Description

**Metrics presented above and throughout the write-up are in SEK. 2023/’24 estimates are consensus sourced from Bloomberg**

Fabege (FABG SS) is a Swedish real estate company which has been relatively insulated from the carnage associated with peers SBB, Balder and Castellum over the past several months. I think the apparent optimism around this business is misguided as FABG’s balance sheet reveals an equally aggressive leverage profile and quickly deteriorating interest coverage. These factors imply a high likelihood of ratings agency downgrades, a dividend cut and/or an equity raise, each of which have driven material declines in the valuations of listed peers. FABG trades at ~20x NTM consensus earnings vs. CAST ~12x, BALDB ~8x and SBB ~7x, and my base case implies ~30-40% downside to the stock over the next twelve months.

As a disclaimer, this pitch is fairly sensitive to interest rate assumptions, and as such may not be compelling to some investors.

Business Overview

Fabege owns a portfolio of office (~84% of revenue) and other commercial buildings (~16%) in Sweden and leases that space to tenants. Approximately 25% of owned space sits in inner-city Stockholm and another 55% of lettable area is in the Solna region which is just north of the CBD. 

Unlike the U.S., property rental contracts in Europe commonly include ‘indexation’ provisions by which annual rent grows with inflation each year. FABG provides the chart below in each of its quarterly reports showing the contracted progression of rental income (revenue) over the NTM. Inflation in Sweden is currently 10.5% on a reported basis, and FABG guided to an indexation benefit of +9% to drive revenue growth in 2023E.

FABG’s average lease term is approximately 5 years with minimal tenant concentration. Thus, the drivers of the top line are: 1) indexation assumptions for ~80% of the portfolio; 2) changes in rental rates for ~20% of leases which roll each year; and 3) changes in occupancy. Fundamentally, this is a fairly stable business, though growth in operating earnings has been a meager +3% from 2019 – 2022.

Thesis Overview

I think FABG is an interesting short because the balance sheet is unsustainable in an environment where the cost of capital is no longer zero. Like many other European real estate companies, FABG’s leverage profile has gotten more aggressive over time, while management would have you believe the opposite is true because of accepted accounting conventions. These ‘conventions’ have given management teams discretion to mark up the value of balance sheet assets – properties in FABG’s case – based on assumed cap rates which have declined over the last fifteen years, coincident with a period in which Swedish 10Y rates went from 4% in 2007 to 0% in 2021.

The takeaway is very clear in the following charts: Management uses inflated property valuations to claim that their LTV (net debt / property value) has declined meaningfully in a period where net leverage (Net Debt / EBITDA) has clearly increased.

These accounting games are not lost on the market, as they are prevalent across public European real estate companies. The asymmetry in this opportunity is driven by a couple of company-specific factors:

• FABG is funded by short-term debt, with nearly half of the Company’s net debt balance due to be re-priced over the next year
• FABG bonds currently trade at a ~6% YTW vs. a reported blended cost of debt of 2.6% as of Q1-23
• By consequence, FABG’s interest coverage (defined by the Company as EBITDA / Interest Expense) has deteriorated meaningfully over the past several quarters and is likely to continue to decline in the future:

With credit for EBITDA growth over the next year, it seems likely that FABG will breach ~2x interest coverage by the end of 2023, which is below management’s ‘internal target’ of 2.2x and approaching debt covenants of 1.5x. These figures look even worse when properly defined to include CapEx.

Amazingly, despite the dynamics above, FABG is currently rated as an investment grade credit by Moody’s and S&P. The past several months have given us a template for what happens to listed Swedish property companies upon a ratings agency downgrade:

• Castellum (CAST SS) was downgraded to a Baa3 rating by Moody’s – one notch above junk -- in July 2022, with potential for a downgrade if EBITDA/Interest Expense fell below 3x. Subsequent to this, CAST cut its dividend in November 2022 and announced a dilutive equity raise of 25% of market cap in February 2023. CAST currently trades at ~20x NTM EBITDA or ~12x NTM EPS
• Balder (BALDB SS) was downgraded to a junk rating by Moody’s at the end of February 2023, which was followed by a (24%) decline in the stock price. BALDB currently trades at ~24x NTM EBITDA or ~8x NTM EPS
• SBB (SBBB SS) was downgraded to a junk rating by S&P in early May 2023 and cut its dividend, which was followed by a (50%) decline in the stock price. SBBB currently trades at ~26x NTM EBITDA or ~7x NTM EPS

Of course, the pro forma interest costs for junk-rated credits are higher vs. IG, which is reflected in current YTMs of each of CAST SS, BALDB SS and SBBB SS.

Against this backdrop, FABG currently trades at ~25x NTM consensus EBITDA and ~20x NTM earnings. Moody’s added a negative outlook to their current Baa2 rating on FABG in November 2022, stating that they are likely to downgrade the credit if EBITDA / Interest Expense remains ‘well below 3x’ (currently at 2.6x). I think it is highly likely that Moody’s downgrades FABG over the next several months, at which point the apparent optimism around this business will dissipate as it has in each of the three examples outlined above. Such a downgrade is likely to be followed by a dividend cut and potential dilutive equity raise to improve the health of the balance sheet.

Risks

This stock is clearly sensitive to interest rate assumptions, and will squeeze up on any semblance of optimism from news articles or speculation on Riksbank (Swedish Central Bank) policy. I think that risk is at least partially mitigated by current valuation, though I do not profess to know how Riksbank policy will evolve over the next several years. I anchor to bond prices in Sweden and the Swedish 10Y yield, both of which imply material downside to this stock at current rates.

It is also worth noting that this is a fairly illiquid security with ADV of ~US$6.5mm and growing short interest (c.10%), which likely limits position sizing.

Catalyst

Ratings agency downgrades

Dividend cut

Equity issuance