• Merlin Properties, Spain’s largest REIT, boasts a robust, diversified, commercial real estate portfolio of high-quality assets.

• At €12/share, the stock trades at an 11% discount to NAV and a 4.8% AFFO yield, offering relatively good value.

• The stock offers investors the opportunity to diversify into REITs, which are less vulnerable to broader market swings, and into a growing European market.

• We forecast at least 7% in annual returns, with further upside potential, absent any major macroeconomic setbacks.

• Our return estimate assumes dividend yield of 3.8%; rent increases of 2%; and AFFO growth of 1.2% from reinvestment.

Today, we present our analysis of Merlin Properties (MRPRF) (MRL.MC) – Spain’s largest REIT by net asset value and market capitalization, at about €6 billion.

This first freely-available comprehensive research piece on Merlin Properties is part of our Stocks on the radar series, wherein we explore potential additions to the market-beating IW Portfolio. It follows recent research on Chinese Baozun (BZUN) and Brazilian Ambev (ABEV).

We believe Spain’s Merlin Properties provides investors an opportunity to tap into a REIT that is poised to benefit from strength in its domestic economy and investments in assets that offer long-term growth potential.

The Madrid-based company engages in the acquisition and management of offices, industrial buildings, logistic centres, local premises and shopping centres, mainly in Spain and to a lesser extent in Portugal.

Founded in 2014, Merlin Properties has since grown through acquisitions to emerge as Spain’s #1 REIT in office, high street retail and logistics assets, and the #2 REIT in shopping centres. The company’s commercial focus gives it exposure to the Spanish economy (in growth mode since 2014), while providing substantial immunity to regulatory changes (in contrast to Spanish residential REITs).

While most investors know us from our investments in high-growth tech names such as Nvidia (NVDA), The Trade Desk (TTD), and PayPal (PYPL), we believe Merlin Properties may warrant an exception to our typical 15%+ annual return hurdle for equity investments.

This is because we believe an investment in Merlin Properties provides a two-fold risk diversification: first into a REIT, which is less correlated to the broad equity market, and second into a trust operating outside the US, in one of Europe’s largest economies.

Merlin Properties trades in Madrid under ticker MRL and is part of the IBEX 35 index. US-denominated shares can also be acquired in the gray market under ticker MRPRF.

In this analysis piece, we assume a share price of €12 per MRL share, or $14 per MRPRF share, and an exchange rate of $1.17 to €1.

The business

Brief history and management team

Merlin Properties was co-founded in March 2014 by Ismael Clemente and Miguel Ollero. Since then, the company has witnessed significant growth through acquisitions. A major part of its current commercial real estate portfolio, in particular, comes from its acquisitions of Testa, from Sacyr (SYRVF, SYRVY) in 2015; and Metrovacesa, from Banco Santander (SAN, SC, BSBR) and BBVA (BBVA), in 2016.

Today, Mr. Clemente is the Vice Chairman and CEO of the company and Mr. Ollero, Corporate Managing Director and COO. The duo have a combined experience of 33 years as real estate professionals and have participated in multi-billion aggregate volumes across all property sectors.

Before founding Merlin Properties, the two partners managed Magic Real Estate, an investment firm that managed Spanish real estate assets for foreign investors with €2,800 million in assets under management as of end 2013. They later launched the REIT after the SOCIMI regulation was approved.

David Brush, a US national who was previously Managing Partner at Brookfield Property Group, is CIO of Merlin Properties. Previously, he headed Brookfield Property’s real estate activities in Europe.

Overall, we have a positive view of the CEO, based on available interviews and presentations in Spanish and English. We also believe management interests are aligned with shareholders’ through the company’s 2017-2019 management incentive plan, which is based on total returns (dividends and share-based appreciation) and EPRA NAV.

As per the plan, in order for the incentive to be vested, the total shareholder rate of return (TSR) must be at least 24% during the 3-year period, or about 7.4% annualized. The maximum incentive is realized when TSR is above 36%, or at 10.8% annualized. Note that the share was trading at about €10/share in January 2017.

Real estate portfolio

Since its inception, the company has made rapid strides towards its target asset allocation of 40% offices, 20% high street retail, 20% shopping centres and 20% logistics, as shown in the figure below.

The 3% allocation in low-yielding non-strategic assets includes hotel and residential assets obtained as part of the acquisitions of Testa and Metrovacesa. These will be divested in the near future.

Source: Merlin IR Website

The lion’s share of its portfolio is made up of premium office buildings that are located mainly in Madrid, Barcelona and Lisbon. Merlin Properties owns and is building some of the most iconic office buildings and high street retail complexes in the Iberian peninsula, including Torre Castellana 259 (PwC HQ), Torre Chamartín, Callao 5 and Adequa in Madrid; and Torre Glòries in Barcelona.

The company has also been increasing its exposure to logistics to meet its asset allocation target. To be sure, logistics presents the most promising area of investment for the company, given the rapid expansion of e-commerce in the country. It is also the category that offers the highest yields. Merlin Properties is expected to expand its exposure in logistics to 20% of gross rental income from 14% in a few years.

As of Q1 2018, the occupancy rate is 92.4% and the average lease term (WAULT), 6.8 years.

The SOCIMI tax regime

The Spanish legal regime for real investment trusts is SOCIMI, with requirements and fiscal advantages similar to those of REITs in the US and other EU countries.

In particular, a SOCIMI, or a Spanish REIT, is required to ensure that:

• At least 80% of assets are leasable real estate properties or shares of other SOCIMI, and

• At least 80% of the earnings come from leases or dividends distributed by a subsidiary SOCIMI.

Moreover, a SOCIMI must distribute as dividends at least:

• 80% of overall earnings,

• 50% of the capital gains obtained from the transfer of assets, and

• 100% of profits coming from entities in which the SOCIMI holds a stake.

In exchange, SOCIMIs are not subjected to corporate income tax.

Merlin Properties’ management has committed to annual dividend distributions of 80% of AFFO (Adjusted Fund From Operations, a measure of recurrent FCF for REITs). This is beyond the requirements of the SOCIMI regime (REITs’ accounting earnings are much lower than AFFO due to non-cash accounting expenses).

Significant shareholders

Banco Santander: 22.3%.

BlackRock (BLK, BKCC): 4%

Financial metrics

Capital structure and credit rating

Merlin Properties has an EPRA net asset value ( NAV) of €6,300 million, or €13.5/share, with 470 million shares outstanding.

This is the result of gross asset value (GAV) of €11,400 million and net financial debt of €4,900 million, for a loan-to-value ratio of 43.4%. The EBITDA/debt ratio of 12 is relatively high due to the acquisitions of Testa and Metrovacesa.

However, Merlin Properties has an investment-grade credit rating from S&P (BBB) and Moody’s (Baa2). The company pays a low average interest rate of 2.2% on its debt, with 99% at a fixed rate. 78% of its debt is non-mortgage-related, with an average maturity of 6 years.

The company also has no material debt maturities before 2021.

Funds from operations

For 2018, the company has guided to AFFO of at least €272.5 million, or €0.58 per share, and to a minimum annual dividend of €0.50/share, of which €0.46 comes from an 80% distribution of AFFO and €0.04 from disposals.

To err on the side of caution, we take €0.46 as an ongoing recurrent annual dividend payment.

Cost of capital and capitalization rate

As of Q1 2018, 51.4% of capital is equity (at an AFFO yield of 4.8%), 48.2% is debt (at 2.21% average interest rates) and the remaining 0.5% comes from reinvested funds (20% of AFFO).

Hence, we estimate the weighted average cost of capital of Merlin Properties at only 3.5%.

We estimate that the average capitalization rate on new assets is about 5%, although project cap rates vary substantially across asset classes, with logistic assets offering the most generous investment returns.

That puts the REIT’s investment spread, or the net return on investments funded with external capital, at 1.5% (5-3.5).

Future plans

In 2018-2021, management plans to invest about €500 million in refurbishments and new projects, with a focus on expanding its footprint in logistics spaces and into the Portugal market.

The emphasis on logistics assets is driven primarily by the rapid growth in online retail penetration in Spain, still below the EU5 average. With that in mind, the company is expanding its last-mile warehouse solutions in key cities. In addition, the growing demand for Spanish imports, stemming from a recovery in domestic consumption, has given rise to a higher demand for logistics spaces.    

The company also plans to divest €550 million in non-core assets, including its 17% stake in Testa Residencial. The divestiture had been halted by the one-year "divestment freezing" due to the Socimi regime. Besides the €50 million one-time asset rotation surplus, management expects a net positive effect on annual rents of €9 million.

Merlin Properties, which has a 92.4% occupancy rate, expects an improvement in occupancy and rents, on the back of strong economic growth and an increase in employment levels. It estimates its refurbishment program, development projects, and investment activity to potentially drive a 32% increase in annual gross rental income for the 2018-2021 period (up from €469.4 million at end 2017).

These also include potential contributions from 2018 property additions of Torre Glories, one of the most iconic buildings in Barcelona, and Torre Chamartin office spaces as well as the full refurbishments of Arturo Soria and Larios shopping centres.

Management is also focused on further optimizing the company’s capital structure. The loan to value ratio has been in steady decline since the last large acquisition (Metrovacesa). Today, it sits at 43.4%, from 43.6% in 2017 and 45.5% in 2016. And management has guided to further deleveraging.

Valuation

Traditional valuation metrics

At €12/share, the common stock is trading at an 11% discount to NAV and a 4.8% AFFO yield (or 20.8x forward AFFO). The dividend yield is 4.2%, or 3.8% if only the 80% distribution from AFFO is considered.

The total return for an investment in REIT equity can be broken down into two components: dividend yield and share price appreciation. Share price appreciation, in turn, is a function of AFFO growth (or growth in any other measure of profitability) and P/AFFO multiple expansion.

AFFO growth can stem from both investments in property upgrades and new developments that increase NAV, and from organic growth, that is, increases in return on capital for a given NAV, due to rent increases, occupancy rate improvements or operating leverage (lower G&A expenses per rental income).

Total return model

These dynamics are summarized in our diagram below.

 Breakdown of expected total return for an investment in Merlin Properties (source:Investment Works Research)

We estimate a minimum 7% total annual return on investment in Merlin Properties. Our conservative return estimate considers the following:

• 2018 dividend yield of 3.8%

• Rent increases of 2% (this is conservative: CPI inflation rate in Spain is at 2%, but recent LTM release spreads have been closer to mid-single digits).

• AFFO growth from retained “earnings” (0.2x AFFO) of 1% (20% reinvestment rate at 5% ROIC).

• AFFO growth from external funds (0.77x the reinvestment rate, to preserve the current debt-to-equity ratio) of 0.2% (0.77x 0.2x the 1.5% investment spread).

Note that we are ignoring other likely drivers of AFFO growth such as improvements in the current occupancy rate of 92.4% (occupancy rate is especially low in office, but should improve in line with Spanish GDP and employment growth), operating leverage (as gross rental income continues to expand) or any value generated from investments funded with external capital other than the retained 20% AFFO and associated debt financing.

Moreover, since the company’s properties sit in the Eurozone, investors should consider the 2%+ differential between USD and EUR interest rates when comparing yields. In the absence of fees, US-based investors could receive an extra 2% annual return for “hedging” their currency risk due to the interest rate differential. Hence, the EUR-based 7% total expected return should be viewed as roughly equivalent to a 9% total return on a comparable US REIT.

Risks

The main risk to the conservative estimate of 7% total annual return would be a P/AFFO multiple contraction, possibly due to weakness in the Spanish economy (the focus on commercial property makes the REIT relatively sensitive to economic activity) or to faster-than-expected increases in Eurozone interest rates (AFFO is relatively resilient to interest rate increases, but the discount rate used by equity investors to value the company would likely increase, impacting the P/AFFO multiple).

Takeaways and future work

At €12/share, Merlin Properties offers relatively good value.

It trades at an 11% discount to NAV, offers a 3.8%+ dividend yield, and absent a sharp economic slowdown in Spain or faster-than-expected interest rate hikes by the ECB, we estimate future annual returns of at least 7%, with a margin for further upside.

The 7% total return from Euro-based assets is equivalent to a 9% total return from a comparable US commercial REIT, given the current EUR.USD interest rate differential.

We are going to wait for an entry price in the low €11s, which would offer an even better risk-reward.

However, we acknowledge that such an opportunity may never present itself and so, investors seeking income within a non-taxable account may want to jump in at current prices.