Description

Here is an opportunity to buy 7 properties in Europe for 60c on the dollar. There is a dream catalyst. The board has appointed Shroders to “maximize returns to shareholders through the orderly disposal of the properties”.

Scroders had originally intended to have all the properties sold by December 2013, but, this has taken a little longer than targeted. It now appears that the disposals will be completed by June 2014. This means your 60c turns into $1 in a little over seven months.

Company Background

 European Reit (ERET LN) is currently trading in London for GBP1.20 versus an NAV of GBP1.94.

              Stock Price     GBP1.20

              #Shares           33.16mil

              Mcap               GBP39.8

                             Property                            Sector            m2                              Major Tenants                                                                          

                        Value above €50 million

                        Germany, Frankfurt                        Industrial      85,204                        Schenker, LSG Lufthansa, Fedex                                                           

                         Value €25-50 million                                                           

                         Germany, Kaiserslautern               Retail           11,334                         Peek&Cloppenberg, Hennes&Mauritz                                                   

                         Value under €25 million

                         France, Nice                                      Office           36,720                       IBM                                                                                                                

                         Spain, Madrid                                  Industrial     19,616                         Panrico       

                         Spain, Cordoba                                Industrial     14,119                         Panrico       

                         Spain, Murcia                                   Industrial       9,234                         Panrico       

How to Destroy Value the Old Fashioned Way

ERET have been a little naughty. Back in 2007 the valuations were proudly given for each property, now we just have ranges above and below EUR50mil.

I have had to estimate current values for the remaining properties and compared them to the 2007 values in the following table.

             Property                             Dec2007                         June2013                        %Change

                 Germany, Frankfurt                        EUR125mil                   EUR  55mil                      -56%

                 Germany, Kaiserslautern               EUR  32mil                   EUR  29mil                      -   8%                          

                 France, Nice                                      EUR  39mil                   EUR  25mil                      -64%                                                                  

                Spain, Madrid                                  EUR  16mil                   EUR    8mil                      -50%

               Spain, Cordoba                                EUR    8mil                   EUR    3mil                      -50%

               Spain, Murcia                                   EUR    6mil                   EUR    3mil                      -50% *burnt down, put in insurance claim

              Total(EUR)                                      EUR251mil                 EUR 132mil                    -53%

              GBPEUR                                                     1.40                               1.18

             Total(GBP)                                      GBP 179mil                 GBP 112mil                    -37%

 These are not typing errors. Commercial property has been properly smashed in Europe. This tremendous destruction in value prompted the board to pull the plug on the company in September 2012 and appointed Shroders to “effect an orderly disposal programme and return surplus capital to shareholders”.

 ERET do not disclose rental income from each property. Where possible, I have used available disclosures to gain further comfort wrt my valuation estimates.

• The total value of the Spanish buildings is EUR23mil (2007 value=EUR50mil). The current rent if EUR3.5mil generating a 15% yield on my valuation. The Spanish buildings are not without hair as they have been leased to Panrico. Panrico, owned by Oaktree, is a large baker in Spain which has generated losses of EUR700mil over the last four years.
• I estimate the IBM building in Nice is valued at $25mil (2007 value = EUR41mil). The current rent is EUR3mil implying a yield of 12%. The bad news here is that the lease expires in 2015 and there are serious doubts whether IBM will renew.

NAV Calculation

ERET report every six month. The last earnings report was for the 6 months ended June 2013. Since then ERET have sold two properties, both in October.

Below is my NAV calculation using a simplified June 2013 balance sheet and a pro-forma balance sheet which adjusts for both disposals.

                                                     June 2013                          Disposals             Proforma BS

                                                    --------------                       -------------           ---------------------

                       Assets

                       ---------

                      Properties            GBP192mil                         GBP80mil            GBP112mil

                    ------------

                    Debt                      GBP108mil                         GBP80mil            GBP  28mil

                   Swaps                   GBP  17mil                                                       GBP  17mil

                   Other                    GBP    8mil                                                       GBP    8mil

                  Equity

               ------------

                   Equity                  GBP 65mil                                                        GBP 65mil

 At today’s share price of GBP1.20 the market cap is GBP39.8mil, a 39% discount to the current NAV of GBP65mil.

Risks

The obvious risk is that the remaining seven properties are worth less than GBP112mil.

While I do not want to trivialise this risk to date the values seem to be holding up as evidenced by the following

•        The June 2013 values determined by independent valuators were only 1.4% below the December 2012 values.
•        The two properties sold in October 2013 were sold at small premiums to the June 2013 values.

I should also mention that part of this bet is a bet on the jockey, Shroders, to perform. Schroders have a good track record and it has been profitable to back them in the past (eg SREI LN) I don’t want to get too deep into this now, but, Schroder’s get a bonus if the return more than GBP1.60 to shareholders.

Margin of Safety

Given an NAV of GBP65mil and a market cap of GBP40mil investors benefit from a margin of safety described below.

If the properties can only be sold for GBP85mil (a 23% discount to GBP112mil) then ERET’s NAV falls to GBP1.18 and investors break even.

Simple math shows that this margin of safety grows as more properties are sold and debt is repaid. For example, if a further GBP40mil of disposals are made and the proceeds are used to pay down debt, then,  the value of the remaining properties will have to fall from GBP72mil to GBP47mil (35%) before shareholders buying at GBP1.20 will suffer a loss.

This rise in the margin of safety as disposals are made at fair value are clearly reflected in movements in the stock price which rose strongly in July 2013 following the sale of Saint Etiene property and October 2013 following the announcements of property sales.

Operating Profit adds to Margin of Safety

It should also be noted that ERET generated EUR3mil from operations in the six months ended June 2013. The dividend has been suspended so these profits continue to boost the NAV. I think ERET will conservatively add another EUR2.5mil to NAV for the six months ended December 2013.

After December 2013, the amount added to NAV will depend on the timing of property disposals, debt repayments and access to lower interest rate. While these amounts are not that material every little bit helps to add to the margin of safety.

Debt Expiration

As stated above the original intention was to sell all the properties by December 2013. This was a serious deadline as all of ERET’s debt needed to be repaid to Loyds TSB by January 4, 2014.

The January, 2014 repayment date became a concern to shareholders as the disposals were taking longer than expected. Fortunately on October 30, 2013 ERET announced that they had extended the repayment date to June 30, 2014.

 The renegotiation of the debt also included the following

• Dropped the interest rate on the debt from 5.5% to 2.5% wef January 2014.
• Terminated the currency swap (EUR for GBP) freezing the swap liability to a maximum of GBP17mil.
• Introduced a 5.7% discount on liabilities (debt+swap) if ERET managed to reduced their debt to EUR68mil by December 31, 2013. As a result of the October sales it seems certain that ERET will easily hit this target. This will cut the liabilities by GBP10mil boosting the NAV by 32p to 226p.

Investors should be aware that the termination of the currency swap introduces a new risk as the equity is now subject to currency risk. If the EUR is strong the NAV in GBP will increase and vice versa. The GBP has been gaining slowly against the EUR so this could hurt the NAV if this trend continues. Obviously this risk can be hedged out or the exposure can be used as a natural hedge in an invetsment portfolio.

 Conclusion  

 This is a very simple idea. Sell seven properties and turn 60c into $1 in a little over seven months.

 I expect the stock price to continue to rise in a step-like manner as further disposals are announced. I am speculating that one or two announcements can be made by the end of this year which will send me well on the way to turning my GBP1.20 investment into at least GBP1.60 and hopefully GBP220 by June2014.

Catalyst