Description

Sirius Real Estate is an under-the-radar owner of flexible office space in Germany led by CEO Andrew Coombs. The business has been growing nicely and has further growth opportunities ahead. The stock is cheap on this year’s metrics and very cheap on expected earnings ~12-18 months out. Sirius is seeking to up list from the AIM to London’s main market early next year, which should place the stock among a broader peer group and pick up coverage from more analysts. I believe an investment at today’s price of €0.53, including dividends, can result in an IRR of ~30% in less than two years, using undemanding assumptions.

The Business and Management

Sirius is similar to Regus in that it provides flexible office space, but the business model is very different. Regus will lease a large space in an urban class A office building (typically), and then subdivide the space into smaller units and lease it piecemeal to small businesses.

Sirius, on the other hand, owns the real estate. It keeps around half the rent roll with 50 anchor tenants (think large German companies like Siemens) on typical office leases. This allows it to obtain very cheap bank financing. The rest of the rent roll is split among ~3,600 small tenants, small and medium enterprises (SMEs), who need flexible space and pay a higher rate per square foot. Sirius’s locations are typically secondary or suburban.

CEO Andrew Coombs comes from Regus. He’s been CEO at Sirius for four years, and has executed extremely well. He inherited a company with a lousy mix of assets, an overleveraged balance sheet, and high cost of debt.

Since then, he’s grown annualized rent roll from €45m to €65m, lowered LTV from 61% to 45% (with a goal of reaching 40% in early 2018), and lowered the cost of debt from around 5.8% to less than 2%. He initiated a dividend in 2014 and has grown it consistently, and just raised the dividend by 51%, maintaining a 65% payout ratio on FFO.

Coombs seems to have good risk management instincts. He’s constantly thinking of the next downturn. Sirius’s rents are ~25% lower than Regus’s for comparable product, because when the next downturn comes, 100 can become 80 tomorrow and then Sirius will be at a 5% discount. Ergo, no need to cut prices. He’s also always looking for long-term debt, and has extended the average maturity to 5.8 years, locking in as much of the low-cost debt available today as possible.

Finally, I’ll note that Coombs has been a smart financier, buying his own stock at €0.19 in 2012 and again at €0.53 recently, when he raised additional equity capital. He also found a pocket of investors in South Africa, and pursued the opportunity by creating an additional listing on the Johannesburg Stock Exchange.

The Opportunity

Coombs has been exploiting a large capital spread in Germany and a tailwind in the SME space. Simply stated, he’s buying properties at 8% cap rates or higher, financing it with money costing 2% or lower, and applying intensive asset management to improve occupancy and rents.

There is solid demand from SMEs as evidenced by higher rents over time (although there is also some change in product mix here which is hard to disentangle): in six years, rents have grown at a 3.1% CAGR.

Now, it’s reasonable to ask what kind of idiot would sell property at an 8% cap rate when it can be financed at 2% and the German 10-year is at 23 bps (was negative until recently) and the 30-year is at 88 bps.

Coombs says that they work differently from others in the German market. In a typical transaction, the buyer and seller work slowly through the documents and agree on a closing date as negotiations conclude. Instead, Sirius will promise sellers a near-term closing date and a firm price, and then work hard to get all the documents done in time (Coombs has told me sometimes people sleep in the office to get it past the finish line).

Besides that, the assets Coombs buys are typically in need of asset management work (a couple of years left on the lease, lots of vacancy), and need some capex to fill up the space. With an in-house sales and asset management team, Coombs markets the space, tracks inquiries and conversions, and is able to execute better than the seller could.

Sirius is now close to €800m of assets and Coombs believes they can manage €1.2bn with the current team. In other words, the incremental margins are very high in this business. This has been demonstrated in the numbers, with adjusted operating profit at 60% of rental income for the year ended March 31, 2016 compared with 55% for the previous year.

Near-Term Rental Growth & Valuation

Sirius has been making several business park acquisitions, and recent incremental NOI hasn’t flowed through to half-year results, reported on Nov 28. The company stated that annualized rent roll is €69.1m including all recent acquisitions, but that the operating profit from Dresden and Wiesbaden are not included in the half-year numbers.

I’m estimating that including these, we should see full-year recurring profit before tax of €39.4m (half year was €16.1m, which annualizes to €35.3m; then there is NOI of €4m from Dresden and Wiesbaden, which gets us to €39.4m).

This should get us FFO of €41.4m (adding back depreciation and amortization of financing fees). At a 65% payout ratio, the dividend per share is 0.032 or a 6.0% yield.

Then there are four sources of rent and NOI growth:

1. Improvement in occupancy: the average occupancy of the recently acquired assets is 69%. Rental income is €7.2m and NOI is €6.0m. Assuming Coombs can increase this to the portfolio average of 81%, the incremental rent roll should be €1.25m and incremental NOI should be €1.04m

2. Capex program: Sirius has identified 71k sqm of space to deploy €9.7m of capital. This should grow rents by €3.9m and I’m estimating the NOI derived from this is €3.2m

3. Sirius still has around €10m left from the recent equity raise and has said it’ll use most of it for acquisitions. Here I’m assuming it deploys €9m at an 8% cap rate, getting an additional €0.87m of rent roll and €0.7m of NOI

4. By year-end, it should be able to sell two non-core assets, Merseburg and land at CöllnParc, for €7.4m. I assume this gets redeployed at an 8% cap rate, picking up €0.71m of rent roll and €0.6m of NOI

In total, near-term I see €6.7m of incremental rent roll and €5.6m of NOI (sum of 1-4 above). This gets us to recurring profit before tax of €45m, which should translate into FFO of €47m. If this FFO is achieved, then Sirius is currently trading at 9.5x FFO and 10.3x earnings.

At a 65% payout ratio, that’s a dividend per share of 0.0364 and a 6.9% yield.

Note that I’m growing total debt by €9.7m to take into account the capex program, but at 2% interest rates, this only increases debt service by €0.2m.

IRR

The stock can be bought for €0.53. On Jan 20, the investor receives 0.0139 in dividends (already declared, goes ex-dividend on Dec 15). I assume the final dividend on Jul 15 gets increased by a similar amount as this one (0.0196 payout). Then in 2018 you get the dividend of 0.0364 noted above, split between interim and final (0.0145 on Jan 20, 2018 and 0.0218 on Jul 15, 2018).

Where should this trade? I don’t know. But if it trades at a 5% dividend yield then, it’s a €0.73 stock. This target price of €0.73 would imply a P/FFO of 13x. Not very demanding.

If this trades at a 6.0% yield instead, the target price is €0.61 but your IRR is still a respectable 17%.

On the other hand, if this catches on and trades at a 4% yield (16x FFO), the target price is €0.91 for a 48% IRR.

Peers

There aren’t any simple, direct peers. But I’ll note the following:

1. PS Business Parks, listed in the US, seems to trade at a P/FFO of 18x 2018 estimates. The dividend yield is 2.65%.

2. Workspace (which has the distinction of being exposed to Brexit), trades at 21x 2018 estimated earnings (I don’t have an FFO estimate). The dividend yield is 2.77%.

3. Regus is much more reasonably valued, at 11.2x 2018 earnings estimates. The dividend yield is 2.01%.

So, it seems to me that fundamentally, Sirius is a steal. There is nothing wrong with the business or management – quite the contrary. This just seems to be under the radar.

Coombs notes that in the wake of Brexit, the top German cities are now considered safe havens for business investment (see video, below). I’ll make two obvious points: once this stock is listed in the main market alongside the big boys (many of whom own London office space), it’ll compare nicely; secondly, if the European Union disintegrates, the best European country to be in is Germany.

Catalyst: Moving to the Main Market

Sirius has been working on moving from the AIM to the main market in London (“the premium segment of the Official List”). It looks like this will happen soon, with the company aiming to submit an application to the LSE before the end of 2016, with admission to follow “in the early part of 2017”.

This move will likely improve the liquidity of the stock and attract more analysts. Index inclusion will also result in buying pressure from ETFs.

Longer-Term Rental Growth

The rental growth outlined above is what’s on the table today. Coombs notes that there is a robust pipeline of potential acquisitions, and a capital recycling program he aims to initiate next year. This means selling more mature assets and redeploying the capital into value-added opportunities.

Sirius also has about €21m of additional non-core assets (I’m taking reported €28.8m non-core assets and deducting €7.4m for Merseburg and CöllnParc). These should be sold eventually and the capital, redeployed.

Finally, Coombs has identified several portfolios which he could acquire at the right price.

None of these longer-term opportunities are baked into the short-term projections above.

Taxes

Sirius probably won’t pay cash taxes for quite a while. The company has €236m of NOLs. Income statement taxes are mostly non-cash and accrue when property gets revalued upwards by appraisers.

Further Due Diligence

The half-year report from Nov 28 has almost everything you’d need:

http://www.londonstockexchange.com/exchange/news/market-news/market-news-detail/SRE/13047760.html

Note the links at the top to a video interview with Coombs and photos of the properties:

https://www.brrmedia.co.uk/broadcasts/5835ceba006f4af41f480cbe/event/?livelink=true

https://www.flickr.com/photos/sirius_re/

Older audio:

http://www.sirius-real-estate.com/investor-relations/audiocasts/

Presentations:

http://www.sirius-real-estate.com/investor-relations/presentations/

Catalyst

Up listing to LSE main market, further acquisitions.