the premium that has to be added to the price so that takeovers occur. This is especially applicable to Vonovia.

No major property rental company has grown as quickly through acquisitions as Vonovia, which is listed on the DAX index. The largest of six acquisitions was the purchase of 144,000 apartments from competitor Gagfah in late 2014, for €3.9 billion. As a result of these acquisitions, the share of goodwill in property value is the highest for Vonovia, at about 25 percent in late October.

But that’s a warning sign. "A higher share of goodwill in the net asset value should attract the attention of shareholders and should give rise to questioning the valuation of properties," said Wilhelm Breuer, owner of Dr. Breuer Capital Market Advisory.

For Mr. Buch, goodwill represents the synergies he plans to achieve with takeovers. In other words, Vonovia is convinced that it can achieve higher yields with the acquired apartments than the previous owners did. Mr. Buch also points out that auditors must audit and confirm the intrinsic value of goodwill annually. If this is no longer the case, a property has to be depreciated, which would depress the company's earnings.

Although rising interest rates will not put a strain on balance sheets this year, they will affect share prices. Real estate stocks react to higher capital market interest rates with price losses. However, interest rates in the market can also rise without an increase in base rates, as was evident after the U.S. election. This is why the decision by the European Central Bank to keep base rates near zero not an all-clear signal for German real-estate stocks.

However, rising interest rates for residential real estate are not the only risk. "In this election year, politicians will outdo one another with announcements on all the things they intend to do for renters if they win their election. That will put a strain on the sector," warned Helmut Kurz, manager of the E&G Global REIT fund.


Reiner Reichel specialises in real estate, closed-end funds and system models. To contact the author: [email protected]