Grand City Properties: 8.8% Yield Likely Ahead (OTCMKTS:GRNNF)

Grand City Properties (OTCPK:GRNNF) is likely to resume dividend payments related to 2023 earnings, becoming a high-dividend yielder. This happens mainly because its shares are currently undervalued, trading at only 0.35x NAV, making it an interesting income and value play in the European real estate sector.

As I’ve analyzed in previous articles, I’m bullish on Grand City Properties (GCP) over the long term supported by its strong fundamentals and relatively cheap valuation, due to the cyclical downturn in the real estate market. Over the past year, its shares have recovered and are up by close to 30% since my article in April 2023, beating the market during the same time frame.

As I’ve not covered GCP for some time, in this article I review its Q3 2023 earnings and also update its investment case.

Earnings Analysis

As I’ve analyzed in a previous article, GCP is a real estate company focused on the residential market with an investment portfolio exposed mainly to Germany, but has also some presence in London. At the end of Q3 2023, its investment portfolio was valued at close to €9 billion, a decline of 6% compared to the end of 2022.

Like its peers, GCP’s investment portfolio value has been negatively impacted by higher interest rates since the middle of 2022, despite its organic improvement in rent per square meter and lower vacancy rate in recent years.

This clearly shows that lower portfolio valuations are driven by external factors, while its positive operating trends are supportive for property valuations and have contributed to a lower decline in its portfolio value compared to some of its closest peers. As shown in the previous graph, GCP’s vacancy rate declined to 3.8% at the end of last September, the lowest level in the company’s history.

As long-term interest rates have stabilized in recent months, it’s likely that the value of its investment portfolio has been rather stable in Q4 2023, at least using the German 10-year bond yield as a proxy for the discount rate used in property valuations. As shown in the next graph, the yield reached a top near 3% at the end of last September, and since then has declined to a range between 2-2.5%.

This means that interest rates were not negative for property valuations in recent months, and most likely GCP’s investment portfolio valuation reached a bottom in Q3 2023.

Regarding its operating performance, GCP reported rental income of €307 million in the first nine months of 2023, an increase of 4% YoY. This was supported by like-for-like growth of 3.1% compared to the same period of 2022, due to in-place rent growth (2.8% YoY) and higher occupancy (+0.3% YoY).

Its adjusted EBITDA, which does not include portfolio revaluations, amounted to nearly €240 million in 9M 2023, an increase of 4% YoY. On the other hand, due to higher financing costs, its Free Funds From Operations (FFO) declined by 2% YoY, to €141 million, while on a per share basis the drop was 6% due to a higher number of shares, as the company switched in 2022 to a scrip dividend to save cash.

These results show that despite the cyclical downturn in the real estate sector due to higher interest rates, which led to investors being much more concerned about debt levels of these companies, GCP continues to perform well, as the industry fundamentals on the German residential market remain strong. Indeed, demand for housing wasn’t affected much by higher interest rates and low unemployment is also supportive for higher rents and a tight demand-supply situation in the German housing market.

Given that new construction has slowed down in recent months due to higher financing costs and companies switching their strategy from growth to balance sheet management, this means that over the next few years the industry dynamics are not expected to change much, being supportive for companies like GCP.

Regarding its business strategy, like its peers, GCP had to adapt its priorities to the changing market landscape, moving from an asset rotation strategy to cash preservation. Therefore, while GCP was able to do some asset sales, this was mainly driven by the need to maintain its leverage ratio at an acceptable level, rather than seeking profits.

Indeed, despite lower property valuations its loan-to-value (LTV) ratio, a key measure of leverage in the European real estate market, was quite stable over the past few quarters at about 36%. While this leverage ratio is lower when compared to its peers, investors should be aware that this does not include hybrid debt, which would increase its LTV ratio to 47%, a level that is more in-line with its peers.

Assuming that portfolio valuations become more stable going forward, the need to sell more assets should decrease, which means that GCP can use its organic cash flow generation to reduce debt leverage, rather than selling more assets in the near future.

Regarding its liquidity position, GCP had about €1.1 billion of cash at the end of last September, plus it has some €150 million inflows to receive from signed disposals, which is enough to cover its debt maturities until the second quarter of 2026. This leaves the company in a comfortable position, also allowing it to resume its dividend payments related to 2023 earnings.

While the company is expected to announce a final decision regarding its dividend next week, when it will announce its annual financial figures, its guidance provided some months ago is to distribute a dividend between €0.76-€0.80 per share. Given that its FFO per share is expected to be above €1, this implies a dividend payout ratio below 80%, which can be considered acceptable.

At its current share price, this leads to a forward dividend of about 8.8% at the bottom of its dividend guidance, which is clearly quite attractive to income investors. This isn’t currently expected by the market, given that street estimates regarding its dividend are much lower than €0.76 per share, thus if the company eventually decides to distribute an annual dividend within its guidance this could be a positive catalyst for a higher share price in the short term.

Conclusion

Grand City Properties has reported a resilient operating performance in recent quarters despite the cyclical downturn in the European real estate market, and has successfully protected its balance sheet through asset disposals.

This phase seems to be near its ending, and GCP should resume its capital returns policy in the short term, potentially leading to a high-dividend yield. While this could be a warning sign of poor dividend sustainability, I think its potential high-dividend yield is more a sign of undervaluation rather than an unsustainable dividend.

Indeed, its shares are currently trading at only 0.35x NAV, a very distressed valuation, which reflects mainly negative investor sentiment toward the real estate sector, rather than some fundamental issues with the company.

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