It has now been three months since Russia began its illegal and horrific invasion of Ukraine.
It is causing enormous uncertainty on the European soil with rising energy prices, more inflation, and high risk of a near-term recession. Ukraine also borders many NATO countries, which increases the risk of a third world war, and possibly even a nuclear war if things escalate beyond Ukrainian borders.
Understandably, it has affected the European stock market a lot more than the American one. Investors have sold off because the combination of high inflation, recession, and war isn’t exactly the right recipe for a bull market.
But in every crisis, there lie opportunities.
Today, the European REIT market is the cheapest it has been in a long while, and opportunities are abundant for investors who can see past this crisis and think long-term.
Most REITs own assets that are at least somewhat recession-resistant and offer inflation hedging benefits. A great example would be apartment communities financed with fixed-rate long-term debt. Their performance may suffer a bit in the immediate term due to the war in Ukraine, but for the most part, the need for these properties doesn’t go away. Their value will continue to rise with inflation all while their mortgages are inflated away.
Yet, such assets are today on sale at steep discounts to fair value on the European REIT market. We are accumulating them at High Yield Landlord because we believe that, ultimately, this will a case of short-term pain for long-term gain. Russia’s invasion of Ukraine has been a massive failure, weakening Russia and strengthening the West. NATO countries are now stronger than ever, and even Finland and Sweden are expected to join the alliance. At the same time, Ukraine has already won the war against a full-scale invasion, and it continues to show heroic resistance in the Eastern and Southern parts of the country.
There will be a lot more pain before this is all over, and I don’t mean to downplay the severity of the situation, but I am optimistic that this whole crisis won’t escalate to NATO countries, which are now stronger than ever, reinforcing my conviction in buying REITs that operate in these countries at today’s discounted prices.
Below, we highlight two of our top picks:
We recently initiated a new position in the biggest German apartment REIT-like entity: Vonovia. It is primarily traded in Germany under the ticker VNA, but it also has an ADR listing in the U.S. under the ticker VONOY.
Why invest in Vonovia?
We think that it is today the cheapest blue-chip apartment REIT in the global REIT market.
It is the biggest and most successful apartment REIT in Germany, with a €30B+ market cap, an excellent track record (13% FFO per share growth since IPO), high-quality properties (2.4% vacancy rate), steady organic growth, a platform to develop new properties and add value to existing ones, and a strong balance sheet (BBB+ credit rating).
Despite that, it is today priced at an estimated 45% discount to net asset value, which is truly exceptional because it has historically traded at a 10% premium to NAV on average.
Also, please note that this is not just my estimation, but it is based on the estimation of independent and professional real estate appraisers. Unlike in the U.S., German REITs must disclose their NAV estimate according to IFRS accounting rules, and their latest appraisal puts their NAV at €66.73, up another 13.5% in 2021, compared to a current share price of €36 per share, down over 40% since September.
After trading at new all-time highs in 2021, it is now again priced at near its lowest point of the pandemic:
Looking at its valuation from another angle, it is currently priced at 13x FFO, which is the equivalent of a near 8% FFO yield, and it pays a 4.7% dividend yield with a 61% payout ratio. That’s very cheap compared to U.S. peers, and it is even cheaper when you consider that cap rates and interest rates are lower in Germany.
Why is the share price down by so much?
What is causing it to trade at such a low valuation?
There are quite a few reasons that we discuss in our full investment thesis, but the most important ones are likely the following:
The first one is obvious: Russia’s invasion of Ukraine. It is causing significant inflation in energy prices and utility costs, which are paid by the tenant, and the management believes that this will limit their ability to pass rent hikes in 2022 and possibly 2023.
Secondly, Vonovia closed a massive transaction in late 2021, acquiring the second-largest German apartment REIT, Deutsche Wohnen. Vonovia issued a lot of shares to close this transaction, but it only received one-quarter of cash flow from Deutsche Wohnen. As a result, its FFO per share dropped by 4% in 2021, which caused many investors to sell the stock.
We think that this provides an opportunity for long-term-minded value investors.
In the near term, Vonovia’s market sentiment is likely to remain challenged because its rent hikes likely won’t keep up with the rate of inflation. However, apartment communities remain some of the best inflation hedges in the world, and despite the lag, history shows that rents eventually catch up to a rate of inflation.
Moreover, the guidance for 2022 is exceptionally strong because it now includes the full contribution of its latest acquisition. It is expected to grow its FFO per share by 18% relative to its previous peak in 2020, and another 5% once you take synergies into account:
This guidance was discussed on March 18th, so weeks after Russia’s invasion of Ukraine. It shows clearly that the drop in FFO per share in 2021 was an anomaly and that it was only caused by the large share issuance. It will be corrected in 2022, and we think that this will serve as a strong catalyst for the stock.
We, of course, cannot predict how Vonovia will perform in the short run, but priced at a 45% discount to NAV and growing at such a rapid pace, we think that it offers exceptionally attractive risk-to-reward at the present moment.
As noted earlier, this is a blue-chip that deserves a more reasonable valuation. Its blue-chip nature is well-reflected in the company’s track record, which you can see below:
AS Tallinna Sadam (TSM1T) (OTCPK:TSMTF)
Tallinna Sadam, our Estonian real estate investment, is still priced near its lowest level ever, and recently, we bought more shares of it.
For those of you who are not familiar with Tallinna Sadam, it is the owner of the Port in Tallinn, which is the capital of Estonia. But importantly, it also owns all the valuable land surrounding the port:
The main reason why we invested in Tallinna Sadam is not its port business. It is because we think that these sites are very valuable and will ultimately lead to large upside when Tallinna Sadam finally sells or leases them to real estate developers.
As we explain in our investment thesis, we think that Estonia offers an incredibly attractive opportunity for real estate investors.
That’s because prices are still relatively low, but the country is quickly becoming Europe’s Silicon Valley, and as a result, its real estate prices are soaring.
This year, the growth will slow down due to the war in Ukraine, but the long-term outlook is unchanged.
Estonia has become a haven for digital entrepreneurs and it is attracting a lot of people who relocate there to run their businesses. I know this because I did it myself back in 2018 with my research business.
Today, Estonia has the most start-ups per capita in Europe and the most unicorns (tech start-ups valued at $1+ billion) per capita in the entire world. Last year, it was ranked 1st with 7 unicorns for 1.3 million people. Less than a year later, it already has 10 of them!
Estonian tech start-ups are doing so well that they are running out of people to hire. That’s one of the reasons why Estonia is taking so many Ukrainian people with open arms. Ukrainian people are famous for their IT talent pool, and that’s exactly what Estonia needs. So far, 40k+ refugees have already arrived in Estonia and it is estimated that they could take up to 50-100k refugees in total before the war is over. That’s huge for a country of 1.3 million people.
Not all of these refugees will stay in Estonia, and not all of them are bringing IT talent with them. However, I suspect that many of them who have IT talent will decide to stay because Estonia has great opportunities for them.
The impact of refugees is already being felt in the real estate market. Already a month after the invasion began, rents for apartments had risen by 15-20% year-over-year and the growth has continued since then:
So the real estate aspect of our investment in Tallinna Sadam is still alive and well. Owning shares of the company allows us to have an interest in prime sea-front sites of the city that are rapidly growing in value.
Today, we can buy this interest at a deeper discount because the company’s port will suffer in the immediate term until Russian cargo is rerouted.
It is not ideal, but since we are long-term oriented, and our thesis is real estate driven anyways, it could be seen as a blessing in disguise.
We expect 50% upside, and, while you wait for it, you also earn a near 6% dividend yield.
Crises lead to opportunities.
Early into the pandemic, REITs were extremely cheap in the U.S., and many of our investments doubled or even tripled in value in the recovery.
Now, the war in Ukraine has led to similar opportunities in the European REIT market, and we expect similar gains in the years ahead.