Drazen_ While some months ago I suggested Aroundtown (OTCPK:AANNF) was an interesting income play within the European real estate sector, recent events have not been positive and the prospects of a dividend cut have increased. Operational Performance Since my previous article, Aroundtown has released its most recent quarterly results, which were resilient and continue to show a positive operating performance. Indeed, during the first nine months of 2022, Aroundtown’s rental income increased by 19% YoY to €917 million due to acquisitions, while like-for-like rental income increased by 2.6 YoY. This growth rate includes hotels, which is a segment that is reporting lower growth as challenging economic conditions are putting pressure on rental growth. Its funds from operations (FFO) increased by 3% YoY, to €275 million, showing that its cash flow generation remains good. As part of its business model and capital allocation strategy, Aroundtown continued in recent months to perform portfolio acquisitions and signed some disposals. In 9M 2022, the company was able to sign disposals of €1.1 billion at book value, which means it will not report losses in these sales, which is a positive outcome considering the poor investor sentiment towards real estate assets and rising interest rates in Europe. This is positive to raise cash and reduce the company’s debt leverage, which has become one of the company’s priorities in recent months, as the capital markets have been shut for Aroundtown, and its peers, over the past year. Disposals (Aroundtown) However, while historically the company’s asset portfolio recycling strategy has been focused on selling mature and lower-yielding assets, during the past year, developments were the largest segment to be sold (32% of total disposals), followed by office (30%). This shows that market conditions have been much more difficult to sell assets at reasonable values, as the majority of companies in the sector are all pursuing the same strategy of trying to sell assets to reduce debt leverage and raise cash. This happens because, after several years of low interest rates and plenty of liquidity in the markets, a period that real estate companies used to increase their size and debt levels, conditions have rapidly changed during 2022. Rising interest rates, higher credit spreads, and negative investor sentiment toward cyclical sectors, such as real estate, led credit markets to be wary of new bonds from these issuers. While in the recent past, Aroundtown was a frequent issuer on debt markets, the company did not perform any new issues during the last year, putting some pressure on its liquidity and raising investor concerns about its ability to refinance coming debt maturities. Liquidity Concerns At the end of September 2022, Aroundtown’s liquidity position was acceptable, as the company had cash and liquid assets of about €2.3 billion, plus it has a revolving credit facility in excess of €1 billion, that it can tap if needed to cover cash outflows. Moreover, considering its signed asset disposals, pro forma liquidity is raised to more than €3 billion. This covers its debt maturities until end-2025, which seems to be enough for market conditions to improve and Aroundtown to be able to tap debt markets again to raise funding. However, beyond senior debt, Aroundtown also raised somewhat aggressively hybrid bonds during the past few years. The treatment of hybrid bonds is highly debated, as during periods of good economic and market conditions they are usually treated as ‘equity’, but during bear markets, investors tend to perceive these instruments as ‘debt’. These instruments have no maturity date (they are perpetual like equities), but have a fixed coupon and can be called at a specific date (like bonds). For instance, according to S&P, the point of view on these instruments is the following: Hybrid capital instruments are designed to act like senior debt when credit conditions are good. They pay a known coupon and redeem on predictable dates. When credit market conditions weaken, their equity-like characteristics kick in. These characteristics include not exercising optional calls if that makes economic sense for the issuer. The treatment of hybrid bonds can have a significant impact on the company’s leverage position, given that its reported loan-to-value ratio was 40% at the end of Q3, but this ratio increases to 54% if hybrid debt is treated as bonds. LTV ratio (Aroundtown) While during periods of good credit conditions this is not an issue, as Aroundtown and its peers are easily able to refinance hybrid bonds through new issues, which has not been the case in recent months. Taking into account this background, the company announced at the end of November, not to exercise its call option in the perpetual note with January 2023 call date. Moreover, it also said it will decide on other notes closer to their call dates, plus the decision to defer coupon payments on the perpetual notes will be made closer to the respective interest payment dates. Not surprisingly, the price of this hybrid bond has collapsed during 2022, and is now trading at less than 50% of its par value as shown in the next graph. Note that its price had been consistently between 90-105% from 2017 to mid-2022, with investors becoming more worried in the second half of last year. Hybrid bond price (Bloomberg) This development is quite bad for credit investors, and makes upcoming debt maturities more difficult to be refinanced, at least at reasonable credit spreads. Indeed, investors should note that even its 2027 senior euro bond is trading with a credit spread of 600 basis points and is valued at 70% of its par value (9% yield to maturity), showing that credit investors are treating Aroundtown as a high-yield issuer (despite still having an investment grade credit rating). Despite the gloomy outlook for credit investors, Aroundtown maintained its dividend guidance for 2023 unchanged, even though a final decision is only expected to be made when the company announced its 2022 annual earnings. This is expected to be released in the final days of March 2023, when usually it announces its annual dividend. Current sell-side consensus is for the company to pay a dividend per share of €0.21 (below its guidance of €0.23-0.25), thus analysts are already expecting a dividend cut. Looking at the company’s cash flow statement, its dividend outflow should be around €250 million (at the bottom of its guidance), thus a dividend payment is more a question of favoring equity investors over creditors, rather than saving a significant amount of cash. Aroundtown still has a financial position that enables it to distribute the annual dividend in the coming months, but after its skipped call and probable coupon deferrals to save cash, I think a dividend cut would send a positive message to credit investors that Aroundtown is trying to have a balanced approach regarding its cash management policy. Conclusion Aroundtown’s operational performance has been resilient in recent months, but recent developments have raised some doubts about its dividend sustainability. Therefore, its current dividend yield of close to 9% reflects investor concerns about a looming dividend cut, rather than being an opportunity. While I still like the company, its difficulties to raise new debt on capital markets is a warning sign, and this will only get worse as time passes and if credit conditions don’t improve in Europe. 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.

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