European Residential REIT T.ERE.UN

Scotia comments after conference

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Foreign Real Estate Could Be Discounted on the TSX for Some Periods... but Not Forever

OUR TAKE: Positive. We hosted ERES for institutional 1x1 meetings on January 18, at our 17th annual Scotiabank Multi-family Conference. See Key Points below for takeaways.

From historical perspective, we have seen some REITs with assets outside Canada trade at a discount on the TSX for some periods (in some cases extended periods). However, the discount eventually closes out as some of these REITs were privatized. For example – Dream Global REIT, Pure Multi-family REIT, Agellan Commerical REIT, WPT Industrial etc. In the current lot, BSR REIT and Tricon also come to mind – both traded sideways (or at discount to US peers) for some time, but narrowed the valuation gap in 2021.

ERES reminds us of Dream Global REIT (DRG.UN ticker previously) to some extent. Dream Global with 100% assets in Europe (similar to ERES) traded at a discount to NAV from late 2013 to mid-2016. However, it was privatized by Blackstone in 2019 – at that time it was trading at ~16% discount to Scotia NAV while the offer price equated to 11% premium to NAV. ERES is going through the same phase… trading at 15% discount to Scotia NAV and 21% discount to IFRS NAV.

KEY POINTS

Takeaways from Institutional Investor Meetings: This is the third consecutive year in which ERES had participated in our annual Scotiabank Multi-family Conference. We think the portfolio and the platform has come a long way since ERES inception in 2018. We observe that the investor interest was elevated pre-COVID but has been muted since COVID. Recent regulatory changes in the Netherlands have not helped the story. See Exhibit 7 showing total returns across real estate sector in 2021 – Tricon, BSR REIT, and Boardwalk (all three residential names in non rent control jurisdictions) were up 67% on average while ERES was up only 12% (vs CDN REIT sector up 35%). We reiterate our SO rating and $5.50 target price which equates to potential upside of ~30%. Our NAVPU is slightly increased to C$5.10 from C$5.05 previously and our revised AFFOPU estimates imply a 2021E-2023E CAGR of 9.4%.

Some of the key takeaways below:

(1) We think the management team did a good job in illustrating that ERES growth profile has remained strong despite strict regulatory environment. ERES management guided for 3% to 4% rent growth in 2021, but likely to achieve growth rate closer to 4% y/y in 2021 (our estimate). Management is guiding for a similar 3% to 4% rent growth in 2022 as well (see Exhibit 6 for Scotia forecast).

(2) Acceleration of rent growth on turnovers: rental growth on turnovers is showing no signs of slowing down. Management mentioned they are seeing 15%+ rent growth on turnovers throughout Q4 and 20%+ rent growth on December turnovers. While the December number is not a run rate for 2022, we think rent growth in the mid teens is a reasonable expectation.

(3) NOI Margin Expansion opportunity in 2022 and 2023; similar to the past two quarters, ERES has a landlord levy rebate that will be applied for this coming year and will contribute around 100 bps of NOI margin expansion in 2022. The government has proposed to abolish the municipal landlord levy in 2023 and has lowered and reduced the current rate. Overall, management expects the total impact to be 200 bps positive to NOI margins.

(4) Acquisition pipeline: despite a quiet first half of the year, ERES closed €116M of acquisitions in Q4/21. Overall investment volume in the Dutch residential market (as per Capital Value) fell to €7.7B in 2021 from €11.4B in 2020, mostly due to a rise in the transfer tax from 2% to 8% effective at the beginning of last year (Q4/2020 saw elevated transaction volumes as investors moved 2021 sales to 2020). Management expects transaction volumes in 2022 to be similar to last year but with acquisition activity more spread out throughout the year.

(5) Debt Financing continues to be attractive: European financing continues to be attractive with ERES able to underwrite acquisitions at a total cost of debt between 1.00% and 1.25%. Investment spreads look to remain favorable with no signs that interest rates are moving up in Europe.

(6) Potential cap rate compression in the Dutch multi-family market: the Netherlands has seen house price inflation in the mid-teens y/y. Management mentioned that cap rates on properties continue to come down and that they are acquiring properties in the 3 to 3.5% range. Cap rates continuing to trend down is a reflection of strong investor interest for Dutch residential assets despite a difficult regulatory environment.