Description

European Real Estate Investment Trust Limited

Ticker: ERET LN

Shares out: 29.648m

Recent price: 104p

Market cap: £30.8m

Summary

I like “bogo” deals at the supermarket: buy one, get one free.

ERET has zero debt and 35% of its market cap in cash.

At ERET’s current enterprise value (its market cap less its net cash), you’re buying a German shopping center and a well-leased Spanish industrial building.

For free, you’re getting two other well-leased Spanish industrial buildings and an office building in the commune of La Gaude, very close to Nice, in the French riviera (the “IBM La Gaude” site). That’s 751,492 sf of property in Europe, for free.

The largest shareholder is on the board and understands real estate well. They’re focused on maximizing value and liquidating this entity.

The board appointed a manager (Schroders) and gave them cash incentives to maximize value.

While the board has indicated it may take 2-3 years for this to play out from this point forward, the stock is cheap enough relative to what you’re getting that my IRR estimate is 23-31% over that period, based on the stated net asset value adjusted for the current fx and recent events. I estimate current NAV is 170p per share and the entity is cash flow positive.

I believe there may be a kicker or two to the stated net asset value which could juice this considerably, but that would just be gravy to my IRR estimate.

The stock is down on no news flow, and I think this is a great entry point.

Brief history

ERET is a company that raised money during the boom years, bought a lot of over-valued assets, was externally managed -- everything you don’t want to see. Smart investors saw the opportunity, took over the board, and have been slowly liquidating the portfolio. Today you have a well-managed residual portfolio being liquidated for the benefit of all shareholders.

The assets

Here’s a quick overview:

The company doesn’t really break down the individual valuations for the assets, so this is estimated. The assets are held in euro, but the company reports and is listed in pounds. So I am marking these to today’s GBP/EUR exchange rate. I believe there will likely continue to be pressure on the euro given the initiation of QE, so I’m hedging the euro exposure by being short euros.

Spanish industrial buildings

ERET owns three industrial buildings in Spain. These are all leased to Panrico, which is a well known (in Spain) donut maker, sort of a national icon. Oaktree Capital is Panrico’s owner. Panrico has been restructured, and as part of that restructuring, its rent paid to ERET was lowered by 25% last year in exchange for a lease extension of 8.5 years.

The rent you see above, totalling €2.46m for the three Spanish properties, already takes this into account. These new leases, however, have an average outstanding maturity of over 25 years. After 2018, ERET has the option to re-instate the previous rent level and the previous term based on Panrico’s financial standing.

I’m valuing these industrial buildings at $35/sf which is where I believe the company is marking these based on their balance sheet. I believe this is conservative given that a comparable property, in Murcia, was sold last year for $43/sf (although it was a very small, 9,234 sf site). On the other hand, look at the rental yield, at 14.3%. That’s way too high. If these got sold at a 12% yield, it would represent a mark 19% above this valuation, for example.

(It’s also fun to see how much lower these assets are marked compared with 2007. Back then, the Valladolid asset was at $107/sf; Madrid, $87/sf; and Cordoba, $57/sf, all on current fx.)

The column “Est GBp / sh LIVE” shows the estimated, live pence per share valuation of the assets. In aggregate, the Spanish industrial buildings add up to 43p per share.

Panrico’s site in Valladolid:

Bird’s-eye view:

German shopping center

This is a shopping center located in the town of Kaiserslautern in Germany. Google street view hasn’t been there yet but here’s the map link: http://goo.gl/maps/kSPey.

There are three tenants in the center: Peek & Cloppenburg, H&M and Ernstings Family. Aggregate rental income from these tenants is €1.54m. I mark this asset at €20.94m as I believe this is the “Properties held for sale” on ERET’s balance sheet. I have further adjusted this (and all other assets as well) by the 1.50% decline ERET reported on the Dec 2014 valuation. The 7.4% cap rate for this asset makes sense given the rental income.

Ironically, I view this as the “riskiest” asset, because it is held on a ground lease. This makes this property less liquid than it should be. The tenants have >9 years remaining on their leases; I imagine that, if it weren’t for the ground lease issue, this asset would have been sold a while ago. The company is in talks with the lessor and my best guess here is that we’ll have to give them some sort of concession, in the form of a higher rent for the land, in order to package this for a sale. This will mean a lower value for this center, although it’s hard to quantify how much. For now, I keep it as marked.

IBM La Gaude

La Gaude is a residential commune about a half hour drive from Nice, in the south of France. IBM established its research center there (and this office building), in 1962. It’s the x-shaped building closer to the top:

Unfortunately, IBM decided to leave this building behind and take up a built-to-suit building in Nice.

http://www.nicematin.com/cagnes-sur-mer/le-demenagement-dibm-a-nice-meridia-est-signe.1743101.html

They were going to vacate our building next month (February), but I’m told they’re now staying through September, as their new site isn’t yet ready.

Nice’s mayor wants to keep IBM in La Gaude -- not sure why, since they’re moving to Nice -- and wants to keep this site commercial. ERET thinks that it makes much more sense to re-zone it residential, given that the building is in a residential neighborhood: https://goo.gl/maps/g0hIE

I estimate ERET is marking this asset at €15.2m, which is a very low $44/sf.

While this seems to be the least straightforward asset of the bunch, I also think it’s the one with the most potential upside “optionality.”

See, IBM La Gaude sits on a massive 146,672 sqm plot:

That’s 1.58m square feet or 36 acres.

Spread across all that land, the valuation of this asset is only $11/sf.

I did a very non-scientific Google search for houses selling in the neighborhood. I obtained 28 data points and the median asking price is $423/sf:

http://www.frenchrivieraonly.com/house,for-sale,la-gaude,0.html

And the views appear to be pretty stunning. La Gaude is a “perched village” and oversees Nice.

This is what the current building looks like, with a few glimpses of the surroundings (the IBM La Gaude site is the reddish x-shaped building to the left of the photo):

Notice the mountains in the background.

From Google Earth, you can see the view towards the water:

The view below tilts the plane so we’re level with the building. The building is squashed but you can see the view one would have from the ground:

And towards the ocean:

Indeed, if you ask the company, they’ll tell you that developers are very enthusiastic about the possibilities for building residential here. Now it’s up to the board to convince Nice’s mayor to allow the re-zoning.

What could this be worth in that scenario? I have no idea. But it wouldn’t be at all impossible that this asset is worth at least two or three times what it’s on the books for. (Again, it’s fun to see that in 2007 it was marked at $113/sf using today’s fx; that’s 157% above today’s valuation but it’s based on the office use of a single-tenant building that only takes up 25% of the land area.)

For now, I keep IBM La Gaude at the balance sheet value, which amounts to 38p per share.

Balance sheet bridge and SOTP

Here is the most recent balance sheet, with a bridge for subsequent events and current fx. At the bottom is the sum of the parts showing the values in pence per share.

Potential kickers

Let’s speculate, shall we?

If the Spanish assets get sold at a 12% yield on current rents, NAV would increase by 8p. If Nice is worth $88/sf, that’s another 38p. Added to the current NAV, we get a total of 217p. In two years, that’s a 49% IRR.

If instead we revert back to the old rents, and keep the same cap rates, the Spanish assets would bump NAV by 14p. If Nice is worth 3x, that’s an extra 77p. Total NAV would be 262p. In three years, that’s a 43% IRR.

Note that I’m assuming some distributions along the way. The company distributed £6.4m in July of last year and any further asset sales should result in more distributions.

Management alignment

Schroders, the management company hired to market and sell the assets, gets 0.25% of each property’s disposal value.

For performance, they also get 15% of any amount in excess of June 2014’s valuation for the Nice asset.

Further, they get an extra 0.50% for the Panrico assets disposed if no external broker is used, and an additional 0.25% if the valuation is greater than that of June 2014. If any asset is sold to a Schroder fund, no performance fees get paid.

Cash flow and running costs

Schroders gets an annual fee of €0.54m and Klockensteijn, a consultant, gets €0.03m. Altogether that’s 1.4p. Rental income, ignoring IBM’s rent, is 10.1p. The entity is cash flow positive and I’m not too worried about running costs as they’re minimal. I’m also ignoring the frictional costs -- performance fees to Schroders -- in my IRR calculation. They’re immaterial in the context of the overall numbers.

Risks

A massive devaluation of the euro would impair the NAV in pounds, however the assets just become that much cheaper for a buyer. I find that scenario unlikely, especially given the supportive nature of QE (which devalues the euro but supports the economy and makes high yielding real estate comparatively more attractive than before).

There is always execution risk, but as mentioned previously, the board is excellent and the largest shareholders know what they’re doing. Plus, you’re getting a lot for free here, and what you’re paying for is at post-crisis discounted valuations, so in general I see this as a very low risk proposition. Finally, there’s no debt.

Catalyst

Further asset sales, re-zoning of Nice, Spaniards rediscover their love of donuts.