DO Deutsch Office (PMOX)
Long Thesis:
Acquiring PMOX shares ahead of the merger is a good way to gain exposure to the largest German REIT
and a play on the strengthening German office market

Price: €4.37 | Target Price: €14.75 (post-merger entity) (+30% upside)

Market Cap: €788.9 million | Employees 35

September 30, 2015

Macro Overview

REITs are relatively new in Germany with the framework only introduced in 2007. Presently, tremendous real estate value is trapped on German corporate balance sheets. 73% of German companies own real estate compared to 25% in the US and 54% in UK. G-REITs as an asset class is expected to grow as German property owners free up capital trapped in real estate by selling property to tax advantaged G-REITs. Given this macro backdrop, corporate activity and property acquisition involving G-REITs should be heightened in the coming years.

AOX is acquiring PMOX (6.7% annualized return opportunity)

The German real estate property management sector has been undergoing consolidation and further consolidation is expected. On June 16, 2015, AOX announced it would acquire PMOX by exchanging 0.381 AOX shares for 1 share of PMOX. A merger of AOX and PMOX would result in the largest German office REIT with a portfolio value of €3.4 billion, which is still relatively small compared to REITs in more mature REIT markets like the US. AOX is active in Hamburg, Stuttgart, and Rhine-Rhur (Dusseldorf & Cologne) while PMOX is active in Rhine-Ruhr, Rhine-Main (Frankfurt), and Berlin. The combined REIT would command a presence in six of the “Big 7” office markets of Germany. Management expects €17.5M of cost synergies that include reduced administrative and financing costs.

Acquiring PMOX shares is a good way to gain exposure to the new G-REIT. On 9/30, PMOX traded at a 1.12% discount to the takeover value and the shares are expected to trade as combined shares by the end of November (6.7% annualized return). This new G-REIT is a play on the strong and improving German office real estate market.

German office market is strong and improving

Capital flows are strong into office, particularly from foreign investors

  • Commercial investment transaction volume was €24 billion (40% yoy increase) for the first half of 2015.
  • Germany is considered a safe haven for capital. Foreign investors make up 50% of volume across the Big 7 with Dusseldorf having 65% of its transactions involving foreign investors.
  • Cap rates (or “prime yield” in Germany) for office range from 3.75% in Munich to 5% in Cologne and average 4.45% across the Big 7. Yield compression is supported due to falling Euro and low interests rates, making German office buildings an attractive investment for foreigners.
  • Who is selling: corporations and owner-occupiers. Who is buying: open-ended funds and REITs.

Vacancy in office continues to decline

  • Average vacancy in the Big 7 is 6.1%. Vacancy is lowest in Stuttgart at 3.8% and highest in Frankfurt at 11.8%. 5.4 million m2 vacant across the big 7 and decreasing in all but Dusseldorf.
  • 2015H1 take-up was 1,521,200 m2 vs 1,348,00 m2 in 2014H1. Strong macroeconomy is attributed to more businesses looking for office space.
  • Construction activity has not increased despite drop in vacancy. 992,100 m2 of office space is scheduled for delivery in 2015. 74% has been pre-leased already.

Rent for office continues to improve

  • Average rents are expected to increase throughout 2015 in Berlin, Cologne, and Stuttgart and steady in the other four. Frankfurt has the highest average rent at €20.00 per m2, which was a 5% increase yoy.
  • Prime rents are expected to increase throughout 2015 in Berlin and Stuttgart, declining in Munich, and steady in the other four. Frankfurt has the highest prime rents at €38.50 per m2.

Combined REIT is better value

The new REIT would be trading at 1.04 P/B and 19 trailing P/FFO ratios. The average of Bloomberg’s US office REIT comp sheet currently trades at 1.47 P/B and 20.5 trailing P/FFO ratios. A 19 P/FFO can be interpreted as a 5.26% FFO yield, which is higher than the 4.45% average cap rate for office property across the Big 7.

Potential to improve FFO without large capex

The combined company has significant room to improve FFO without additional acquisitions because its properties have 14.1% vacancy. This likely explains both companies’ currently discounted P/B vs comps. Given that average German office vacancies are significantly lower and supply continues to tighten, it is very possible for the firm to reduce vacancies on existing properties. AOX management has a plan to aggressively lease PMOX vacancies.

Furthermore, roughly 37% of current rent will expire in the next three calendar years. This enables the combined company to negotiate new leases at today’s higher market rents.

Improve leasing and management

The merger will enable a critical mass of properties in six of the Big 7, allowing the firm to open new local offices in Frankfurt and Stuttgart. New local offices and critical mass of properties enable more efficient leasing and property management. The firm will divest PMOX’s non-office and non-Big 6 (excluding Munich) properties to concentrate its leasing and management efforts.

Stronger balance sheet and better credit

Size and diversification will enable the combined company to tap credit at better terms. The combined G-REIT will have €217 million cash with €1.6 billion debt due between 2018 and 2020. AOX management believes it can refinance PMOX debt with €7.5 million in interest savings and plans to reduce LTV to 40% in the medium term. The firm will maintain its dividend targets, which has been 4.32% for AOX and 3.43% for PMOX. AOX has never missed a dividend, including during the US and European financial crises, while PMOX just recently initiated a dividend (PMOX was formed in 2014 after the merger of two G-REITS).

Potential equity value appreciation of 29% post merger in 2016

Based on managements’ forecasts of €205M for 2015 gross rents and assuming vacancy is reduced by 150bps and rents increase by 5% on 1/5 of rent revenue, then 2016 gross rent would be €210.7M. Assuming 2015 expenses of €104M are reduced by half of management’s expected €17.5 million in cost synergies, then 2016 FFO would be €115.4M. Assuming P/FFO can expand to 20, then market cap for the combined company could reach €2.3 billion, representing a 29% appreciation. Assuming shares outstanding for the combined REIT will be 155.9 million shares, the price target would be €14.75, compared to AOX’s €11.67 price today.

Combined Company Financials

DO Deutsche Office (PMOX) alstria office (AOX) Combined
Real Estate Portfolio
Real estate property value €1,705M €1,692M €3,397M
Number of properties 51 74 125
Lettable area (sq-m) 866,280 873,000 1,739,280
Vacancy 15.9% 12.4% 14.1%
Corporate Financials
Equity (Balance Sheet) €805.5M €922.2M €1,727.7M
Market Cap €796.5M €1,005.8M €1,802.3M
Price-to-Book Ratio 0.95 1.07 1.04
Long-term Debt €929.6M €902.7M €1,832.3M
Net LTV 54.5% 45.6% 50.1%
REIT Equity Ratio 41.5% 52.9% 47.2%
Gross Rental Income, 2014 €94.2M €89.0M €183.2M
Gross Rental Income, 2015 €107M €98M €205M
Fund From Operations, 2014 €46.6M €47.6M €94.2M
Fund From Operations, 2015 €52.0M €49.0M €101.0M
FFO Growth, 2015 11.59% 2.94% 7.22%
P / FFO, 2014 17.09 21.13 19.13
P / FFO, 2015 15.32 20.53 17.84