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Rating action

Scope Ratings GmbH (Scope) has affirmed the A- issuer rating on German residential real estate company Vonovia SE and its financing subsidiary Vonovia Finance B.V. and revised the Outlook to Negative from Stable. Scope has also affirmed the senior unsecured debt rating at A- and the short-term debt rating at S-1.

Rating rationale

The rating affirmation is based on the unchanged assessment of the company's business risk profile, which benefits from stable rental cash flow from a well-diversified regulated residential real estate portfolio. The Outlook change reflects the increased risk that the leverage ratio – driven by further yield expansion – will remain at a level that is not consistent with the current rating, despite Vonovia's efforts to reduce debt by selling assets and accelerating rental growth.

Vonovia’s business risk profile (assessed at A) benefits from strong operations with accelerated rental growth despite investment cuts as the supply/demand imbalance increased in most of Vonovia's markets over the last 12 months. The imbalance is due to fewer new flats being delivered and increasing demand from potential homebuyers forced out of the market by interest rate hikes.

At end-March 2023, Vonovia was by far Europe’s largest residential landlord commanding a portfolio of around 550,000 residential units (stable YoY). Vonovia applies a buy-and-hold strategy and also has exposure to healthcare services and real estate development. Its portfolio is likely to shrink as Vonovia is expected to become a net seller in 2023 with inorganic growth put on hold to preserve cash. Vonovia has identified around 40,000 units that could be opportunistically disposed as they show either i) above-average capex needs to achieve climate neutrality; ii) high restrictions on rent increases; or iii) low-yielding assets outside urban quarters.

The strong market positioning supports Vonovia's access to investment markets as demonstrated by recent disposals (1,350 flats to CBRE Investment Management for EUR 0.6bn) and the successful participation of minority shareholders in certain portfolios (sale of 30 % of the preferred shares in the Südewo portfolio to an investment vehicle managed by Apollo for EUR 1.0bn). These large capital releases are unmatched by peers, underpinning Vonovia’s standing in the markets. Vonovia aims to dispose further assets, including portfolios to municipalities, the healthcare division of Deutsche Wohnen and minority interests in its Swedish operations. Vonovia’s absolute size and cash generation capacity will keep it ahead of peers, affording it excellent access to capital markets to source financing.

Vonovia’s portfolio remains well diversified across German, Austrian and Swedish metropolitan areas. The company’s ambitions to become a truly European company came to a halt as higher cost of capital from rising interest rates and the strong reduction in Vonovia’s share price met unchanged market fundamentals, thus making accretive acquisitions difficult. An increase of non-domestic rental income to above 15%, a level that would be commensurate with the assigned business risk profile, will only materialise over the medium term. Scope notes that Vonovia's healthcare business mitigates the comparatively lower contribution of non-domestic income for now, as it benefits from market fundamentals and regulations that are different to those in the residential business.

Scope expects the portfolio’s key performance indicators to remain strong. These are the occupancy rate (97.8% as at end-March 2023, up 20bp YoY); a sticky tenant portfolio (13-year average lease); and rental income growth (3.9% like-for-like rental growth for the 12 months ending March 2023). Scope forecasts that capex and maintenance expenditure will remain at around EUR 1.8bn to maintain the high run rate for energy efficiency (at least 3% of the portfolio yearly; ESG factor: credit-positive), which will also help to keep occupancy high and ensure stable and predictable cash flows that allow for further organic growth with rent increases in line with the cities' qualified rent indices, expected to increase significantly in 2023 and 2024.

Rental growth will remain strong, supporting Vonovia’s operational cash generation that is further boosted by expected synergies from the Deutsche Wohnen acquisition (EUR 105m run rate by 2024; of which 80% to be achieved in 2023). These factors should help to ease i) inflationary pressure on the company’s cost base that is expected to grow faster than the company’s top line in 2023; ii) the transformational shift of the development portfolio towards develop-to-sell from develop-to-hold with achievable margins below that of buy-and-hold activities; and iii) a significant decline in EBITDA contribution from value-added services linked to a cut back in investment (optimising apartments) that drove utilisation of 4,000 full-time equivalents¹ in the past. Scope expects profitability to remain stable at around 75%² in the medium term.

The company’s financial risk profile (assessed at BBB-; revised from BBB) reflects the increased risk that leverage – driven by further yield expansions – will remain at a level not commensurate with the current rating despite Vonovia's efforts to reduce debt by selling assets and accelerating rental growth. The pressure on interest cover is largely offset by interest hedges, debt repayments from the sale of assets and positive operating free cash flow as well as Scope-adjusted EBITDA growth.

Lower house prices have become an issue given the decline in fair values visible since H2 2022 (around 4%). Scope expects fair values to drop by another 10% by end-2024 driven by further yield widenings, especially as most central bank rates³ are either equal to or close to Vonovia’s portfolio yield (end-2022: 3.5%) and Scope does not expect a near-term halt or reversion of interest rate increases by the Fed or the ECB. Like-for-like rental growth in the next couple of years will not make up for this, leaving the fair value of investment properties subject to constant pressure.

The Scope-adjusted loan/value ratio is expected to remain at 45-50% in the next 12-18 months (end-March 2023: 46%) supported by inorganic growth being put on hold to preserve cash, dispose of properties and raise fresh capital by selling minority stakes in dedicated portfolios that will reduce debt by around EUR 2bn by end-2023. However, a Scope-adjusted loan/value of above 45% is not commensurate with the current issuer rating.

Residential real estate cash flows tend to be resilient to changes in general demand. Therefore, Scope’s financial risk assessment puts less emphasis on leverage, as measured by Scope-adjusted debt/EBITDA. Nonetheless, Vonovia needs to reduce Scope-adjusted debt/EBITDA. This is necessary to partially offset the pressure on leverage from expected market value declines and to enable the offsetting of higher interest costs while keeping the financial risk profile at a level that supports a good investment grade rating.

Vonovia’s debt protection (Scope-adjusted EBITDA interest cover) stood at a strong 4.5x for the 12 months ending March 2023; unchanged YoY). However, Scope expects interest cover to decrease to 3-4x, factoring in the drastically changed interest rate environment that significantly increases financing costs in the medium term. Still, the increase in funding costs is partially mitigated by i) Scope-adjusted EBITDA forecasted to grow by more than 3% annually (like-for-like); ii) a substantial reduction in interest-bearing debt through asset sales⁴ and limited capital expenditure (down to EUR 0.9bn in 2023, from EUR 1.4bn in 2022); iii) a focus on secured lending, which has been subject to only limited margin increases (20-50bp) to keep borrowing costs under control; and iii) high hedging (96% as at end-March 2023) and a long average maturity (7.2 years).

Vonovia’s liquidity is adequate based on Scope’s expectation that sources of liquidity (EUR 1.2bn in cash; EUR 3.0bn in undrawn committed credit lines, both at end-2022; and EUR 2.7bn in forecasted Scope-adjusted free operating cash flow) will cover uses by about 1.8x in the 12 months to YE 2023. Scope takes a positive view of the company's revised objective to meet refinancing needs well in advance (within 12-18 months) given the challenging refinancing environment. Scope recognises the company's successful strategy of diversifying its equity sources by inviting investors to take minority stakes in certain portfolios, as well as its ability to sell properties close to market value in the current environment to ensure the repayment of unsecured bonds from available cash while prolonging secured financing or securing higher funding, e.g. signing a EUR 600m European Investment bank loan (undrawn to date) or a EUR 550m loan with Berlin Hyp.

One or more key drivers of the credit rating action are considered an ESG factor.

Outlook and rating-change drivers

Scope has revised Vonovia’s Outlook to Negative from Stable due to the risk that the Scope-adjusted loan/value ratio might remain above 45%, despite Vonovia's ability to reduce its debt burden over the next 18 months by selling assets and raising fresh capital by selling minority stakes in certain portfolios. The Outlook includes investments of EUR 0.9bn per year with the goal of creating a carbon-neutral portfolio by 2045, minimising ESG-related risks for real estate assets. Strong cash generation, as well as the relatively slow transition of higher interest rates into Vonovia's liability structure ensure that Scope-adjusted EBITDA interest coverage is maintained above 3x.

A downgrade would occur if the Scope-adjusted loan/value ratio were persistently above 45%. This could be triggered by a further decline in portfolio value, which Scope expects due to a potential weakening of residential property values that may not be offset by a reduction in debt. A negative rating action could also be triggered if the share of non-domestic net rental income failed to rise above 15% in the medium term, likely driven by a limited success in disposing of German assets.

A positive rating action, i.e. a return of the Outlook to Stable, could be justified by a return of the Scope-adjusted loan/value ratio to below 45%. This could be supported by a successful capital release through the disposal of the non-core portfolio and fair value declines below Scope’s expectations.

Long-term and short-term debt ratings

As at end-May 2023, Vonovia had partially utilised a EUR 40bn euro medium-term note programme. Bonds which were issued under this programme by Vonovia Finance B.V. are guaranteed by Vonovia SE. Senior unsecured debt, affirmed at A-, continues to benefit from an unencumbered asset ratio of 157%, as disclosed by the issuer, which provides a pool of collateral to debt holders.

The S-1 short-term debt rating is supported by better-than-adequate internal liquidity, good banking relationships, strong access to diverse funding sources and to undrawn committed credit lines, which allows the company to address short-term refinancing needs. Vonovia had a non-utilised EUR 3bn commercial paper programme as at end-May 2023.

1. Reduction of workforce through fluctuation, not because of a cost-cutting strategy
2. An important share of rental income (11% as at end-March 2023) does not allow for separation between service charge prepayments and gross rents, thus distorting Scope-adjusted EBITDA margin by 3-5pp
3. Fed: 5.25%; Bank of Canada 4.5%; Bank of England: 4.5%; ECB: 3.25%
4. Given the company's track record of closing deals out of the 40,000 units that do not strategically match and shall be disposed of opportunistically, Scope has factored in successful sales in addition to signed deals (Apollo and CBRE) once the markets reopen, which Scope expects to happen starting in late 2023 and helping to reduce the issuers gross indebtedness.

Stress testing & cash flow analysis
No stress testing was performed. Scope Ratings performed its standard cash flow forecasting for the company.

Methodology
The methodologies used for these Credit Ratings and/or Outlooks, (General Corporate Rating Methodology, 15 July 2022; European Real Estate Rating Methodology, 25 January 2023), are available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. Also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Rated Entity and/or its Related Third Parties participated in the Credit Rating process.
The following substantially material sources of information were used to prepare the Credit Ratings: public domain, the Rated Entity and Scope Ratings' internal sources.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting the Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data.
Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Philipp Wass, Managing Director
Person responsible for approval of the Credit Ratings: Olaf Tölke, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings on 13 December 2019. The Credit Ratings/Outlooks were last updated on 8 July 2022.

Potential conflicts
See www.scoperatings.com under Governance & Policies/Regulatory for a list of potential conflicts of interest disclosures related to the issuance of Credit Ratings.

Conditions of use/exclusion of liability
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