The company was created over 10 years ago to focus on apartment ownership in the Berlin market with a particular emphasis on the old style of buildings (“Altbau”) built in the early 20th century. These older buildings are very desirable for their rustic style and high ceiling heights which are also more difficult to acquire given their wide market appeal. ADO’s experienced and energetic management team appealed to us as did their size relative to the industry giants like Vonovia, with over US$16 billion in market cap. For ADO, at c.US$1.3 billion market cap, the impact of every deal has far greater significance than for Vonovia. Since we first acquired shares in the company when it went public in 2015, ADO in market cap has risen by over 70%.
While formerly a dull market dominated by civil servants, Berlin has become one of the more vibrant cities in Europe over the past decade as its low cost of living and abundance of artists and other creative types have attracted tech and media employers, as well as other entrepreneurs. Berlin has the highest rate of internet start-ups in Germany and it has become a major tourist destination and is now the third most visited city in Europe after Paris and London. With its population estimated to be 3.4 million, Germany’s capital city is expected to continue to expand due to rising immigration and the shift of population from rural areas to the more dynamic city centers. Although its surging popularity has caused apartment rental rates to rise nearly 20% over the past several years and the vacancy rate to fall to 1.5%, rents remain relatively cheap at roughly US$1 per square foot per month for a 600 sf apartment.
The rental apartment market is highly regulated which is largely responsible for the tight supply conditions as it dramatically reduces return potential for new construction, and it is becoming even more restrictive. Rental rates must follow the “mietspiegel”, a published rent (miet) schedule that limits rental increases and is reset every four years. In addition, the government has implemented caps on rental increases (“mietpreisbremse”, literally, putting the brakes on rental rates) to 10% above the rent schedules. Previously, the landlord could increase rents to market once a tenant moved out provided the landlord made certain capital improvements like the pictures shown on page 2. The latest regulations limit the ability to recover and profit from these improvements. While the industry is beset with numerous restrictions and limited upside potential, international investors have been attracted to the stable yields (3-4%) and low supply risk, bidding up share prices to 20-30% above the underlying property values. Although the larger companies have been able to take advantage of the availability of their low cost capital to expand their portfolios, they have begun to run out of room for growth and appear to have limited upside, whereas the smaller companies still have the ability to acquire smaller units from individual owners and improve operating efficiencies. Note that this industry attracted significant US private equity capital in the past decade (Goldman Sachs/ Whitehall, Fortress, and others) who assumed that the renters would be willing to buy their units and when this failed to occur, the returns declined dramatically. Many of the public companies acquired these portfolios after they were restructured, and today conversion to ownership is a minor factor in generating additional upside.
We toured 19 of ADO’s properties in Berlin, comprising 3,878 units (24% of the total portfolio), with a total value of €326 million. We first visited a portfolio in the Spandau neighborhood in Berlin, just west of the city center, which was purchased from Germany’s second largest residential company, Deutsche Wohnen (market cap over US$10 billion). The portfolio was purchased at an initial yield of 6.4% in early 2015 with an average rent of 40% below the Berlin average and is valued today at 10% above the purchase price. While it will take ADO three years to fully stabilize the property and achieve optimal rents and operating income, the current rental rates that they are achieving are nearly 14% above the level generated by its prior owner. Further gains can be achieved by improving the building and its surroundings and attracting a higher quality tenant base. The company expects to modernize 250 units per year at an average cost of US$14,700 per unit.
We visited 3 units in Spandau, two relatively small units which had identical lay-outs; one before and one after capex investments, and another larger refurbished apartment. The smaller unit size was 82 square meters (sm) and was rented at €4.84/sm, while current asking rent, after capex, is €7.00/sm. The company spent €370/sm to upgrade the apartment yielding 7.3%. The third apartment we visited of c.120sm was rented at
€4.72/sm before capex and the current asking rent is €7.40-7.50/sm. ADO spent €320/sm capex including asbestos removal translating in a 10% yield on investment. We passed some of the recently acquired assets for which the change of ownership is planned in July. The nine buildings are all “Altbau” and situated in the city-centre. The 277 units were acquired at €2,360/sm. Two out of the nine assets bought are condominiums and will be sold at prices of around €4,000 – 4,500/sm. Excluding these higher priced condominiums, the €50 million portfolio was acquired at a 4% yield with in-place rents 40–50% below market and management expects 5% like-for-like rental growth, which will see the yield to increase to 5% in year 4 (almost a 10% IRR).
ADO has identified almost 4,000 units in their portfolio suitable for highly profitable sale in the private market. So far this year, they have sold 49 units for gross proceeds of €8.9 million generating almost 75% increase over book value and residential prices continue to increase. During 1Q16, the company sold at an average of €2,964/sm, while currently they are selling at €3,100/sm.
We visited a unit which will be privatized at Leibnizstrasse 58 in Charlottenburg near the center of Berlin. The asset is located 100 meters from the Kurfürstendamm, the prime shopping street of Berlin.
ADO sells the units as is, without spending capex, in order to avoid becoming liable for any issues relating to electricity, plumbing, etc. over the coming years. Newly built condominiums in this area are being sold at €6,000-7,000/sm and management believes their condominiums can be sold at €5,000/sm. Currently 5 out of 21 units are vacant, and 6 others are leased to businesses which makes it easier to terminate the rental agreement. Management is holding off on the marketing campaign until a few more units become vacant. The objective is to sell all units in a building in order to avoid “Swiss Cheese” in an asset (mix of renters/owners.)
Private investors and insurance companies have started buying again in recent years, while funds are selling. Most funds acquired assets in 2009-2011 and are now exiting at attractive returns. Market prices in the outskirts of the city are €1,400-1,700/sm implying multiples of up to 22x (4.5% yield), and inner-city locations are €2,100-2,500/sm or 26x multiples (3.8% yield). The inner-city locations often have 40-50% reversionary potential.
The company has roughly €700 million of deals in the pipeline, of which €400 million are auction-type processes where management believes ADO will probably be outbid. €300 million are off-market deals, or with a limited selection of potential buyers. €50 million of these were signed two weeks ago (as mentioned previously) and will exchange hands in July. The company has €200 million of firepower left, and wants to grow the business by 3,000-3,500 units per annum. Depending on deal success, a capital increase before year-end is likely. Since the IPO in July last year, the company acquired 2,600 units.
ADO has consistently delivered for shareholders, despite the market becoming more competitive, and management has demonstrated a deep market knowledge and ability to source transactions. However, as pricing has become elevated and the government is increasing its efforts to dampen rental growth, we will continue to monitor this market to ensure that the upside we expect the company to achieve remains within the realm of possibility.
About the Author
The lead portfolio manager is Jim Rehlaender, who has over 34 years of real estate industry experience. Jim is supported by regional teams in North America, Europe and Asia. Team members have extensive industry experience in their respective regions and disciplines – senior partners average over 20 years in the real estate and finance industries.