Since bursting on to the scene in 2014, Spanish REIT Merlin Properties has matured into a long-term player that could assist Madrid’s future expansion.
At a packed EPRA conference held in Madrid in September, Ismael Clemente, CEO of Spanish socimi Merlin Properties, had a gentle dig at Madrid city council.
Clemente called the council’s middle management only ‘so-so’, contrasting them with officials working in rival city Barcelona whom he praised as ‘in my view, the best public clerks in Spain.’ He said: ‘In Barcelona, if you go to the municipality, they have a proactive approach; anything can be done, providing it makes sense for the city. In Madrid it is more like a Napoleonic code: ‘Ah, paragraph 2, roman numeral i, of municipal ordinance number three says you cannot do this, and you cannot do that! It has been difficult...’
When the head of the country’s largest property company suggests there is room for improvement, you take it seriously, especially when he says it in front of several hundred interested real estate people. Madrid representative Jose Luis Moreno, the council’s Economy MD, who participated in the same session, did just that. ‘I agree with Ismael’s message about middle management in Madrid. We have a lot of big real estate operations (planned) in the future and with that view it would be impossible to go ahead,’ he said.
Clemente’s upfront comment was typical of the man: Merlin’s CEO is an asset on a conference platform and rewarding to interview precisely because he tends to speak what the British call ‘the unvarnished truth’, while managing to deliver it in an engaging way and on matters about which he is undeniably knowledgeable.
At EPRA he did soften his point about Madrid by adding that the city was improving. But he had found his mark. Both as a Spaniard, and as leader of a company with €12.6 bn of real estate, the majority in Spain’s capital city, his interest is in the council improving to the point that it will actually deliver a step-change for Madrid. ‘Things are changing,’ he allowed. ‘Madrid is quickly learning and I am glad it is because Madrid is now facing the most interesting urban development planned in the world which is the Madrid Nuevo Norte...’
NEW NORTH PROJECT
Nuevo Norte, or the New North, is the vast, 3.3 million m2 mixed-use project centred around Chamartín railway station. This high-rise development would extend the existing office area that runs up La Castellana from the city’s historic heart, and it is being compared to La Défense in Paris or Canary Wharf in London in terms of its significance.
It has been stuck on the drawing board for some 25 years, but took a significant step forward in July, when Madrid’s new conservative People’s Party (PP)-led city administration and mayor José Luis Martínez-Almeida, who took over in mid-June, united with other politicians to approve it. As José Luis Moreno said at EPRA: ‘We have consensus across all political parties from far right to far left in the council of Madrid... And also consensus with the national and the regional government.’
Clemente is not alone in seeing this moment as an inflection point for the city. ‘If it is done well, it might place Madrid on the global map.’ When PropertyEU interviewed him after the conference session and asked what kind of opportunity the New North might be for Merlin he replied: ‘The best thing I can do is make ourselves available to help the developer, the city, whoever might need our services in the best way possible.
‘Madrid needs to find quality office supply – it is the only way it can compete globally. This is the opportunity to create high-quality offices, that will eventually make Madrid join the top 20-25 cities in the world, which are always considered by investors as relatively safe havens for investment. This is what we will make Madrid – a safe haven for investment – so let’s do it at once.’
Merlin already has a close interest because it has ownerships in the Chamartín area. Furthermore, what Clemente didn’t say in the interview but which came out two weeks later in the Spanish press is that Merlin’s ambitions extended beyond ‘helping’ to the extent of actually leading the New North project. The socimi was one of a number of parties which made approaches to the major landowner and promoter of the scheme, BBVA. The bank owns 75% of Distrito Castellana Norte (DCN), which manages the mega project.
Unconfirmed reports said that Merlin had offered a deal which involved swapping the socimi’s ‘Tree’ portfolio of 699 bank branches across Spain which are all let to BBVA on inflation-linked leases running to 2039, in return for the rights to DCN.
Whether or not Clemente and his co-management foresaw the bank branches as a negotiating card five years ago, when Merlin held its €1.25 bn initial public offering seeded with Tree, isn’t clear. They acquired the portfolio in 2012 when they launched Merlin’s private precursor, Magic Real Estate, and have hung on to the portfolio since, with Clemente consistently making the point that the portfolio alone almost covers the socimi’s interest service.
BBVA issued a statement on 29 September saying: ‘Among the various approaches that have taken place by third parties interested in DCN, Merlin Properties has shown interest in the project. Such interest has resulted in preliminary conversations that, at this time, do not continue.’ Brookfield and the sovereign wealth funds of Qatar and Abu Dhabi are also rumoured to have made approaches.
Then, on 31 October, Merlin announced it had bought a 2014.14.46% stake in DCN from the project’s minority shareholder, construction company San Jose Group.
You would back Merlin’s management to use that foothold for a big role in Nuevo Norte. In the five years since the IPO, this team – which also includes long-time associates of Clemente’s David Brush, the socimi’s CIO and Miguel Ollero, the COO – has rapidly grown the company. The strategy was to specialise in Iberia alone, but to build a REIT with scale, and liquidity for shareholders, by investing in a diversified portfolio across offices, retail and logistics.
The timing was auspicious – in 2014 Spain’s real estate market was on the verge of recovery. ‘The first thing was: get out and buy every good office, every piece of good retail, every logistics site we could amass’, Clemente recalls. The second stage was two transformational acquisitions, of listed companies that were themselves suffering from lack of liquidity: Testa in 2015 and Metrovacesa the year after. The team stripped out the assets that didn’t fit Merlin’s strategy, residential and the hotels.
Merlin has since reaped the benefit of the rising markets in Spain and Portugal with its 2.9 million m2 logistics development strategy which is yielding 7.75% on cost, and consistently strong release spreads (the difference between rent paid on a new lease compared to the rent paid previously for the same space) on its extensive four-year rolling programme of capital expenditure on the portfolio. The target is to increase cashflow from around €500 mln in 2018 to in the region of €650 mln by 2022.
RIDING THE CYCLE
Clemente emphasises several times that as the managers of a REIT they are in it for long-term. More recently the team has dramatically slowed down asset purchases because the cycle has moved on and properties are more expensive. ‘You cannot go with the cycle to the end, because then you fall with the cycle,’ he says. ‘Sooner or later, and it could be three years or it could be 10 years from now, there will be a new cycle.’
One exception is Lisbon offices where ‘we will continue looking, although the market is now much hotter and it will be more difficult. There is a premium in Lisbon compared to Spain which in our view is unjustified in terms of market risk - although the entry yield for prime Lisbon assets is going down sharply as we speak! So we are trying to do opportunities we believe are interesting or have an alpha generation aspect’. In September for example, Merlin bought Nestlé’s headquarters in a sale-and-leaseback and will construct a sister building for the expanding company creating a Nestlé Campus.
Merlin plans to increase its share of assets in Portugal from 9% or so of its portfolio to 15% and expects to debut on the Portuguese stock market soon.
His emphasis on the long-term is understandable because Clemente and his team were known for their private equity background from many years spent in opportunistic investing at Deutsche Bank’s RREEF. At the 2014 IPO, Merlin was largely backed by hedge fund investors, with the likes of PIMCO’s Bill Gross, Quantum’s George Soros and billionaire John Paulson investing for a ride on Spain’s recovery. Merlin’s CEO says key to the socimi’s future is that its shareholder base has since rotated. ‘We are now owned by long-term, institutional investors’ he says, ‘many of them professional money placers with long-term pension or life liabilities. They require a stable cashflow base.’ The job these days is to continue to generate high-quality, recurring earnings.
Readily admitting that Merlin doesn’t yet have the luxury of a long-term track record he jokes: ‘We don’t have the benefit of having a long-established name. We are not British Land or Land Securities where Sir Robert Johnson III was already at the helm of the company at the end of the 19th century!’. Nevertheless, he says management has ‘little by little earned the confidence of the market’, doing everything as they said they would.
With the capex programme on track, the company’s other stated priorities include reducing debt and selling remaining non-core assets.
Merlin’s portfolio loan-to-value ratio has reduced ‘from 50.6% to 40.7%...but that is not what obsesses us. What obsesses us is to get to single digits in terms of debt to EBITDA’. Currently that figure is above 12%. ‘We want to get that figure below 10% because that is the best insurance you have when the cycle changes,’ says Clemente. Merlin has a BBB rating and the board is looking to take advantage of favourable market conditions to restructure some debt and issue longer term bonds.
In terms of non-core assets, there are about €450 mln of properties lined up to go. This includes two office portfolios, Juno and Jupiter. Merlin has held various off-market discussions with potential buyers; Cain International with Freo are in negotiations to buy Juno for around €200 mln. Four malls are earmarked for disposal when the price is right. ‘We will divest €450 mln, and let’s see how it happens and at what pace,’ Clemente says. ‘We have learned painfully not to shoot ourselves in the foot by being too precise about divestment objectives.’
Retail accounts for 36.5% of Merlin’s portfolio, 18.5% of that shopping centres (June 2019). Is that a reason for the persistent discount in the company’s share price? In late October, the shares traded around the €13 mark – back at a level last reached in 2015 and compared to a June 2019 NAV of €15.11. He shrugs: ‘The market is heavily discounting retail. The new herd idea is that we should sell the shopping centres. Ten years from now, maybe online sales will represent 25% of total sales and the market will find a new equilibrium and shopping centres will shine again. Then they will say you should be buying shopping centres.’
He agrees that Spain faces the same structural challenge from e-commerce as the rest of the world but says it has much lower density than the US, few malls anchored by department stores whose trading problems have destroyed value elsewhere, and that Spain is coming up from a deep recession, seeing employment growth and salary inflation which is fuelling consumption.
Another benefit of the team’s deep knowledge of the retail market is that it will continue to yield synergies for the logistics portfolio in terms of knowledge of tenants occupying both types of space. ‘We were pioneers by having shopping centres and logistics managed together from the beginning,’ he points out. ‘Merlin is a shell that provides logistics, retail and office “companies”’ with access to capital markets, a good rating, liquidity, cost management...We have three separate teams, but from the beginning, retail and logistics were managed together.
Along with Madrid and Lisbon, Merlin also invests in offices in Barcelona and Clemente is on record as saying they would invest more in Spain’s second city if it were not for the unrest, which flared up again in October after the jailing of nine Catalan political leaders. The group’s last big buy was the iconic Glóries tower there, which is almost fully occupied after refurbishment.
Madrid and Barcelona office rents are still at ‘only 80% of the peak’ and vacancy rates are falling in both the CBDs and submarkets, Of course, at some point the rate of growth will slow and Merlin will be in another phase of its evolution. Clemente intends to be prepared. ‘This company is a massive work in progress,’ he declares. ‘When I was doing private equity I had to think my long term was three years; my mid-term was six months; short-term was tomorrow. For the first time in our lives we can think beyond the cycle. Let’s enjoy it.’
Ismael Clemente’s career began at Spanish law firm Garrigues Andersen. He left in 1996 to join Bankers Trust and became part of Deutsche Bank in 1999 when the German bank took over its US peer. At Deutsche Bank he worked at RREEF, the real estate investment management arm, alongside David Brush and Miguel Ollero, now part of the Merlin Properties senior management team. In 2012 he led a new property company, Magic Real Estate, formed when Deutsche Bank spun off a BBVA portfolio of 898 bank branches which were acquired in a 30-year sale and leaseback in 2009/10. Merlin’s IPO followed in 2014