Description

5.90% Grand City Properties Perpetual bond

ISIN XS1811181566

I believe the 5.90% Grand City Properties Perpetual bond is an attractive long, offering a rare double-digit annualised total return potential for bearing Investment Grade risk.

These bonds currently trade around 57 cents on the euro for a cash-on cash yield of 10.4%.

Grand City Properties is a real estate company focusing on the German residential sector. It currently holds 76k units located mainly in North Rhine-Westphalia, Berlin and other large metropolitan areas. Since 2018, it has also held residential properties in London. Grand City‘s common equity is listed on the Frankfurt Stock Exchange.

Summary of Grand City’s balance sheet, capitalization, debt burden, leverage and some chosen risk and performance metrics.

Shares outstanding: 172 million

Last traded price: EUR 8.3

Market Cap: 1,448 million

Gross Debt: 4,032 million (bonds: 3,525 million, loans: 506 million)

Cash and liquid assets: 714 million

Net Debt: 3,318 million

Investment Properties: 8,990 million (unencumbered assets: 7.7 billion)

Held for Sale Properties: 193 million

LTV: 36%

Current cost of debt: 1.6%.

H1 23 Net rental Income 204 million

H1 23 Financial Expenses: 27.3 million

H1 23 Adjusted EBITDA: 160 million

Business performance looks satisfactory. Both rental increases and vacancy seem to follow a positive trajectory so far:

In line with the company PR, I calculate that the Interest Coverage Ratio stands at x5.8.

This is how the debt stack is spread out:

Up until Q2 2026 Grand City is not liquidity-challenged as cash and liquid assets cover the few upcoming maturities. However 2027 and 2028 maturity cliffs are a different matter and we need to form a view on the refi risk.

 Let’s have a look at some of the main senior bond covenants.

Total Debt/Assets <60% test: we sit at 36%. It would take a minus 40% hit on the property values, about 3.6 bln to reach this limit.  I think this implicit market view is a bit harsh. I do not exclude, say, a 25% drop, top-to-bottom, but richer cap rates with a big premium to Bund yields should offer a floor thereafter.

 Interest Coverage Ratio> 2 test: all issuances under the EMTN program require a minimum Adjusted EBITDA/ Interest coverage of 1.8x; we sit at x5.8, but that is looking at the rear view. 

I suspect that ICR is without a doubt the main worry today. The trajectory of WACC for all Real Estate funds has been one way up since the ECB started to fight inflation after Covid and the Ukraine war.

Why this opportunity exists

Higher interest rates are very challenging to mitigate within the REIT sub-sector that is German Residential, as the liability side is undoubtedly levered but the asset side, i.e the rents, are not directly benefiting from inflation: there is some growing local CPI indexation of rents, but within a capped regulatory framework that limits what the landlords can do. Germany enforces a general cap on rent increases, allowing landlords to raise rents by up to 20 percent over three years. In regions with a particularly competitive housing market, this cap is lowered to 15 percent.

It is a well-known fact that most tenants tend and intend to stay as long as possible in their rental flats, where rents are usually well below market levels. According to industry sources, this points to tenant rotation of circa 5 to 7% per annum, with limited differentiation between Berlin and the rest of Germany. Consequently, even though there is an acute housing supply shortage it takes a lot of time for landlords to capture reversion, because so few tenants plan to move flat.

Grand City Properties would be toast if they had to refinance all upcoming debt at the prevailing market yields. Current Yield-to-Maturity of their listed 1 billion Jan 28 issue is 7.18%. That is more than 4 times their current average fixed interest cost of 1.6%. Applying such a punitive bond market refinancing cost on their Gross Debt would drive the interest cost to an annualised EUR 290m charge, not so far from the current running EBITDA of about EUR 320 million.

A path towards refinancing?

To mitigate this new refinancing cost, Grand City is increasingly resorting to bank loans. They point out that current bank financing is relatively attractive with all in rates well below bond yields, with a 130 bp/140 bp spread locked-in in H1 2023 for new debt. I work out this equates before any interest rate hedge, to a spot interest rate charge of about 5.50%, a hefty150 bp below the 2028 bond yield.

Grand City could also use part of their unencumbered assets (70% of their Total Assets) to access secured financing well below unsecured bond rates.

By way of cash preservation, Grand City, in line with his peers such as LEG, has already cut its dividend for 2022. According to their PR, they may resume the dividend as early as 2023, but a lower pay-out (from historical 75% of FFO) is also envisageable. From their PR’s DPS for 2023 will also be "subject to market condition and AGM approval" ; GCP then guided they could be possibly reinstated down 12% to €0.74-€0.78.

There is no sugarcoating it: Grand City needs to greatly delever their Net debt/EBITDA ratio but I think a combination of rental growth, increasingly driven by direct CPI indexation, maybe close to the current 3% underlying trend, asset sales (300 million per annum does not seem out of reach), and of course continued cash preservation measures, should avoid a liquidity crunch at least in the next 2 years.

Why choosing the Perp over the common equity?

We should first recap the Perp’s essential features.

I have picked GCP’s EUR 250 million issue which has very recently switched to a stepped- up 5.9% coupon (EUR CMS 5y +243 bp fixing in late Oct 2023) from the initial 2.5%,  and obviously has not be called.

Credit Ratings are Moodys Baa3, SP BBB-.

Those Perpetual notes are ranked junior to debt securities and have no covenants. They stand as undated subordinated notes. GCP has the option to call the Perpetuals at or around every future interest payment date. The issuer has no strict requirement to call. Not calling a note on the first optional call date doesn’t necessarily lead S&P to take a negative view on the Company’s creditworthiness. Naturally, noteholders don’t have a put option on the call date.

Under S&P methodology Perpetual Notes are considered 50% equity / 50% debt until the first call date.  Thereafter once the Coupon reset date is past, and Grand City does not call the Perps, they are treated as 100% equity under IFRS and serve to the calculation of financial covenants of GCP’s senior bonds. Coupons are deferrable at GCP’s discretion and would automatically resume if and when any dividends are paid on the common. So far so good, none of GCP Perps coupons have been deferred.

Let’s not fool ourselves, owning Grand City securities amounts to a leveraged play on interest rates. Any whiff of indication that ECB rates are plateauing or reversing and the equity and bonds should greatly perform. But we cannot exclude a prolonged period of weak rental increases, difficult asset sales, and sustained challenging bond and capital markets that could compress earnings and distribution for an extended period. In that context a capital raise to extend the equity buffer is a scenario with decent probability.

I like the double digit carry on those GCP perps, and I assume any deferral of coupons would not necessarily be a thesis-killer thanks to the deferral mechanism. I am not naïve enough to think they will converge to Par, there is no requirement to call but I posit the Perps should benefit from any tightening of GCP’s overall financing costs, and would at some point in time become a prime candidate for an opportunistic tender. This is also why I prefer the 5.9% over the 6.33% which trade at a higher price (circa 68%)-those are less likely to be bought back as they offer less capital gain potential for CGP.

Catalyst

Asset sales

Equity issuance

Continued operating improvement, rental increases, vacancies rate

Paydown, refinancing of near term debt maturities