Sirius Real Estate - Great returns, solid foundations
Sirius Real Estate has been a stand-out performer within the UK listed commercial real estate sector over the last three years, delivering a total shareholder return of 107%. The shares also offer a valuable portfolio diversifier for investors, with a geographic focus on Germany, and a focus on property classes that are underrepresented in the listed peer group. We present some peer group comparison data on p8.
The company holds a portfolio of 67 (including six joint venture) properties across Germany, consisting of multi-tenanted mixed-use business park facilities in the office, industrial, and storage segments, with a focus on the Mittelstand tenant base.
Some key attributes of Sirius as an investment include:
- A steadily growing dividend, currently offering a yield of 3.6%
- A strong record of capital gains on its property investments, driven by a property improvement strategy that continues to deliver results
- Sufficient balance sheet resources to sustain ongoing growth at a high level
The business has exhibited robust operational performance during the past 12 months, maintaining strong levels of occupancy and rent collection despite the COVID situation. We argue that this reflects the nature of the tenant base, as industrial distribution and out-of-town office facilities have proved to be resilient assets during the crisis.
Value-add strategy, and two ‘kickers’:
One of the major drivers of Sirius’s outperformance versus the market has been the company’s value-add strategy, acquiring properties with scope for increased utilisation. The value-add strategy has enabled Sirius to realise 5.9% rent uplifts (like for like) per year over the last six years, well ahead of the market trend. We examine this aspect of the investment thesis on p5-6.
In particular, Sirius has two key differentiators in terms of maximising its returns on investments – the proprietary SmartSpace platform for flexible workspace and storage space, and the Titanium joint venture that allows Sirius to earn additional management fees.
Proven earnings growth and resilience
We argue that Sirius remains well-positioned to maintain earnings and dividend growth ahead of the sector peer group, with adequate balance sheet headroom to support further investment in the portfolio. We are forecasting 7.5% annual growth in earnings per share and dividends through to 2023e. We offer a valuation scenario analysis (p14) which suggests shareholder returns of 10.5-49.1% over the next two years from the current level.
Potential returns for shareholders
Year end Mar 31 · Current · 2021 · 2022 · 2023
Portfolio value, €-bn · 1.19 · 1.30 · 1.44 · 1.59
FFO, €-mln · 55.7 · 59.9 · 65.7 · 71.0
FFO/Shr, €-cents · 5.41 · 5.77 · 6.27 · 6.75
Div/Shr, €-cents · 3.57 · 3.72 · 4.07 · 4.39
Adj. NAV/shr €-cents · 80.6 · 88.0 · 93.9 · 100.6
In terms of shareholder returns, Sirius Real Estate has been an outlier (upside) compared with the UK-listed commercial real estate sector over the last one, five or 10 years.
Going forward we highlight the following key attributes for investors:
- An attractive 3.6% dividend yield
- Continuation of the successful value-add property strategy that has delivered a strong track record of capital gains
- Very solid financial metrics through the COVID crisis
- Balance sheet firepower to continue executing the strategy over the next three years
The company was formed out of the UK-listed German-focussed commercial real estate company Dawnay Day Sirius ltd. that had entered the 2008/09 financial crisis with too much leverage, and was in need of enhanced operational performance as well as refinancing. The current chief executive officer, Andrew Coombs joined the company in 2010. Over the period 2010-2014 the company achieved refinancing through additional equity issuance and a secondary listing on the JSE (Johannesburg Stock Exchange).
The company holds a portfolio of 61 properties with a market value of €1.3bn, plus six properties held in the Titanium joint venture (JV). The following charts summarise the portfolio.
Investment summary
Property Portfolio
Source: Sirius Real Estate
Typical properties acquired by Sirius are business-park based office/industrial mixed-used facilities, often properties that were originally constructed for a single user, and which have the wrong mix of office/industrial/storage for modern multi-tenant occupancy. Sirius reallocates space using various strategies including the company’s proprietary SmartSpace platform for flexible work and storage lettings.
The following graphic summarises Sirius's business process:
Four key elements of the Sirius business model
Stages of the business model
Source: Proactive Research
Sirius Real Estate has been an exceptional performer in terms of the returns it has delivered to shareholders. The following graph compares Sirius’s total shareholder returns (dividend plus capital) against the FTSE 350 and the UK REIT (Real Estate Investment Trust) sector. Although Sirius itself does not operate under a REIT structure, we consider the REIT index to be the closest peer group as an asset class:
Stand-out performer in terms of total shareholder returns
Historic performance - Total Shareholder Returns
Source: LSE Data, EPRA Nareit REIT index
We identify the following factors among the major drivers of Sirius’s relative outperformance:
- Rental yields — German industrial and office properties have offered, and continue to offer higher rental yields (rental income relative to acquisition price) when compared with the UK commercial property market, which is the focus for many UK-listed peers.
- Rent uplifts — Sirius has achieved strong rental income uplifts on its portfolio due to the company’s value-add strategy enhancing utilisation of the properties.
- Active management of the portfolio — acquisitions are typically accretive to earnings from day one, and the earnings growth is further enhanced by recycling of capital through selective disposals.
In this report, we pay particular attention to point (2), the value-add strategy, with detailed analysis on p5-6.
The financial success of Sirius’s strategy can be measured in terms of earnings per share growth. For this purpose, we consider earnings in terms of the EPRA EPS (earnings per share) metric. This is earnings per share by the definitions of the European Public Real-estate Association (EPRA) and is an industry-standard measure. This measures earnings per share from rental income, after all costs, but excluding any capital gains. The following chart summarises Sirius’s earnings growth.
Earnings per share growth demonstrates the success of the strategy
Earnings per share growth
Source: Sirius Real Estate
We argue that Sirius is well-positioned to continue delivering strong growth in EPS and dividends, which in turn potentially drives further increases in the share price. We consider the valuation upside on p14.
The value-add strategy
One of the key differentiators for Sirius Real Estate is the success of its value-add strategy — acquiring properties with the potential to improve utilisation. When Sirius implements property enhancements, this leads to increased rental income, which in turn contributes to valuation uplifts. The following chart summarises the like-for-like uplifts in rental income and valuation on Sirius’s portfolio over the last six years.
Sirius's capital gains on properties - 10.1% per year
Rent and valuation uplifts - like-for-like annual increase
Source: Sirius Real Estate
We can compare the performance of Sirius’s portfolio with the German commercial real estate market. The following chart summarises the office market:
Market's capital gains - 7.0% per year
Rent and valuation uplifts for the German office market
Source: Bundesbank data
The charts show that Sirius realised 10.1% average annual valuation increases versus 7.0% for the market, and 5.9% annual rent uplifts versus 3.7% for the market.
The company has published data specifically outlining the returns achieved on properties acquired during the last five years. This highlights the contribution that the property enhancement strategy makes to the group’s overall profits. The following table summarises:
Sirius has achieved 25.0% returns per year on properties acquired in the last five years
Returns on properties acquired over the last five years, held for more than one year
Source: Sirius Real Estate
These properties have been held for a weighted average of 3.7 years (as of September 2020 reporting date), and achieved a profit of €262mln on initial equity investment of €205.1mln. This represents a return of 128.4% over the average 3.7-year holding period or 25.0% per year.
A proprietary platform for flexible workspace and flexible storage
The SmartSpace platform
The main driver of these outsized returns on acquired properties is Sirius’s ability to achieve increased utilisation of the available floor space. An important tool in delivering this is the company’s proprietary flexible letting platform SmartSpace, which operates in three categories — flexible workshop, flexible office, and flexible storage.
SmartSpace accounts for 5% of Sirius’s total, but importantly this space would be generating zero rent under a conventional operating model.
Furthermore, the SmartSpace platform not only generates revenue from otherwise void space but also generates rent at a premium to conventional letting:
Rent per square metre
Source: Sirius Real Estate
Overall, the SmartSpace platform offers a valuable rental income enhancer for Sirius, and a material uplift to the company’s return on capital.
The Titanium venture
During the full-year (FY) to March 2020, Sirius established an additional channel for achieving enhanced returns on capital via a JV called Titanium established in partnership with Axa Investment Managers.
Under the JV structure, Sirius contributes 35% of the equity and Axa 65%. As of September 30th 2020, the Titanium venture held six properties, including the initial seed properties sold into the venture from Sirius's own balance sheet. The value of the portfolio was €235.1mln, financed by €141.7mln of equity (Axa and Sirius) and €93.4mln of debt.
Sirius and Axa each received a share of profit and tax in proportion with their equity holding. Also, Sirius receives a fee for acting as asset manager for the properties. The structure allows Sirius to benefit from a return on equity plus fees, while Axa benefits from access to the SmartSpace platform and Sirius’s overall asset management expertise.
The following table summarises Sirius’s financial exposure to Titanium:
Sirius generates attractive returns on its investment in Titanium
Sirius'd returns on the Titanium venture
Source: Sirius Real Estate
The combination of profit share and management fees allows Sirius to attain an attractive and sustainable double-digit margin on its participation in the Titanium venture.
Peers comparison
Sirius has outperformed the commercial real estate sector over the past decade (see p2) and also over the last three years, including the coronavirus (COVID-19) period. The following chart shows the total shareholder return over three years compared with the UK listed peer group and also the wider market:
Total shareholder returns
Source: LSE Data, EPRA Nareit REIT index
Solid rental yields are important as well as the value-add strategy
We have highlighted Sirius’s value-add strategy as a major driver for this outperformance but it is also worth noting that Sirius holds a portfolio that offers a strong rental income yield as a starting point. The following chart compares Sirius with the market listed peer group based on net initial yield, which is the industry standard measure of rental income to portfolio value.
Net initial yield
Source: Proactive Research
Sirius compares favourably with the UK-focussed peers, which partly reflects higher yields available on acquisitions in Germany compared with the UK but even compared with German-listed Deutsche Industrie, Sirius derives a higher yield on its assets, partly reflecting the contribution SmartSpace platform in utilising additional floor space.
In addition, we note that properties acquired by Sirius during FY Mar 2020 and thee half-year to September 2021 came at an average net initial yield (NIY) of 5.7%, demonstrating that the company is still able to acquire property at attractive yields.
Still attaining good yields on acquisitions at 7.1% for fully occupied properties
Furthermore, this understates the yield that will be achieved over time, as the acquisitions include two properties — Buxtehude near Hamburg and Hallbergmoos near Munich — that were acquired with substantial vacancy levels as they were purchased for repurposing. These two have a combined NIY of close to zero but will achieve attractive rental income once converted. The remainder of the acquisitions came at an average NIY of 7.1%.
One particular advantage of a high yielding portfolio is that Sirius maintains strong interest cover (rental income versus interest payments) even when compared with companies that have a similar loan-to-value ratio. This gives the net earnings stream a greater degree of resilience when compared with some peers.
Current trading - COVID resilience
In addition to generating a high level of rental income on its portfolio, during the calendar year 2020 Sirius has also demonstrated a high degree of robustness in terms of ongoing occupancy and rent collection. The following chart shows occupancy metric for Sirius’s properties.
Occupancy barely affected by the Coronavirus
Occupancy
Source: Sirius Real Estate
We have divided the portfolio into ‘mature’ properties and ‘value-add’ properties (meaning those that are still undergoing improvement work). Both categories have registered barely any deviance on occupancy rates during the COVID crisis.
The next chart shows the level of successful rent collection, which has remained at consistently high levels throughout the period.
The resilience in occupancy and rent collection compares favourably with many other names in the UK-listed commercial real estate space. This partly reflects Germany having implemented less severe lockdown measures than other European countries but it also reflects the nature of Sirius’s tenant base — no retailers, high exposure to warehousing and industrial, and office exposure to business parks rather than city-centre offices.
Cash collection of rent has remained solid
Cash collection
Source: Sirius Real Estate
We argue that Sirius’s property portfolio is also well-positioned for the post COVID environment. We believe that businesses are likely to favour out-of-town office space over city centres as employee safety is served by a less crowded working environment. Furthermore, there is evidence that German industrial groups are seeking to on-shore their supply chain back to continental Europe as a resilience measure, and this trend favours the industrial and logistics property spaces.
Notwithstanding new lockdown measures implemented in Germany in January 2021, we expect continued resilience in cash income for Sirius during the coming quarters.
Financials
We argue that Sirius is well-positioned to continue its strong financial progress in the next 2-5 years in terms of earnings per share, net asset value (NAV) growth and dividend increases.
An important element is the balance sheet firepower available to continue with property acquisitions and enhancements. The following charts show the key balance sheet metrics.
Balance sheet
Source: Proactive Research
Cash balances above trend level - leaves firepower for further investments
The charts show that historically Sirius has maintained a net loan-to-value ratio of 30-40%, and a gross cash balance trending at €40-60mln or around 4-5% of gross assets. From its current gross cash position of €128.4mln (Sep 2020), the company estimates that it has €70mln readily available for investment. These cash balances can be augmented with leverage on new property purchases and additional retained cash from rental income.
Based on the current balance sheet and assumption of the continued availability of property acquisitions on acceptable yields, the company has published a medium-term outlook for earnings as measured by funds from operations (FFO).
FFO is another measure of net rental income, similar to EPRA earnings. The company uses FFO as a core measure of operating performance. It is calculated as net income excluding depreciation and amortisation charges and excluding gains on revaluation.
The following chart shows the medium term FFO outlook.
FFO growth potential
Source: Sirius Real Estate
The contribution from acquisitions in the FFO bridge includes only acquisitions funded from currently available cash of €70mln (see the previous chart), of which €26mln has now been committed through the acquisition of three business parks announced January 4th 2021.
The ‘other’ category in the chart includes a contribution from further investments that could be financed by increasing balance sheet leverage, equity raise, and asset disposal and capital recycling.
Finally, the ‘rent uplift’ category includes only contractual rent uplifts and does not double-count the rental increase that comes from capital expenditure programmes, asset management, and vacated space transformation.
We expect Sirius to make progress towards this FFO target during the next two years. The following chart shows our earnings forecast for the period 2021-2023e.
Revenue and profit (FFO) outlook to FY Mar 2023e
Source: Proactive Research
Attractive earnings growth and dividend payout are sustainable in the coming years
Our forecast projects that Sirius maintains 8.3% annual growth in FFO during the period (a period which includes the ‘COVID’ year FY Mar 2021) as well as maintaining a 65% dividend payout ratio and therefore continuing to grow the annual dividend.
Valuation
Our preferred valuation methodology for Sirius Real Estate is using an earnings per share multiple. For this purpose we use FFO/Shr as the earnings measure, consistent with the metric used for analyst consensus forecasts for Sirius, which can be found on the Sirius Real Estate investor relations pages.
The following table shows the value per Sirius share, as at January 2023, based on various FY Mar 2023 FFO/Shr scenarios and valuation multiples. Our central case of a 17.5x multiple is in line with the valuation of Sirius shares as at January 2021 based on our FY Mar 2021 FFO/shr forecast, i.e. the central case assumes the market applies the same near-year earnings multiple as is being applied today.
Valuation upside at different levels of earnings per share and valuation multiples
Share price (GBp) based on different Mar 2023 FFO levels and multiples
Source: Proactive Research
Based on the central case, investors are offered an exit price of 106.4p, together with our forecast 7.0p of dividends between now and January 2023 (dividend converted into sterling), to give a total end value of 113.4p or 29.0% gain from the current share price of 87.9p, equating to 13.6% annual return for the next two years.
We argue it would also make sense for the market to start applying a higher earnings multiple, given the earnings resilience that Sirius has demonstrated in the current year, and the strong earnings growth, historic and prospective. Any multiple expansion will mean further upside over and above the 29.0% in our central case. Our central range of valuations — 90.1p to 124.1p — represents upside of between 10.5% and 49.1% over the next two years.