Welcome to all my readers.
For a while now, I've been looking at a new residential REIT to include into my portfolio. Upon my research spanning dozens of companies, I came up with two interesting prospects from Europe. Overall the availability and quality of purely residential REITs in Europe is relatively low but I have identified two potential investment targets. We will first go over my reasoning for focusing on residential REITs, why I'm interested in European ones and then we will proceed to take a closer look at these two companies. The main point of this article is to provide investors with some basic knowledge of these foreign investments, and why some might want to consider these instead, or in addition to, North American companies.
Why Residential REITs?
I have always been interested in residential real estate. I have never owned, and I will probably never own, an investment property due to the time, effort and risk involved in owning a single house or apartment. REITs were a convenient way for me to enter the real estate market, I do not have to worry about my tenants, renovations or repairs, or even selecting the real estate asset(s): it's all taken care of.
While REITs offer several different types of real estate properties to invest in, I prefer residential. It is resistant to economic downturns, and very resistant to new technology. Online shopping is Europe has been increasing at a significant pace, more and more restaurants are benefiting from food delivery services and I think the current pandemic will also speed up the adoption of different work from home arrangements. These are just the trends we are already seeing today, and I think it would be foolish to imagine that similar types of services would stop from emerging. While other real estate sectors will suffer from these changes, residential real estate might even profit. When people spend more time at home, surely they are also willing to spend a bit more money on having a nice house or apartment?
There is also the issue of mobility as less and less people are planning on spending their entire lives in the same location. In Europe the percentage of "mobile citizens" (people residing in a member country that they are not a citizen of) has increased significantly from 2008 to 2018. The reasons for moving could be family, work, studies or people might just want to try living in another country for a while. Owning a house just isn't a very plausible option if you are not sure that you will be spending a long time in the same city. I believe this strongly increases the demand for rental apartments, especially from young adults.
To sum it up: I believe that there are several trends that provide increased demand for rental apartments and houses. It is not a very cyclical industry and I believe residential REITs to be significantly safer and more stable in the long term than their peers who chose to invest in commercial real estate. These investments won't make you rich overnight but they can be a good way to generate stable cash flows without going through the trouble of finding and managing your own properties.
Why Europe?
There are a couple of reasons why I'm interested in real estate in Europe.
Firstly, geographical diversification. I am skeptical of investing into many sectors in Europe due to the current economic and political environment but there are exceptions, and I think real estate is one of them. If I want to invest a part of my portfolio into Europe for diversification, I believe real estate and utilities to be a good place to start. They always have demand from consumers and it is not possible to outsource these industries abroad, which has been the downfall of many manufacturing industries in Europe.
What is very encouraging is also the ridiculously low interest rate environment in Europe. The European Central Bank's deposit facility interest rate was set to zero in July 2012 and entered negative territory in June 2014. Currently the interest rate stands at -0.50% and it is very unlikely to climb up anytime soon. It has even taken otherworldly proportions in 2019 when a bank in Denmark started offering negative interest rates on their mortgages. However, keep in mind that Denmark is using their own currency.
While I don't expect negative mortgage rates for most of Europe anytime soon, I do see very low interest rates lasting a long time. What this means for stable REITs is an interest expense between 1% and 2% for the foreseeable future, and coupled with relatively high rents this should show up in the bottom line.
ERES - The Risky Option
A relative newcomer to this field, ERES (European Residential Real Estate Investment Trust; ticker TSX: ERE-UN.v) is a real estate investment trust listed in Canada but specializing in European real estate. They have been in business under their current setup since March 29, 2019.
ERES currently owns 131 multi-residential properties, comprised of 5,632 suites and ancillary retail space located in the Netherlands. In addition to this, they also own one office property in Germany and one office property in Belgium. While there are some commercial properties included in this REIT, they only represent a small part of the portfolio and it appears that the company is trying to sell them, with a successful sale of their second German office location finalized on January 31, 2020.
I particularly like the Netherlands as a location for residential real estate. Population density is among the highest in Europe, especially in the western part of the country, and the total population is still increasing slowly. The large majority of the population already lives in urban areas, and this number is increasing annually too. Due to the above mentioned reasons, residential real estate is already very expensive and rents are high in cities but I still believe that overall the conditions make the Netherlands an attractive location for residential real estate investments with a long-term view.
The main issue with ERES is the fact that Canadian Apartment Properties Real Estate Investment Trust, CAPREIT (TSX: Car-un.to, OTC:CDPYF) owns 66% of the outstanding units and as such controls the company. They are also responsible for managing all of the residential units of ERES in the Netherlands, which of course is the large majority of their total portfolio.
Finances
Unfortunately, with ERES being such a new company, we don't really have any realistic numbers that we can compare to in order to determine historical growth rates. As such, I will only be focusing on the pure numbers from their 2019 annual report. It is important to note that while ERES units trade in Canadian dollars, they report their financials in euros.
For the year 2019, the company generated Funds From Operations (FFO) of 0.136 euros per unit. This would lead to a current Price/FFO of around 18 but please keep in mind that the company only operated under its current structure for 9 months in 2019 and did not own the majority of their current portfolio for the whole 9 months.
They are paying a monthly distribution of 0.00875 euros per unit, resulting in an annual yield of roughly 4.30%. Currently their FFO payout ratio is 77%, so this yield is definitely manageable and the management has indicated that their plan is to increase distributions annually, which seems like a very plausible scenario considering the growth of the REIT as well as their modest payout ratio.
Thesis
ERES is operating in a lucrative geographical location and while the company is new, they seem to be trending in the right direction in terms of growth. During the last 9 months of 2019, the company more than doubled their existing portfolio by acquiring over 3500 residential units. The company has a modest payout ratio resulting in an annual yield of 4.30% with room to grow. It's also worth noting that the monthly distribution is certainly welcome for investors looking for steady cash flow. As I mentioned above, the management has stated that the plan is to increase distributions annually so we do not have to worry about the yield diminishing due to inflation.
While this REIT looks interesting due to the above mentioned facts, I am a bit skeptical due to the lack of history and due to their situation with CAPREIT. I am not very comfortable seeing CAPREIT both own 66% of outstanding units and also having the rights to manage a large portion of ERES' assets.
(chart from TIKR.com)
While not exactly cheap, units can now be purchased with a pretty significant COVID-19 discount relative to their historical price. This is a welcome discount as in my view their ownership structure, relatively small size and young age result in heightened risk. I believe that ERES has significant potential and could be a great investment for the long term, however it does require more risk tolerance than your average residential REIT.
Vonovia - The Old Reliable
Vonovia SE (OTCPK:VNNVF, OTCPK:VONOY) is one of the larger players in the European residential real estate market. Based in Germany, they own roughly 416,000 residential units in Germany, Austria and Sweden. While operating strongly in all of the markets above, it should be noted that Germany still makes up for a lion's share of their business. I should also mention that while they do not currently own any real estate in France of Netherlands, both of these countries are on their list of potential targets for expansion.
(image from Vonovia Investor Presentation, March 2020)
Vonovia has only been listed as a public company since 2013 but its history goes back to the year 2000 when it, under the name of Deutsche Annington, bought railway workers' homes from the German government in a privatization deal. Obviously since then the company has quickly grown and is now one of the major players in European residential real estate.
Vonovia offers investors a rock solid history, economies of scale, diversification across multiple countries and the potential for extended growth in multiple countries within the EU. Growth has been fantastic, especially in their early days of being a private company, but the track record since the IPO in 2013 also speaks for itself.
Financials
(image from Vonovia Investor Presentation, March 2020)
As you can see, Vonovia has rewarded investors with stable and significant growth since their IPO. I am especially satisfied to see that they have increased their Funds From Operations per share during each and every year of their existence as a public company.
Closely related to both company success and shareholder returns, Vonovia has also been successful in increasing their annual dividend by roughly 10% every year while maintaining a modest payout ratio of around 70% of FFO.
Thesis
Vonovia has all the trademarks of a successful investment for long-term investors. The company is growing profitably, FFO is increasing at a steady pace and the company has been generous in rewarding unitholders with an increasing dividend.
The only issue with Vonovia is the valuation. The company is currently trading around 46 euros per share, a P/FFO of over 20. Dividend yield, while growing at a good pace, is only 3.40%. This will surely not impress investors who turn to REITs for high yields, though the impressive growth rate partially makes up for this shortcoming.
(chart from TIKR.com)
As you can see from this 5 year chart, Vonovia is currently trading close to where it was for the majority of 2019. The COVID-19 induced dip at the beginning of the year certainly helped to bring valuation down but the subsequent rebound has been fast and I do not consider Vonovia to be historically cheap at this time.
Conclusion
Truth be told, the selection of residential REITs from Europe is relatively weak. These two companies present the ones that I was most interested in researching after spending some time getting to know the sector.
Still, neither of these companies exactly stands out as a screaming buy. They both have their strong and weak points and represent somewhat different types of investments.
ERES is certainly much more riskier than your average residential REIT, though they have shown promises of fast growth and their geographical location should benefit them in the long term.
Vonovia does appear to be a diamond in the rough, and perhaps the relative stability of their business models, attractive locations for their assets, geographical diversification and relatively low payout ratio together with the promise of annually increasing distributions might be enough for some investors to justify paying a little extra for quality.
Dividends From The Moon
I started investing in my early twenties. At first it was to find a productive use for my cash, then it turned into a hobby, then into a passion. Throughout the years my plans and strategies have evolved but the focus has always been on achieving financial independence through long-term investments into high quality companies with competitive dividends.
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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