GRAND CITY Properties S.A. : GCP’s credit profile far superior to many residential property peers; Buy on € 550m straight bond due in 2025 and € 200m hybrid callable in 2023

>Strengths / Opportunities - Benign German residential real estate fundamentals: i/ low return potential in other asset classes; ii/ low mortgage rates; and iii/ undersupply of “affordable housing”.Existing track record in transforming underperforming properties; vacancies are improving and rents are growing; strong management team.Healthy earnings profile provides significant cushion if interest rates should rise (Oddo def. interest coverage of 4.8x at end-2016); rental income run rate with 26% upside.Management commitment to keep LTV below 45%; low LTV compared with peers.Residential real estate less cyclical than e.g. office, retail or logistics real estate.Higher transparency from switch to prime standard; potential MDAX listing.Weaknesses / Threats - Long-term interest rate risk and/or wave of new speculative construction eroding property valuations cannot be ruled out.Acquiring real estate getting more competitive – even in distressed assets.Relatively low maintenance and modernisation capex; partly driven by different strategies among peers.Increased cost and capex for energy efficiency and/or adverse tenancy legislation.Existing dividend policy; dividends pay-out ratio of 65% of FFO I going forward.Contractually and structurally subordinated to bank debt (€ 915m at end-Dec 2016).IFRS property valuation adjustments have inflated group equity for years; an adverse scenario would trigger rapid rating downgrades, which we cannot foresee yet.Management is challenged to distinguish bargain properties from value traps.Opinion: ‘BBB+‘/St.; Reco: Buy on 2025 straight bond, € 200m hybrid - Credit Opinion: We assume GCP will remain ‘BBB+’ in 2017. S&P could have assigned an ‘a–‘ or ‘bbb+’ anchor rating but opted for the latter. A positive outlook is possible due to further KPI improvements, but an upgrade to ‘A–‘ is more a scenario for 2019, we believe. We note that rating agencies do not incorporate any haircut on IFRS property values, and therefore rising property values, KPI improvements and property-market-inherent yield compression help GCP. We view this “low hanging fruit” logic somewhat critically, but take existing rating schemes as they are. If property values would decline – e.g. driven by the Fed’s agenda and/or the ECB starting to taper – harsh downwards rating actions could challenge GCP. Such a scenario is difficult to imagine right now, however. GCP has upside potential to its rental income and already operates with a substantial earnings cushion against rising interest rates – in our view the most important financial metric for real estate companies – and moreover has hedged these almost fully for an average of seven years. Contractual and structural subordination to bank debt is a latent concern, but cannot be avoided in the sector. Should Aroundtown Property Holdings plc (‘BBB’/Stable; 36% shareholder) acquire GCP, this could create downward rating pressure.Recommendations: We issue neutral recommendations on the 2021 CB (current conversion price is € 27; higher than our equity colleagues’ target price of € 21 – see also page 11), the € 500m hybrid callable in 2022 and the 2021 straight bond. We issue buy recommendations on the 2025 straight bond and the € 200m hybrid callable in 2023. Yield deviations from comparable bonds are in most cases not meaningful enough for a more bullish/bearish view, except the 2025 straight bond (vs Vonovia’s 2025 issue) and the € 200m hybrid (vs the hybrid universe and vs GCP’s € 500m hybrid: ASW of 294bp vs. 258bp). In the long-term, we fear that rising interest rates could hurt bond investors not only on a relative basis, but also via a deteriorating credit profile as the level of interest rates is more crucial for a real estate business than for other industries.