Description

Thesis: We believe Merlin (MRL) is the best REIT in Spain, one of country’s most affected by Covid and, therefore, one of the ones with the greatest recovery potential as therapies and vaccines normalize the economy in 2021/2022. MRL is run by the best real estate management team in the country and possibly one of the best in the region. Its high-quality assets have been affected by Covid, but the market has overreacted. Investors can buy MRL at a deep discount and own some of the country’s best shopping centers and office buildings for free. 

Introduction to Merlin Properties:

• MRL is the largest REIT in Spain. It was started by Ismael Clemente, someone who I have respected since 2007 - he was the only Spaniard in the real estate industry with a contrarian view of what was in hindsight the greatest real estate bubble in the world at the time. Ismael had been working at REEF, Deutsche Bank’s Real Estate Private Equity Group. He was selling assets – despite pressure from investors - whereas everyone else was buying at record prices. During Spain’s real estate meltdown from 2009-2013, Ismael devised a long-term plan to lobby and create a REIT (a first in Spain) to benefit from an eventual recovery. Ismael built Merlin with one asset class: triple-net leases of BBVA’s bank branches in Spain. 

• Ismael and his team moved fast to take advantage of the country’s improving real estate market. Today, Merlin owns 1.2mm M2 of Office space, 0.5mm M2 of Shopping space and 1.1mm M2 of Logistics space, making it the largest holder of Office and Logistics space in the country. Its Shopping business is a residue of other acquisitions - it has shedded some of shopping assets, keeping only the highest quality. It still has strong cash flows from a 30-year, triple-net lease with BBVA for all of its Spanish branch locations (BBVA needs to pay even if it closes a branch).

The Opportunity: Covid disrupted MRL’s operations, particularly their retail/shopping centers. However, even before Covid, MRL’s valuation assumed no value to shopping centers. While that is a very US-centric view given that shopping centers in Spain are not oversupplied and were doing very well pre-Covid, a shareholder would get a free option on that business segment. Since Covid, Merlin is trading at a huge discount to all of its other assets, many of which are prized assets in offices that have multi-year contracts with multinational clients. MRL is also the largest owner of logistics assets that have been performing well during Covid; moreover, Merlin is looking to double its GLA in logistics. 

1. COVID: Spain was one of the countries most hard-hit by COVID-19. Like elsewhere, offices and malls in Spain were closed. The Spanish economy entered a recession. While MRL’s office buildings continued to pay rent as agreed in their contracts, MRL forgave shopping center tenants rent until July 1st or to the end of the lock-down, impacting 21% of the company’s revenue. 

Spain seemed to have COVID under control over the summer and the stock rose from €7 to €9. In November, COVID again is on a tear, reaching >20k cases a day vs. its peak in March of >10k cases a day. The stock is back at €7. It is notable, however, that deaths have not risen to the same level of last March. In March, cases rose to 1,000 deaths a day vs. a stable 200-350 a day in November. While the reasons why are something outside of this analysis, it is important for the thesis because it shows the country is handling the pandemic better and is less disruptive than it was. 

2. Market assumes Shopping has no value: MRL’s retail centers represent only 21% of revenues, are some of the best in the country and focused on entertainment, unlike the US, malls in Spain are not as  oversupplied. Before COVID, occupancy was tightening to 94.2% in 1Q20 vs. 93.3% in 1Q19. All other metrics were going up, including Tenant Sales (up 5.1% yoy) and Footfall (up 2.4% yoy). 

Despite this growth the market assumed MRL Shopping had no value. According to third-party appraisals (JLL, CBRE and Savills) the most recent Net Asset Value (end of June 2020) of all of Merlin was valued at €11.4bn (€1bn lower than pre-Covid) this is much lower than the current market cap of €3.4bn. Merlin’s market cap peak was €6bn in 2019, indicating Shopping and other assets are not valued by the market.

3. Work-From-Home (WFH) will lead to lower Office demand: An extreme view of a post-COVID world is that there will be a permanent shift to WFH. Some Silicon Valley firms, like Facebook, have said they will not need offices in the future. We believe that Spain is not California. People in Spain are less mobile, have less space to WFH and are overall more social. As we show below, executives in the US are eager to see activity in offices as soon as safely possible. We believe the same with Spain. 

Digging into Office and Logistics:

We are buying MRL with a free option on shopping. So we need to understand the office and logistics portfolio. In addition, Merlin retains its compulsory triple-net leases with BBVA until 2029.   

• MRL’s #1 business is its offices with 45% of revenues. MRL’s offices are Class-A buildings in Madrid and Barcelona with blue-chip companies. Their tenants use MRL’s properties as country or global headquarters that cannot easily be replaced. Moreover, MRL’s leases have an average life of 3 years. We believe demand for office space for MRL’s building will either be the same as before or possibly higher given the need for distancing.

• Office density in Spain was very high which gives room to see more hybrid WFH and still see sustainability in the amount of space Merlin will rent out. The space was 20 M2 per person 3 years ago and pre-Covid it fell to 7 M2. This density doesn’t allow for social distancing. It is possible companies will hire out temporary space until they redesign office spaces. Merlin has 25,000 M2 of flexible space under the Loom brand and has seen a lot of calls for that space. 

• We believe that WFH examples like Facebook are the exception and not the rule, if it happens at all. In a conference, Barry Sternlicht from Starwood said he’d had a conversation with Google. Their view was different from their public stance - they are trying to get people back in the office because of a drop in creativity and productivity. It is true that COVID forced WFH and that ZOOM showed it can be done effectively, but we believe offices are still crucial for a company’s culture and efficiency.

• Experts in employment, and training services, such as the CEO of Adecco, do not believe WFH will eliminate the office: “For some, it is very convenient to work from home. But for many others, it’s a nightmare. There is the question, Who will pay for all the digital infrastructure work needed? Who will take the benefit of time and money saved not commuting—the employee or employer? And there is the third part, which, for me, is very important: What about the culture—the social proximity—you have in a company?”  

• We can further support those comments with quotes made by Hastings from Netflix who said “I don’t see any positives [from WFH]. Not being able to get in person, particularly internationally, is a pure negative.” There are similar comments from Jamie Dimon as discussed in a Bloomberg article: “A troubling pattern emerged as most of JPMorgan Chase & Co.’s employees worked from home to stem the spread of Covid-19: productivity slipped.” 

• Salesforce prepared a 3,000 person survey on WFH (link) – its result is that over 60% of respondents want to work in an office, even if part-time. Interestingly, it is the younger generations that want to work from an office (part-time or full time). It is in the office that they bond with colleagues. It also shows that Gen X, Millennials and Gen Z prefer to work in an Urban setting. While this study is US-centric, I believe these numbers would skew more favorably for offices in Europe. People in Europe are more social and living quarters are more limiting.

• Lastly, Merlin’s tenants are not Silicon Valley types. Among their top 10 tenants are large companies like Endesa (utility), PwC, L’Oreal, Galp (energy), Uria Menendez (top law firm) and Comunidad de Madrid (government), which don’t tend to adopt permanent changes quickly. We have been in touch with office brokers in Spain and they have not seen tenants breaking contracts, or asking for large reductions. Moreover, they point to rents being relatively low compared to the country’s unsustainable boom of 2008. Rents in prime areas are currently €34/sq. mtr. vs. €42 sq. mtrs back in 2008. Supply is tight at the moment. 

Logistics:

• MRL is the leader in logistics which are a play on on-line retail. It’s tenants are companies like Amazon, Zalando and other on-line leaders. Most of MRL’s capex is focused on logistics to double its current size. We believe MRL to spin off its logistics assets once the construction is completed by 2021, unlocking value for shareholders (Prologis’ dividend yield is ½ of MRLs).

• Below is an example of a new logistics center that has already been leased by A-class tenants. Logistics firms like Prologis have a FFO yield of approx. 3.5%. That compares very favorably to MRL’s yield to cost of approx. 8%. 

Debt Covenants

• Merlin has always been judicious of debt – they have never had debt above 40% LTV and it has all been unsecured at the holding company to benefit from sector diversification. The market had some concern about debt covenants, but based on our analysis, there is practically no chance they will be tripped (NAV of all assets would have to fall 30%). Merlin also accessed their bank line for an additional €1bn of liquidity just in case. Their capex program has been cut and is focused only on projects already fully leased. Lastly, Merlin doesn’t have relevant debt maturities until 2022.

• Merlin’s management is excellent. They are savvy of the local real estate market (including Portugal) but maintain a laser-focused on returns. The pandemic has bolstered the company’s standing in the community by being the first REIT to help its shopping tenants and is playing offense with office tenants by extending their contracts in return for slight discounts. Merlin has also developed a WeWork product tailored for any companies testing WFH.

• We have analyzed whether MRL could get into trouble with its covenants, and we believe it covers all the criteria comfortably. One of the tests is Net Asset Value / Net Debt and MRL has a margin of safety based on the appraised values from CBRE, Savills and JLL. It would take for the valuation of all of MRL’s assets to be shaved by another 30% from here to trip that covenant. 

Upside: We believe MRL is an excellent risk-reward. A draconian case where shopping centers never recover (25% utilization even if rent falls) and other assets just stumble along and the market places a 12x long-term multiple on the company the value would be 36% below its current value. We think that is unlikely, but we contrast that with a base case/slow recovery case where shopping returns to 50% and its multiple returns to its 5-year average, the value could increase by 60%. 

Risks: 

1- Continued COVID-relaterd disruptions

2- WFH is far stickier than assumed 

3- Logistics go from tailwind to headwind based on recession

Catalyst

1- We are seeing positive news on vaccines. The stock rose 20% on Pfizer's news.

2- Second wave put under control over the next 2-3 months. 

3- MRL sells shopping centers once market improves, which would re-rate the stock meaningfully.

4- MRL announces plan to spin