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LEG Immobilien Research Report

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Robur link for LEG Immobilien: here

ISIN: DE000LEG1110

About

LEG Immobilien AG is a German-based residential real estate company. The Group’s portfolio primarily comprises real estate properties located in the North Rhine Westphalia region in Germany. The portfolio is focused on three regions: the Rhineland, the Ruhr and the Westphalia region. It ranges from urban apartments to residential neighborhoods in rural areas and owns/operates more than 90,000 units.

LEG has some good points of interest.

  • This a purely residential operation
  • The company operates only in Nord-Rhein Westfalen (NRW), the part of Germany with the most interesting demographics
  • Unusual business model, good credit ratings, ambitious capex plans
  • Interesting focus on customer satisfaction as a means of retaining lessees and reducing vacancy rates

Financials

LEG is a leveraged growth story – which is why the Robur engine has recently highlighted it.  Long term debt mirrors shareholder equity and runs around 4.25 times revenue.  However, interest rates are low and in the last financial year amounted to EUR 83M, about 2.6%, helped by two bond issues which carry interest at 1.25% (on EUR 500M) and 0.5% (on EUR 300M) respectively (but see below on the risks attached to the EUR 300M bond).

The company makes the most of its credit in order to achieve the remarkable compound annual growth rates (CAGR) shown above.

A high percentage of the residential portfolio is fifty years old of over – 70% of the buildings were constructed before 1969, and only 6% after 1990.  Such an elderly portfolio offers good potential for rent uplifts following refurbishment and that is the LEG model in a nutshell.  This requires a robust capex program and it also requires very careful management and control of that capex, both financially and on the ground.

LEG have done their demographic analysis.  NRW has two things going for it as a region:

  • it is the “youngest” region of Germany, with low unemployment (<7.5%)
  • it is the principal target for immigrants because of employment prospects
  • since 2011, the major cities in the region have reversed previous population declines and are now growing again
  • majority of tenants are 1-2 person households and this is the market LEG serves (the trend in household size continues to drop);
  • average rents of just EUR 324 per month are currently highly affordable and ensure low vacancy rates (<6%);
  • 60% of households rent, only 40% are owner-occupied.

LEG have reduced their administrative costs in relation to revenue from 10.2% of “cold” rents in 2012 to 6.3% in 2016.

With their elderly housing stock, LEG have recognised the need for prompt efficient and satisfactory repair and maintenance functions.

  • Recognising the issues faced by skills shortages in residential housing maintenance, LEG has entered into a joint venture to provide a stable source of qualified labour for repairs.
  • This is part of their focus on customer retention as one factor in reducing vacancy rates.

Risks

There are the obvious risks with real estate – markets can head into downward spirals for political or macro-economic reasons outside the control of the company; new regulations can impose high refurbishment costs or rent controls.

LEG has a specific risk –  a risk which actually amounts to a near certainty:

  • EUR 300M of convertible bonds become due 1 July 2021, and can be converted in 2019 if the share price meets certain criteria, which currently amount to EUR 74 per share (compare the current share price of EUR 75.75
  • If converted, the result would be to reduce long term debt but to dilute the present equity by a net 7.2% (5.3 M shares added to current shares outstanding of 68.3 M shares). The shareholder equity of the company would, at current prices, be reduced by EUR 100M – a 3% drop.
  • This is not a major issue but it is probably going to happen in about 2 1/2 years time.

LEG is vulnerable to significant interest rate rises:

  • a rise of 1% in average interest rates would mean that over half current cash from operations would go straight to interest payments;
  • a rise of 2% in average rates would mean that three-quarters of current cash flow would go to interest payments LEG Immobilien
  • rises of this kind would put in question the capex program on which rising rents are predicated.

LEG has the typical leveraged real estate risks:

  • Shareholder equity is consistently valued at approximately the total long-term debt. Although currently EUR 800M of the EUR 3.2Bn long term debt is in the form of bonds, the rest is presumably vulnerable to the usual covenants, which a prolonged down-turn in the residential market in NRW would trigger.  In such a case, the company might become insolvent, or face a very long recovery period.
  • This is a much more serious issue than the bond conversion issue, but is (hopefully) not very probable. It would take a very substantial political earthquake to cause covenant breaches on this scale – but, for example, a win by the NF for the French presidency, and by AfD for the German presidency or for substantial influence on state or federal parliaments, could represent precisely that sort of earthquake. LEG Immobilien

Assessment

 

Judging by the share price graph, investors are fully aware of the risks of this highly leveraged company, operating with old housing stock.  We certainly see the risks.  On the other hand, we think LEG have a really interesting model, whereby refurbishment, combined with the removal in many cases of old rent controls over the next few years, offers a real opportunity for steady rental uplift.  There is little doubt that the increased size of the operation is helping to drive down unit costs, both in administration and in capex. LEG Immobilien

LEG is not a no-brainer.  Nor is it expensive:  Price:Earnings of 9.2, Price:Book of 1.5, a Graham multiplier of 13.8, and a yield of 3.64% (this year), expected to rise to 3.86% next year and 4.2% in 2018 (on the current share price) are all attractive, if not startling.

We like LEG but we accept that it is rather high risk compared to many real estate operations.  If the executive team can carry out their interesting business model as successfully over the next five years as they have over the previous five years, this will be a good long-term stock.

 

*Disclaimer: I/we have recently initiated a long position in this security

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