Description

Prime Office (PMO DE), owner of 57 office properties in Germany, is trading at a 40% discount to book. The discount is probably related to a miserable 19.9% vacancy rate which will be the immediate focus of prized asset management team which was acquired in January 2014.

The bet on PMO should appeal to short term investors hoping that the new asset management team will fill the vacancies and to “value will out” contrarian investors who dare to buy buildings when they are empty.

Overview

Prime Office was formed in a January 2014 merger between Prime Office REIT (10 properties) and OCM German Real Estate Holdings (47 properties).

Oaktree Capital owned 100% of OCM and now owns over 60% of PMO with strong representation on the board.

PMO has a Mcap of EU529mil and is forecast to generate FFO between EU44mil and EU46mil for the year ended Dec 2014.

Property Portfolio

Below are some details on the 57 properties

• The properties are valued at EU1 900mil and generate EU112mil of contractual rents per annum.
• Total lettable area = 950 000m2
• Breakdown by use: 52 office, 2 hotels and 3 nursing homes.
• Eight of the buildings are single tenanted
• Weighted average time of lease = 5 years
• Vacancy = 19.9%

Vacancies of 19%

The vacancy rate is a concerning 19.9%. I think it’s worth spending some time understanding the vacancy as there is no doubt in my mind that filling these vacancies will be the number one driver of the stock price.

The high vacancy is almost entirely due to a few vacancies in some of the larger properties including, Westend Ensemble (Frankfurt), Am Seestern (Dusseldorf) and Kastor Tower(Frankfurt).

Frankfurt, Westend Ensemble (value=EU116mil, 35 100m2)

Westend, a historic building in the middle of Franfurt, has been vacant since Jan 2013 following the expiration of a 10 year lease with Deutsche Post. All efforts to re-let this space have been unsuccessful and PMO is currently weighing an option to convert the property to residential. 

The property had been generating a rent in excess of EU20mil pa so this vacancy has been painful. In addition, even though the property is vacant it still burns EU6mil a year. Turning the EU20mil rent on again would be a big win for PMO and will add significantly to the current rent roll of EU112mil.

However, I would not bet the house that the EU20mil will return in a hurry as the Frankfurt office market is slow with double digit vacancies. On the other hand, the Frankfurt residential market is strong, so the conversion to residential could be an attractive option. (Note: PMO will not do the development and the most likely option is a sale/JV with a developer. )

Although the property has been written-down management have warned that a further write-down of EU39mil may be required.

Dusseldorf, Am Seestern  (value=EU60mil, 35 100m2)

Am Seestern is 84% vacant following the expiration of a lease with Vodafone in March 2013. The property is in the process of being converted from a single to multi-tenanted building. The re-development is expected to be completed in June 2014 so hold thumbs that this rent comes back soon. Management appear to be positive as they have a pipeline of prospective tenants who want to be close to Vodafone who have moved across the road.

 Frankfurt, Kastor Tower, Platz der Einheit(value=EU116mil, 30 650m2)

A lease over 22 000m2 with Commerzbank expired in October 2013. This is a modern multi-tenanted high rise close to Westend and the space is expected to be let in the normal course of business.

Before the merger, Prime Office Reit outsourced it’s letting function to third party brokers and had a vacancy rate of 22%. In contrast, OCM used an in-house asset management team to manage their properties and had a vacancy of 13%.

OCM’s asset management team are respected market leaders who earned their stripes managing OCM’s vacancies down from 22% in 2006 to 13% in 2013. A big promise of the merger is that this in-house team will successfully fill these vacancies.

Discount to Gross Assets and NAV                     

In January 2014, immediately following the merger, PMO raised EU128mil issuing 46.6mil shares at EU2.80. The capital was used to repay debt in order to reduce the LTV ratio of the merged company from 70% to 58%. The various metrics calculated below have been adjusted to include the effects of this capital raise.

PMO has a MCap of EU529mil and an EV of EU 1 535mil. 

Gross assets equalled EU1 904mil funded by EU840mil equity (44%) and Net Debt of EU1 006mil (53%).

The NAV per share is EU4.65, a 59% premium to the current EU2.90 share price.

The Gross Assets of EU1 904mil exceed the EU1 535mil EV by 24%.

Dividends

Management have guided that PMO will generate FFO between EU44 and EU46mil for the year ended December 2014.

Assuming a 100% payout ratio PMO should trade on a 8.5% dividend yield. Unfortunately management have elected to only pay out 45% of the FFO cutting the dividend yield to 3.8%.

I think the 45% payout ratio is stupid, but, management seem to think that they need to retain money for new acquisitions. The medium term goal is to grow the portfolio to EU3bil. Thankfully, my discussions with management indicate that no acquisitions will be made until the discount to NAV is narrowed and to achieve this they need to be totally focused on driving down vacancies.

I guess Oaktree Capital, as an influential 60% shareholder, endorse the dividend policy and acquisition strategy. I, however, am convinced that a high payout ratio is a very effective tool which should be used with the vacancy drive to narrow the discount. My view is steeped in a belief that equity should be the primary currency in an acquisition and that acquisitions should preferably/only be made with highly rated paper. This forces management to be primarily focused on their share price before running out and building empires.

Benchmarking a Target Price

Benchmarking PMO’s metrics is difficult as there are only two comparable listed “office” REITS in Germany.  Fortunately one of these companies, Alstria (AOX GR), is a perfect match on size and capital structure and is an ideal comparative to establish possible target prices for PMO.

NAV Target

Alstria currently trades at a 9% discount to NAV. If PMO re-rates to a similar discount the share will appreciate by 44%.

Gross Asset Target

Alstrai trades at a 5% discount to it’s gross asset value. Again, if PMO re-rated to a similar level shareholders will make a 40% profit on their investment.

DY Target

On the dividend metric Altria trades on a 5% dividend yield with a 100% payout ratio. Assuming a 100% payout ratio, PMO is trading on a 8.5% dividend yield.

On this metric Alstria is trading at a 72% premium to PMO. This target is probably far too optimistic given the poor 45% payout ratio adopted by PMO.

The Promised Benefits of the Merger

Before discussing the benefits of the merger I thought it would be useful to first summarise the key points of the merger.

• OCM was 100% owned by Oaktree Capital. Subsequent to the merger Oaktree owned 61% of PMO and Prime Reit’s shareholders owned the remaining 39%.

• The merger was effective from Jan 2014 and was immediately followed by the issue of 46.5mil shares raising EU128.6mil. The new capital was used to repay expensive debt and to reduce the LTV from 70% to a more acceptable 58%.

• There was resistance to the merger from some Prime Office REIT shareholders as the merger and associated capital raise diluted their NAV from an original EU6.64 to EU4.65.

• The merged entity elected not to operate as a REIT as they felt that the regulations governing REITS were too restrictive. These restrictions include a maximum gearing of 45% and restrictions on owning residential property. This decision will not have any financial implications as PMO has a tax loss of EU200mil and the capacity to pay out EU900mil in tax free dividends.

The promised benefits of the merger include

• Using the respected in-house asset management team to fill the vacancies.

• Benefits from economies of scale and synergies will lower operating expenses.

• A reduction in the cost of debt. Prime Office REIT contributed debt of EU432mil costing 5.7% to the merged entity. OCM contributed EU967mil costing 4%. The proceeds from the new shares (plus some property sales) have been used to repay expensive debt and from what I understand the average cost of debt has fallen to 3.7%.

Timing of the Trade

PMO will provide a quarterly update on tomorrow (May, 13). I am not expecting much good news as there has been very little time to fill the vacancies. Also, as mentioned above there is a possibility that Westend Ensemble will be written-down by EU39mil. There is also a EU25mil merger related cost which will be recognised in Q1.

Taking the above into account my predicted NAV for March 2014 falls 7.5% from EU840mil to EU786mil.

While the large discount to NAV already reflects a lot of bad news, I am concerned that the market will react negatively to a further dilution in NAV. Because of this fear, I think it is prudent to delay putting on a full position until the market has absorbed the Q1 result.  This delay will help avoid short term noise and give investors a clear run into the benefits of the merger.

This recommendation will not be complete without a review of the German property market. To keep this write-up short I will post some bullet points in the Q&A.

For now I think it is sufficient to highlight that there are consistent signs of a gradual improvement in the German office market. I also want to recommend the following website which has links to very helpful monthly reports on the German property market.

http://www.colliers.com/en-gb/germany/insights/ger-market-reports

Conclusion

This idea is ultimately for contrarian investors who have the resolve to buy properties when they are empty.

The bull case is that the asset management team deliver lower vacancies in 2014. But, if the vacancies take longer to fill I think the downside is protected by the 40% discount to NAV plus a 4% dividend yield which will make it easier for  “value will out” investors to hang on and profit.

Catalyst