01 May 2011
2011 Q1 Investor Letter - TFDA
Despite turmoil in the Middle East, the tragic tsunami and nuclear disaster in Japan, ongoing financial instability in peripheral Europe and volatile oil and commodity prices, financial markets continued to rise in the first quarter. Robust corporate profits, particularly from companies exposed to or doing business in the emerging countries underpinned stock prices. Nonetheless, inflationary expectations continue to build along with social and political pressures. In countries such as China and India, inflation has become an immediate problem, where raising interest rates threatens to depress economic growth and job creation. Western economies are facing similar inflationary trends and yet have little power to combat the problem as most Western economies are too weak to contemplate increasing interest rates.
In spite of the general economic weakness of the West, the economic expansion in Germany persists as exports continue to propel the German economy. Industrial production rose, once again, at double-digit rates and as a result, unemployment fell to 7.3% in April from 7.6% in March. For Germany, the good economic news is tempered by rising inflationary anxiety, with consumer prices rising 2.4% in April, and the growing gap between the economic performance in Germany and the performance of the weakest economies in Europe, most notably Greece, Spain and Portugal. Under normal circumstances, we would expect the Deutsche Bundesbank to confront the inflationary threat forcefully. However, with Germany tethered to the rest of the European economies by the euro, it is quite simply unable to take positive action. Moreover, while the German economy is strong, its banking sector remains weak, and thus the urge to act decisively is tempered.
The early signs of inflation and abnormally low interest rates are showing up in selected real estate markets in Germany with housing prices rising in some of Germany’s biggest cities. We are also seeing investor interest rise in agricultural and forestry properties as they seek diversification. This is a pattern that has manifested itself in many countries, such as China, Australia and India, where low interest rates have driven investors toward real assets. Clearly, in the long term, this environment should be positive for the Deutsche Annington portfolio.
The first quarter represented a good start for TFDA in 2011. As of 31 March 2011, the valuation of the fund is €2.05 billion while the cash on cash multiple is 1.28x and the gross IRR is 5.8%. Whilst the returns are modest on an absolute basis, they represent strong performance among real estate investments made in the 2006 timeframe. Moreover, we expect these returns to improve as we further develop Deutsche Annington. The financial performance and operational improvements at Deutsche Annington remain the key drivers to these gains and this trend should continue. As you will read in this report, the company’s performance exceeded budget for the first quarter on strong rental and sales results – the best first quarter performance for each division in the company’s history. Whilst the Rental and Sales businesses were on or above budget, vacancies continue to be above the business’s aggressive target; however, we are confident that the vacancy rate will meet its year-end goal. Expenses were well controlled for the quarter, leading to an encouraging start to the year.
Terra Firma’s plan for Deutsche Annington has three primary components in 2011. First, we look to management to drive ongoing improvements in EBITDA and FFO (funds from operations) from the existing platform. While some of these gains will come from increased rental prices, we will continue to push for cost savings and enhanced productivity. Project Clearwater, for example, which we discussed in our last letter, should deliver more than 30% in cost savings over 2007 base costs by the end of the year.
Second, Terra Firma is intent on modestly reducing the leverage on Deutsche Annington’s balance sheet. Although, as we noted earlier, the financial markets have recovered, a refinancing remains challenging and will take time to complete. Nonetheless, we expect to make significant progress in 2011 in restructuring Deutsche Annington’s balance sheet.
Finally, Terra Firma along with the management of Deutsche Annington have invested heavily in protecting the company’s reputation and meeting our social obligations under German law over the past decade. As many of you are no doubt aware, some in private equity have had an uneasy relationship with government, trade unions and the press in Germany. We think it is imperative that we maintain close relationships with all our stakeholders, building trust through transparency and demonstrating that a private equity firm can be a constructive and progressive owner of Deutsche Annington.
We fully expect Deutsche Annington to continue to demonstrate ongoing improvement in its performance in 2011 and we very much appreciate your ongoing support.
With best wishes,