Initiation at prospective ‘BB’/Stable; Buy recommendation on the € 500m straight bond, neutral on the € 138m convertible bond

>Strengths / Opportunities - Benign residential real estate fundamentals; inherent rental income growth potential.Focus on B and C locations that offer higher yields than core locations.Sound liquidity position after monetisation of conwert stake.Accentro trading and privatisation business to remain profitable in this special real estate climate; it diversifies and complements Adler’s business model.Management and staff highly experienced with extensive sector expertise.Real estate demand also driven by relatively low return potential in other asset classes; low mortgage rates and undersupply are fuelling demand for property.Residential real estate less cyclical than e.g. office, retail or logistics real estate.Weaknesses / Threats - Long-term interest rate risk.Asset sales drive free cash flow generation.Relatively high LTV although it has improved in recent years; bond investors are contractually and structurally subordinated to bank debt (a high € 1.4bn – 2/3 of financial debt), which cannot be avoided in the sector.IFRS property valuation adjustments have helped to improve group equity for years.High asset exposure to eastern Germany.Bargain property purchases may turn out to be value traps.A wave of new speculative construction cannot be ruled out.Increased cost and capex for energy efficiency and/or adverse tenancy legislation.Fragmented ownership structure makes support less likely in case of need.Litigation risk from class action suit in Austria; plaintiff seeks reportedly € 60m from Adler and other former conwert shareholders – outcome is uncertain.Opinion: Stable / Recommendation: € 500m 2020 notes: Buy; € 138m 2021 convertible: Neutral - Credit Opinion: Our Stable credit opinion assumes i/ the German residential real estate market stays benign and ii/ Adler will be able to execute on its value-accretive strategy and gradually improve its high LTV and interest coverage, accompanied by cash income from its trading and privatisation business as well as the sale of non-strategic assets. Interest-rate risk is high, but not an immediate risk, and setting up a platform that can work in a more unfavourable interest rate landscape is management’s greatest medium-term challenge. Contractual and structural subordination to bank debt is a severe and latent concern, but reflected in our corporate and issue rating of ‘BB’/Stable, which already anticipates an upgrade by S&P. The “concrete gold” investment sentiment is reflected in the yields of German residential property bonds. And Adler is no exception.Recommendations: i/ € 500m 2020 bond: This instrument offers more vs other ‘BB’ issues (our prospective rating) – even if called in 2019 at 100.0 (YTW: 1.6%). However, we note that Adler will need to refinance this sizeable bond (€ 500m after a € 150m tap in 2017). Nonetheless, we issue a Buy recommendation.ii/ € 138m 2021 convertible: Oddo equity research has a price target of € 17.50 (current share price: € 13.58). However, the gap between the yields of ‘BB’ rated straight bonds (1.8%) and the instrument’s YTW (–1.1%) is wide. Adler’s NAV (as of end-March 2017), also driven by fair value adjustments, is c.37% higher than its market cap, but the shares have performed strongly in recent months and years. Investors’ fears of inflation, the Fed’s agenda, or ECB tapering could pre-empt any equity upside, although we consider our equity colleagues’ price target reasonable. For now we issue a Neutral recommendation.