Heimstaden Bostad - thinking out of the box: A two step process - Positioning

All,

Please find our updated analysis on Heimstaden Bostad here.

We have spent considerable time modelling the options available to Bostad’s institutional investors in order to support Bostad’s ratings and improve the overall leverage of the Company. This has enabled us to take an initial position in the Bostad structure, and although we are not comfortable in taking a position at Heimstaden AB we do see the pathway to value at the AB structure.  

Investment Rationale:

- We strongly suspect an equity investment will be made by the private investors at Heimstaden Bostad. We see limited opportunity for the equity providers to impose conditions on the creditors. The unsecured bonds all trade in a relatively tight range, c. 8% for the 8yr paper, and although there would likely to be some tightening if equity is provided, we see limited upside in these bonds (3-5pts).  

- We are taking a 1% long position in the 2026 Hybrid bonds at 48%. At the current price, we see the bonds fully covered, and although coupon may be suspended this year, we would envisage coupon to be turned back on in subsequent years. In addition, any equity raising will have a disproportionate impact on these Hybrid bonds. Downside is limited as subsequent coupon deferral will have the impact of improving LTV ratios, and at current levels, 40-50%, there is limited downside.

- However, we fully acknowledge the risk in the name, and are dipping our toes with a 1% long portion with a view to following our money if the price drops along the way on such events as coupon being switched off or a coercive approach from shareholders.

- We acknowledge that this is not a fundamental investment. Should Heimstaden have to restructure (we think this is some way off), the hybrids are in a weak position. In recognition of the risk however, we are keeping the position limited for now.

Background:

- Heimstaden Bostad is a Swedish property Company, with c. SEK 340bn of real estate assets, financed with c.SEK 110bn secured debt (32% LTV), SEK 85bn of unsecured BBB-rated bonds (55% LTV) and c. SEK 40bn of Hybrid perpetual bonds (68% LTV) - all figures using company valuation. The equity is unlisted, but held, via preference and ordinary shares, majority by Heimstaden AB, and other long-term investors including Alecta (5th largest pension fund), Folksam (insurance), Swedish Pension Agency and Ericsson.   

- The assets, primarily residential assets, are split across the Nordics and Central Europe - Sweden (28%), Germany (26%) and Denmark (21%) are the largest three, combined at 75%, with each of the rest, Netherlands, Czech Republic, Norway, Finland, UK and Poland all below 10% individually.  

- Heimstaden AB also has outstanding debt, both secured and unsecured. Heimstaden AB holds directly some Icelandic and Swedish properties. The Icelandic assets were acquired in Q3 2021, mainly in Reykjavik, which Heimstaden AB value of SEK 5.5bn. The minor Swedish Portfolio, totalling SEK 848m as at Dec 22, consists of Swedish headquarters in Malmo and a school in the city of Eskilstuna.  

- However, despite announcing the sale of the Icelandic assets, to private investors on a home-by-home basis, Heimstaden AB requires dividends to be funnelled up from Heimstaden Bostad in order to pay coupon.  

- Heimstaden AB holds a Group Management Contract with Heimstaden Bostad for the management of the properties. The Group Management Agreement outlines the operational structure and Heimstaden AB's responsibilities. The contract has recently been extended to 2047, with a management fee of 0.2% of fair value of investment properties and paid quarterly

The issue:

- In a rising rate environment, rental income from the owned residential properties have not increased sufficiently to cover the increase cost of financing. This in turn has reduced the accessibility of the unsecured market, forcing Heimstaden Bostad to increase its secured borrowings.  

- Rental income in Sweden and Germany, two of its three main markets, are 100% regulated with rental increases above a threshold level difficult to push through, despite the wider higher inflation. There is potential for catch-up, via further rental increases in these markets, even if inflation declines.  

- With rental income lagging, and some downward pressure on NAV from higher rates, LTV and interest coverage ratios guidance from S&P to maintain investment grade status are coming under pressure.  

- Heimstaden Bostad do not have a large future CAPEX requirement with c. SEK 5bn in the next 18 months and SEK 7bn in total by the end of FY27. This compares favourably to the c. SEK 340bn of overall assets in the portfolio.  

Options Available:

- We have previously outlined the three options available to the Company, namely: 1) muddle through, 2) Asset Sales and 3) Equity Injection, rejecting the first two options for various reasons (see previous email). The body of the recent work is exploring the quantity of an equity cheque and the options available to the institutional investors in order to bolster equity returns. So we are fully focussed from here on Option 3.

- SEK 17bn: Our analysis highlights the need for c. SEK 17bn equity cheque at a minimum, to maintain ICR ratios above 1.8x for FY23-FY25. However, the ICR would fall below 1.8x in FY26, following the non-call event of the 2025 Hybrids (and the further refinancing of upcoming maturities at higher rates). The math rests on the assumption that all upcoming maturities refinance as senior debt at 5%, which is unrealistic as an ongoing assumption.  

- SEK 30bn: The above option relies on all refinancing to be done at the Senior Secured level. This is unrealistic. A larger equity cheque enables the Company to issue some debt at the unsecured level, at 8% cost. With SEK 30bn equity injection, other options open up, including tender of the hybrid bonds. Our scenario highlights that 1/3 (SEK 9bn) could be used to tender for some of the Hybrids at 65c (although we are sceptical they would tender here - see discussion of stick below). If achievable however, the ICR is maintained above 1.8x for FY23-25, and although fails thereafter, there is sufficient tolerance in our model to make us comfortable that the Company can maintain the ratio in FY26. Note, in both of these scenarios we have maintained the Hybrid Coupon and dividends continue to be paid. This is a modelling assumption, but we expect the dividends will not be paid in FY23. Management have said as much.

Where is the Stick?

-it will be difficult to make investors accept a sub-par tender if they envisage equity coming into the business.

- If the company could use SEK 9bn of the equity cheque to buy back hybrids at 65c, namely SEK13.8bn face, they could capture SEK4.8bn of equity value. But as we have seen at AB level, bondholders were holding out at 70c even at a level above.

- The Company can turn off the Hybrid coupons, but only if all dividends are suspended. However, turning off the Coupons has the impact of turning the Hybrid bonds into straight bonds from the perspective of ICR calculation for S&P ratings, negating any interest savings for ratings loss. This could damage shareholders more than hybrids and so would not achieve much. 

- We expect any equity injection to be two-fold. Initial SEK 5-10bn of equity injection showing good faith with the rating agency to ensure the Investment Grade rating and maintain access to the secured bank debt market. A second equity injection of SEK 20 - 25bn to be conditional on a proposal for the Hybrid bonds.  

- The simple proposal in our model is a partial tender at 65c with the balance remaining outstanding. Alternatively, we can see the Company offering a mix of cash, some partial write-down and a newer 5yr Hybrid that would remove the impending step-up wall and again meet S&P rating requirement for equity treatment going forward.  

- Finally, a structural alternative that does not capture incremental value for the equity, but should help reduce the interest burden under the S&P’s ICR ratio, would be to insert a NewCo above Bostad to issue new hybrids or even unsecured bonds in exchange for the hybrids. Interest burden at Bostad level would fall by the currently 50% of hybrid coupon S&P recognise as interest, leading to more headroom at that level. The NewCo would be dependent on dividends or a deeply subordinated proceeds loan. We don’t think the hybrids would settle for a discount in that deal and it would likely require some cash pay-down - not least to avoid the new paper become too expensive, but it could amount to a simple solution to keep the Bostad SUNs investment grade.

Impact of Equity Raise on Heimstaden AB:

- Assuming Heimstaden AB doesn't participate in the new equity injection, the table below shows the dilution to Heimstaden AB's stake. This ovbviously depends on the Cap Rate used for the underlying EV assumption (across the top) and the level of equity injection (down the side).  

- Note, we are using as a starting position that Heimstaden AB has a 35.6% equity stake in Heimstaden Bostad. It is officially 37.7% but to account for the Allianz Partnership we have diluted the institutional investors at Bostad level. There is the possibility the Allianz move their ownership of the Partnership to a direct holding at Bostad level. 

- The second table shows the level of Bostad dividends (on the right), following SEK 30bn equity injection and tendering for the Hybrids. This drives the portion dilution of AB (on the left). Under this scenario, the HY bonds are just paid in full from operating cash flow and dividends, but there would be no money available for Hybrid coupons at Heimstaden AB level.  

- Note, we have assumed fresh equity comes in at a dilutive price (namely valuing the NAV on a 3.5% cap rate, versus current 2.9% book value), diluting Heimstaden AB down to a 24% economic stake.  

There is a lot going on in the model, but the ultimate direction and decisions to be made by Alecta and co. remain the same. We strongly expect an equity cheque to be made, but we are coming round to the view that a two-step process allows the institutional investors to make Hybrid investors share the pain in this situation.  

Really happy to discuss this further.

Tomás