I propose purchase of Eurobank Properties (EUPRO AT) common stock around the current price of €5.75 per share.  The range of fair values is €3.25 (-45%) to €12 (+110%).

Eurobank Properties (afterwards: Eupro) is a real estate investment company (REIC).  While the tax laws for REICs in Greece are slightly different from those for REITs in the US, the Greeks aimed for harmonization, so the differences are minor.

I. A SIMPLE INVESTMENT, OUTSIDE OF THE MACROECONOMIC COMPLEXITY

The company owns prime office and retail commercial properties that it leases to blue chip tenants for terms usually longer than ten years.

Eupro was formed in 2000 shortly after REIC legislation was passed and backed by three main shareholders: Eurobank, Lambda Development, and DB REIF. 

• Eurobank is both the largest shareholder (55%) and the largest tenant (35% of rental income).  A merger between Eurobank (No. 2) and National Bank of Greece (No. 1) is underway. 
• Lambda is a real estate development company that sold its 25% ownership to Fairfax last August for €4.75 per share.  The wealthy Latsis family is the major shareholder of both Eurobank and Lambda. 
• Deutsche Bank (REIB) contributed 10% of the original capital, but reduced its stake to 5% in Eupro’s 2006 IPO. 

The company expanded during the mid-naughties, with the founding shareholders contributing €160 million in 2005, new investors adding €80 million in 2006 via IPO, and finally with a rights offering bringing in €325 million in 2007.

Today, Eupro owns 56 properties, of which 50 are in Greece and 37 are in Athens. The expansion outside Greece is being reversed and was undertaken in 2006-07 because prices in Greece were too high.  The strategy is to own only stabilized properties in high quality neighborhoods.  Reflecting the origins of the company, most of the properties are office buildings, but the firm has diversified into retail and a few industrial warehouses too. 

The portfolio of 335,000 meters is 90% occupied.  There are very few lease maturities during the next 10 years for two reasons.  First, many of the long-term leases were initiated during 2005-07 when the firm bought the bulk of its portfolio.  Second, nearly every lease has been opened up and renegotiated.  Eupro reduced rents to market rates in exchange for longer maturities and term guarantees.

Most imaginable catastrophic loss would be either deflation or Grexit.  Deflation hurts three ways.  First, deflation will stymie rental income growth, and could even cause a decline in rental income if vacancies increase.  Since the bulk of Eupro’s expenses have been outlaid, they are fixed and a decline in rental income will directly result in lower profits and lower returns on capital.  Second, deflation provides an opportunity for new competition to add supply with lower construction costs.  Note well, however, that rents on existing leases cannot decline contractually because all leases have upward only rent adjustment clauses.  Third, the real cost of in-place debt increases.

After deflation and five years of recession, however, Eupro’s rental income and funds from operation (FFO) have declined only 11% and 2%.  A combination of luck and good management produced this result.  Eupro finished 2007 with borrowings of €53 million against assets of €514 million, of which €256 million was cash!  The company acquired a few properties, which boosted gross leasable area and rental income, but it still holds €160 million in cash.  Moreover, management has been proactive renegotiating leases to keep vacancy from rising further.

Grexit produces similar consequences as deflation.  About 50% of rental income is from multi-national firms:  35% in Greece from tenants like L’Oreal, GE, Praktiker, Marks & Spencer, Sephora; and 15% outside Greece.  In a Grexit, laws would be passed to require that contracts are converted to the new local currency.  Although Eupro was unable to require that its leases stipulate payment in euro, management did add clauses to protect the CPI escalators from any freezes.  Since the bulk of Eupro’s invested capital and expenses are in euro, converting contracts so rental income is paid in a depreciated currency will cause a reduction in profits and return on investment.  Moreover, Grexit might accelerate capital flight from Greece, which in turn might increase the vacancy rate among Eupro’s properties. 

My thesis does not presuppose a low probability of Grexit. I have no idea.  But some factors that are not often discussed are Greek’s geostrategic importance to the United States and also Germany, and the fact that Greece is a small problem considering the economy is the size of Maryland or Lower Saxony.    

A big positive is that Eupro holds more cash than debt, and the debt is all non-recourse to Eupro and none of the mortgages have cross collateralization.  Management would avoid default on a mortgage at all costs, assuming stability in the present circumstances, because its reputation is so important, especially so if this is the beginning of a major investment cycle in which Eupro will seek financing.

II. MANAGEMENT IMPRESSES ME, BUT GOVERNANCE CAN IMPROVE

During Eupro’s short but difficult history, management has achieved remarkable financial results. Despite a nearly 10% contraction in nominal GDP and a more than 35% decline in rents for the industry, Eupro’s FFO has been stable. 

My evaluation of management corroborates the good-looking numbers. A series of key decisions by the CEO appear to have been critical for the strong financial performance.  First, he renegotiated Eupro’s services contract with Eurobank and drove operating expense from 27% of rental income to 10%.  This was a major contributor to keeping FFO stable during the recession.  Eupro was paying 8% of rental receivables to Eurobank for services.  The CEO reduced the fee to 2.5% of rents received, and in-sourced most functions at much lower cost.

Second, the CEO slowed the investment program in 2007 despite likely pressure from various sources to make acquisitions earlier in the financial crisis.  Since 2007, the yield on the cash has increased while the yield on real property has decreased.  Now Eupro is one of the only buyers while there is a glut of sellers, so it appears that his patience may be rewarded.  During 2011-12, the company was presented with more than 200 investment opportunities but made no purchases.

Third, the CEO continually renegotiated leases throughout the recession to keep occupancy reasonably high.  While vacancy is only about 10% for Class A office in Athens, the rate is 30-40% for secondary locations.  In retail, the vacancy rate for good locations is around 15%, and closer to 30% for secondary areas.  Vacancy at Eupro is 10%.  More important, management has endeavored to strengthen Eupro’s relationship with key multinational tenants like L’Oreal and Praktiker that could lead to expanded business relationships in the future.

In addition, lease maturities were continually extended.  For example, 25% of leases matured in 2013-14 as of 2008, but by 2010, the figure had been reduced to 11.6%.  But during that period rental income per square meter declined only 3% from €136 to €133.

Little overhead or bureaucracy exists at Eupro.  The firm has only 16 employees, up from five in 2006.  Compensation consists of salary only, no bonus or option grants.  Compared to US REITs, employee compensation expense is modest at Eupro.  The table below illustrates that the total expense for all 16 employees at Eupro is $1.1 million, while CEO comp at US REITs averages over $4.0 million. Even adjusting for size, Eupro’s expenses are light.  Total compensation of top five executives for US REITs is typically 0.13% of total assets.  At Eupro, the ratio is 0.11%.

The CEO is focused on improving corporate governance because he wants more international partners, both shareholders and tenants.  I suspect he welcomed Fairfax to the Board of Directors and would enjoy the introduction of incentive compensation for himself and the management team.

Another favorable indicator about governance is share repurchase activity.  During the sovereign crisis in Greece, the company repurchased shares to the extent permissible under local regulations.

III. EUPRO IS AT THE NEXUS OF A PROMISING GROWTH OPPORTUNITY

Opportunities are plentiful.  It is not difficult to identify several investment opportunities in Athens that would consume €500 million in capital, and many similar opportunities are likely to emerge given Eupro’s strategic relationship with Eurobank, which will increase in relevance once Eurobank merges with National Bank of Greece. The Greek banks are waiting for buyers to emerge for OREO, and following the recapitalization planned for this spring, they will have new capital to absorb losses.

Eupro has ample buying capacity.  Most important, cash on hand totals €160 million leftover from a €330 million rights offering in 2007.  Eupro has only €80 million in borrowings, leaving it with considerable borrowing capacity.  Leverage stands at only 15% of assets.  The legal limit on leverage for REICs is being raised from 50% to 70%, although management sees 35% as ideal.

Fairfax Financial stands ready to finance an acquisition program.  The Canadian insurer recently acquired 20% of Eupro’s stock and NBG has announced that Fairfax is interested in recapitalizing the bank – not surprising given what Fairfax has done in Ireland.  Partnering with the local team at Kennedy Wilson, Fairfax has bought four commercial properties in Ireland.  Fairfax ended 2012 with $7 billion in cash, which equals 28% of the firm’s investment portfolio.

Prices are below replacement cost and yields are over 10%.  There have not been many commercial real estate transactions in Greece lately.  But that will change owing to foreclosures and government privatization.  Scuttlebutt research suggests that price negotiations exist around 70% of construction cost and 11-12% cap rates.

Growth prospects are beginning to improve following six years of recession.  Funds from operation derived from the existing portfolio will probably remain stable at around €36 million.  The occupancy rate should not change significantly because only 20% of leases mature in the next five years, and the bulk of these tenants are multi-national firms such as Carrefour and Marks & Spencer.  In exchange for opening up leases and reducing rents, Eupro secured guarantees from tenants to honor minimum lease terms, and to pay penalties if they do not.  The weighted average length of the tenant guarantee is seven years. 

Acquisitions could provide a €10+ million (+25%+) boost to FFO in the near term. The table below sets forth how Eupro is positioned to grow FFO and dividends through acquisitions.  In phase one, the firm purchases properties for €300 million which boosts FFO from €38 million in 2012 to €48 million, and the dividend to €0.75 per share.  Afterwards, the debt-to-assets ratio would approach management’s target of 35%.  But cash balances would remain high, at €110 million, or 11% of assets.  So Eupro could pursue phase two:  purchase another €100 million of assets, boost FFO further to €53 million and the dividend to €0.85 per share, and still have €50 million of cash on hand.

IV. MARGIN OF SAFETY GROUNDED IN FEAR OVER GREXIT

Cash exceeds debt.  Eupro’s €161 million of cash equals €2.70 per share.  There is no reason why some or most of this cash cannot be held outside Greece.  The €80 million of mortgage debt is non-recourse to Eupro, although half the debt is on properties outside Greece.

Cash flows have been resilient.  Funds from operation are only off 2% from the peak, but will likely decline further in 2013. The table below supplies the figures.  Since investment property is carried on the balance sheet at appraised value (AV) not historical cost, and changes to the appraised value are recognized as gains or losses on the income statement, the company reported a loss in 2012.  The reported loss caused a decline in the dividend, and if losses continue, the company’s capacity to pay a dividend may run out.  That is not necessarily negative in my view, given that the return on cash (deposits) is high, and retaining cash creates more opportunity for acquisitions.

The market value is 55-60% of construction costs and 40-45% of appraised value.  Eupro’s assets can be organized into three main categories: (a) €547 million of investment property, (b) €161 million of cash, and (c) €10 million of other assets.  The investment property is carried at appraised value.  The appraisals are done regularly by three different parties: (i) the Body of Sworn-In Valuers of Greece (the value used in financial statements), (ii) the company’s auditor PricewaterhouseCoopers, and (iii) by Colliers, or any other real estate firm that Eupro chooses when it files registration statements with the Hellenic Stock Exchange.  After adjusting for the net cash, Eupro’s enterprise market value at €5.75 per share of €230 million is only 42% of the appraised value of €547 million.

Though I remain skeptical about the appraised value, back testing does not reveal any mismarked properties.  Specifically, Eupro completed six property disposals during the past five years for proceeds of €19.5 million.  No disposal proceeds failed to exceed the appraised book value (see table below).

Management estimates that construction costs for the investment property equal €400-450 million, or €1,200/SQM or €120/SQF or $90/SQF.  This seems reasonable.  For example, when Blackstone’s head of real estate (Jon Gray) discusses buying below physical replacement cost, he typically uses a $100/SQF number.  This ascribes no value to land, although many of the firm’s centrally located plots are not replaceable.  Eupro’s market value of €230 million is only 57% of the estimated construction costs of €400 million.

Eupro is worth between €3.25 to €12, based on poor and positive outcomes that I can imagine.  Based on a purchase price of €5.75, the downside is 45% and upside is 110%.

The following key assumptions form the basis for the €3.25 per share value.

1. Rental rates decline by 20%
2. Occupancy declines by 5%
3. Eupro spends €60 million of its cash adding 70,000 SQM to the portfolio
4. FFO is capitalized at 12.5% (the avg and high for 2012 were 15% and 26%)
5. Currency devaluation of 50%
6. One third of the cash is held outside Greece and does not devalue by 50%

The following key assumptions form the basis for the €12 per share value.

1. Rental rates and occupancy levels for the existing portfolio are stable
2. Eupro spends €300 million adding 270,000 SQM to the portfolio, financing the acquisition with €250 million in debt at 7.0% and with €50 million of cash on hand (some incremental debt is secured by properties that Eupro already owns but are unencumbered presently)
3. FFO is capitalized at 7.5% (the average FFO cap rate in 2006-07 was 6.1%)
4. No currency devaluation