European Residential REIT
Rental market extraordinarily tight; heightened regulatory risks par for the course
Our view: European Residential REIT (“ERES”) reported a solid in-line Q2, with FFO/unit of €0.043, +13% y/y, vs. RBC/consensus of €0.044/€0.042. Rental and housing markets remain tight with rent growth likely 5%+ in the next 12 months. There are a number of potential regulatory changes in light of the tight housing market, which we think the stock price has more than priced in. Maintain Outperform rating and raising target to $5.25 from $5.00.
Key points:
Operating performance – fundamentals remain strong with rent growth likely 5%+ going forward: Q2 SP NOI growth: +3.9% (SP-Rev +5.2%; SP-Exp +9.8%); Resi SP-Occupancy: 98.4%, +40bps y/y. Turnover spreads: +22% vs. Q1/22 +21%, Q2/21 +17%. Notices were served on 96% of portfolio for a 2.95% rent increase effective July 1, 2022. This combined with turnover spreads in the ~20+% range would suggest that ERES should be able achieve rent and NOI growth of ~5%+ starting Q3/22.
Outlook – a few moving parts on the regulatory risk front: Recently, the Housing Minister indicated plans to expand rent control to the ‘mid- market’ effective Jan 2024. While there is nothing put forward yet and there is no specificity on the various thresholds, a potential consequence is that existing liberalized suites that do not meet the points required to be liberalized could see rents rolling lower on turnover to the €1,000-1,250 new maximum rent. About 30-40% of ERES’ liberalized suites have rents > €1,000, and few above €1,250. However, one cannot extrapolate an at- risk number as the gov’t is also considering revamping the point system and measures to increase energy efficiencies. ERES noted that historically, the end result has included a level of ‘pragmatism.’ Moreover, there is a proposal for ‘23 that renewal increases are not tied to CPI (currently CPI and CPI + 1% for regulated & liberalized) given the high inflation rate.
Capital allocation – taking a more cautious acquisition stance given rate and regulatory uncertainty: Acquired 110 suites in Rotterdam for €23m. Management is taking a more cautious stance on acquisition, noting some deals being pulled from market as they did not meet seller expectations. Average debt cost is 1.8%, 3.9 year term. Current debt cost is also a moving target, now around 2.7-2.8%, most recently at 3.2% in June. D/GBV was 48.8%. Net debt to FTM EBITDA at 16x.
Regulatory risks priced in: 2022E/2023E FFOPU estimates are largely unchanged. We are introducing our 2024E FFO estimate at €0.19. Our NAVPU estimate is €3.65 based on a more conservative 3.9% cap rate (ERES’ €4.28, 3.6% cap). Our target of $5.25 is based on parity to one year hence NAV. At ~20% discount to our more conservative NAV, we believe that the regulatory risks are more than discounted, especially as ERES should be able to achieve NOI growth in the 5% range and NAV growth of 10%