Grand City Properties Stock: High Dividend Yield, Discounted Valuation

Grand City Properties (OTCPK:GRNNF) has good fundamentals within the German residential sector, offering a higher dividend yield and cheaper valuation than peers, making it one of the best plays in this investment theme.

Business Overview

Grand City Properties (GCP) is a German real estate company, focused on the residential market segment. Its largest shareholder is Aroundtown (OTCPK:AANNF), a German real estate company focused on the office and hotels segments, with a stake of 58%. As I’ve analyzed in a previous article on Aroundtown, the company has some funding issues and its strategy is to preserve cash on the short term, but when funding conditions improve it’s not unreasonable to expect Aroundtown to eventually increase its stake in GCP.

At the end of September 2022, GCP’s investment portfolio was valued at some $9.7 billion, totaling some 65,000 units, a rental yield of 4.2%, and a vacancy rate of 4.4%. This vacancy rate is higher than compared to LEG or Vonovia, but lower than compared to TAG Immobilien (OTCPK:TAGOF), showing that is portfolio has good value even though not at the same level of its largest peers.

Geographically, GCP’s largest regions are North Rhine-Westphalia (NRW) and Berlin, which together account for some 44% of the total property value. Some 19% of its portfolio is in London, while the rest comes from other German regions. Due to this geographical exposure, its closest peers are LEG Immobilien (OTCPK:LEGIF) and Vonovia (OTCPK:VNNVF), and to a lesser extent TAG Immobilien.

GCP’s has been listed since 2012 and has nowadays a market value of about $1.9 billion, being therefore by this measure a mid-sized company within the European real estate sector. Even though GCP is traded in the U.S. on the over-the-counter (OTC) market, its liquidity is not great and investors should trade its shares in its main listing, on the German stock exchange.

Like its closest peers, GCP’s business model is quite straightforward, aiming to generate value by active management of its property portfolio. This means it aims to buy and manage a portfolio of quality assets, which generate recurring income over the long term. To improve its return on capital invested, it also targets to reduce vacant space through modernization of its units, plus selling lower yielding units that doesn’t have a good fit for its overall portfolio.

Its investment strategy is focused in major German metropolitan areas plus London, on central locations where demand for housing is usually high. This means that GCP is not particularly exposed to the affordable segment in Germany, like LEG and TAG are, but it follows this strategy in London. Indeed, the London portfolio is more focused on affordable housing outside the inner city, with the vast majority of its apartments being relatively close to underground or train stations.

This strategy has been quite successful, measured by its declining vacancy rate over the past few years, which together with a rising rent per square meter are good indicators that GCP’s approach is bearing fruit.

Going forward, GCP’s strategy is not expected to change much, as the company should continue focused on growing its portfolio and add value by modernizing its units. Amid tougher funding conditions in recent months, the company’s investments are expected to be at a lower level than compared to its historical trend.

Financial Overview

Regarding its financial performance, GCP has a good track record on an organic basis, while its asset rotation strategy can lead to some volatility in its reported financial figures. Its historical performance has been supported both by a positive economic backdrop in Germany and a tight demand-supply situation in the residential market, plus the company’s efforts to improve its portfolio that has led to improved fundamentals.

In 2021, GCP has maintained a positive operating momentum, given that its net rental growth on a like-for-like basis was 2.8% YoY and occupancy increased by 0.6% like-for-like. Due to the disposal of non-core properties (about €300 million) and acquisition of quality assets (around €700 million), its total vacancy rate dropped to 5.1% (vs. 6.2% at the end of 2020), which is also supportive for higher rental income.

Nevertheless, net rental income was €375 million (+1% YoY), while its total profit amounted to €675 million (+37% YoY) due to gains on disposals. Its free funds from operations (FFO) were €186 million, an increase of 2% from the previous year, and FFO per share of €1.11 increased by 4% YoY due to share buybacks during the year.

During the first nine months of 2022, the industry landscape has changed considerably due to the rising interest rate environment in Europe, which has led to deteriorated investor sentiment toward the real estate sector and tighter funding conditions, plus has put pressure on property values.

Despite this more challenging backdrop, GCP reported a resilient operating performance over the past few quarters, continuing to increase its like-for-like rental growth (+3.1% YoY) and reducing the vacancy rate to 4.4% at the end of last September. Rental income increased by 7% YoY in 9M 2022 to €295 million, and its FFO was €145 million (+3% YoY).

Regarding its financial profile, GCP has a more conservative approach than its peers, given that its loan-to-value (LTV) ratio was 35% at the end of Q3, while LEG, TAG, and Vonovia’s LTV ratios are around 43-45%. Additionally, even considering its hybrid debt, GCP’s LTV ratio would be 45%, still an acceptable level. This is important because during this market downturn, investors are now wary of companies with high levels of hybrids, which can make a significant difference between the reported and adjusted LTV ratio. This is an issue for Aroundtown for instance, with its reported LTV ratio of about 40%, increasing to 54% when adjusted for hybrid debt, which is a level that is considered somewhat high.

Beyond a more conservative debt level, GCP also has a low average cost of debt of 1.2%, an average maturity of 6.2 years, and enough cash to cover upcoming maturities in the next two and a half years. Its interest coverage ratio was 6.6x at the end of September, which is also higher than compared to its peers (about 5.8x).

Therefore, GCP has a stronger balance sheet than its peers, which is a strong support to provide a sustainable shareholder remuneration policy over the long term. Its goal is to distribute about 75% of its annual FFO to shareholders, which seems to be an acceptable level for a company with its business profile.

Its last dividend was €0.83 per share related to its 2021 earnings, while its guidance for the next dividend is between €0.85-0.89 per share related to 2022 earnings. Investors should note that, like many European companies, GCP only distributes one dividend payment per year. Considering the bottom of its guidance, GCP offers a forward dividend yield of 8.5%, which is very attractive to income investors.

While a high-dividend yield usually can mean some fundamental issues or a high likelihood of a dividend cut ahead, I don’t think this is the case regarding GCP as the company is showing a good operating performance and has a conservative financial profile, thus its dividend seems sustainable for the time being.

Nevertheless, investors should be aware that higher interest rates and an economic slowdown in Europe is likely to result on lower housing prices in the short term, which will put pressure on property values and consequently in the company’s LTV ratio. While GCP has a good liquidity position for now, it may choose to save cash in the future if property prices decrease faster than expected, which could put its dividend at risk. The company will report its Q4 2022 earnings next March, and investors will have then an updated picture about GCP’s operating performance and financial position, plus updated guidance regarding its expected performance during 2023.

Conclusion

Grand City Properties has improved its fundamentals in recent years, and despite a challenging backdrop has delivered good financial figures in recent quarters. It currently offers a high-dividend yield that is superior to its closest peers, and it’s trading at 0.36x NAV, at a discount to peers. This doesn’t seem warranted and shows that GCP is currently undervalued, making a good income play for long-term investors.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.