Our Group is exposed to various trends. Factors that may influence the development of our business, net assets, financial condition and results of operations, and which we believe are material, are discussed below.
General Economic and Demographic Developments in Germany
The market value and rental income of our total portfolio depend to a significant degree on economic factors. Cyclical economic developments beyond our control, including economic growth, unemployment rates, price trends and interest rate levels, affect rental income levels, the potential for property sales, opportunities for acquisitions and purchase prices. In addition, inflation-driven price increases affect our expenses. To the extent permissible under applicable law, and taking into account the market environment, cost increases are compensated for by rent increases and/or allocated ancillary costs. The impact of the global economic and financial crisis on our business in the last years highlights our exposure to general economic trends. We recorded a material loss from the fair value adjustments of investment properties in 2008. Additionally, our sales proceeds, in particular those from institutional sales, decreased significantly from 2008 to 2009.
Further, demographic factors such as changes in living space per capita, average household size, home ownership rate and migration patterns affect the market value and rental yield of our total residential portfolio. Expectations are that from 2010 onwards the number of households will increase, particularly in cities and densely populated areas. Residential floor space demand per capita is also expected to grow by 9% to 41 square meters in 2025 from 2010 levels due to an increased desire for more living space and the ageing population (Source: GFOB Residential Market 2010).
Portfolio size, vacancy rate, tenant turnover and rent restrictions drive revenue from letting
The level of current gross rental income is a material factor affecting our income. The amount of current gross rental income earned depends primarily on the relevant rent per square meter and the relevant rented space, which in turn depends on the location and quality of the properties. In principle, current gross rental income is not subject to any significant seasonal or cyclical fluctuations. Significant changes result primarily from sales and acquisitions, which impact the size of our total portfolio and may have an impact on the average current gross rental income per square meter. Overall, our total residential portfolio slightly
decreased during the period from December 31, 2008 through December 31, 2010, from 50,489 residential units as of December 31, 2008 to 47,688 residential units as of December 31, 2010. This reduction led to a loss of revenue from residential properties. In the first nine months of 2011, our total residential portfolio increased to 49,664 units as of September 30, 2011.
Vacant residential units also have a considerable effect on our earnings, as they negatively affect the level of rental income and allocable operating expenses. Vacancy rates in our total residential portfolio amounted to 5.9% as of December 31, 2008, 4.2% as of December 31, 2009, 3.3% as of December 31, 2010 and 2.9% as of September 30, 2011. In our letting portfolio in our core regions, the vacancy rates amounted to 4.0% as of December 31, 2008, 2.7% as of December 31, 2009, 2.0% as of December 31, 2010 and 1.7% as of September 30, 2011. Generally, vacancy rates tend to differ by region. For example, the vacancy rate in Berlin and Frankfurt/Main were 1.3% and 1.5% as of December 31, 2010, well below the average of 2.0% for our letting portfolio in our core regions as of December 31, 2010.
Further, our earnings are also affected by our ability to drive rent increases in our Residential Property Management segment. Tenant fluctuation helps us to increase rents, as rents for newly-let apartments tend to be higher than our average in-place rent. As of December 31, 2010, the monthly in-place rent for our letting portfolio in our core regions amounted toS5.46 per square meter, while the new-letting rent at year-end 2010 effective in 2010 for units not subject to rent control in the letting portfolio in our core regions amounted toS6.47 per square meter. An increase in tenant turnover allows us to reduce the difference between in-place rent and new-letting rents more quickly and vice versa. Rent restrictions due to ongoing or former subsidies provided by public authorities through programs for new buildings as well as for the modernization and renovation of existing buildings, however, limit the rent increase potential. As of September 30, 2011, approximately 21% of the apartments that we own (10,542 apartments) were rent-restricted (December 31, 2010: 23%; December 31, 2009: 23%; December 31, 2008: 24%).
Maintenance and Modernization Measures
Our results of operations depend in part on the extent to which we maintain and modernize our properties. In general, maintenance expenses are reflected in the consolidated profit and loss statement, while modern- ization measures are capitalized and amortized over time.
Besides ensuring a certain quality standard in our total portfolio by maintaining our properties, we have focused on modernizing certain properties with the aim of significantly improving rental income and reducing vacancies. The cost and time of implementation of maintenance and modernization measures depend heavily on the size of the relevant portfolio, the quality and location of the properties to be maintained, the tenants’ quality expectations, and the scope of measures to be carried out. Maintenance and modernization costs tend to vary on an inversely proportional basis with the purchase price of acquisitions,
i.e., the purchase of high-quality properties generally results in relatively low maintenance and modern-
ization spending.
While maintenance and modernization costs for our total portfolio amounted toS17.88 per square meter in 2008, they decreased toS14.20 per square meter in 2009 and increased to S15.65 per square meter in 2010. In the nine months ended September 30, 2011, maintenance and modernization costs decreased toS12.44 per square meter, compared toS13.81 per square meter in the nine months ended September 30, 2010. Over the recent years, Deutsche Wohnen has been able to reduce required maintenance expenses on an absolute and per square meter basis. This was based on the quality of our portfolio and the ability to rationalize maintenance as maintence requirements declined.
Sale Prices and Sales Proceeds
We engage in the sale of residential real estate units both from our residential portfolio in our core regions and from our residential portfolio in our disposal regions. We engage in both single-unit sales and block sales. In single-unit sales, our objective is to sell apartments, mainly to owner-occupants, at prices exceeding fair value. We refer to such sales as “privatizations.” The residential portfolio in our disposal regions, i.e., the portfolio for block sales, comprises apartments in locations that no longer fit into our business strategy. We refer to such sales as “institutional sales.” While single-unit sales (privatizations) tend to be relatively unaffected by the economic situation, institutional sales are generally strongly influenced by the economic situation. For example, sales proceeds from institutional sales decreased from S58.7 million in 2008 to S28.1 million in 2009 and rebounded to S114.9 million in 2010, while sales proceeds from single-unit sales (privatizations) wereS61.0 million in 2008, S57.6 million in 2009 and S56.8 million in 2010. As margins in institutional sales tend to be significantly lower than in single-unit sales (privatizations), the Disposal
segment’s profit/loss tends to be less affected by fluctuations of institutional sales than changes in single-unit sales (privatizations). This is highlighted by the Disposals segment’s profit which was relatively stable from 2008 through 2010 (2008:S13.2 million; 2009: S9.7 million; 2010: S12.7 million).
Generally, our sales proceeds depend on the number of properties sold and their respective prices. Sales prices of properties depend on supply and demand, which are influenced substantially by the location, condition of the property and prospective rental income. In addition, tenant structure and purchasing power are relevant. Overall, sales proceeds are also subject to regional fluctuations. In addition, increases in the new construction of residential units can reduce market demand for our real estate holdings and adversely affect the results of operations. Political and regulatory decisions and developments, such as, for example, public subsidies for residential space, also influence supply and demand in the residential property market and affect price trends for residential real estate.
Our cost of sales, which include pre-sale expenses and broker commissions, tend to be relatively stable over time and amounted toS4.2 million in 2008, S6.2 million in 2009 and S6.9 million in 2010. In the nine months ended September 30, 2011 our cost of sales amounted toS5.4 million, compared to S4.4 million in the nine months ended September 30, 2010.
Fair Value Adjustments of Investment Properties
The investment properties that we own are revalued internally on a quarterly basis in accordance with IAS 40 at their respective market values on the reporting dates. Two significant factors influence the valuation of investment properties. The first is the cash flow arising from operational performance and the second is the discount rates and capitalization rates that result from the interest rates in the market and risk premiums applied to our business. The cash flow arising from operational performance is primarily determined by current gross rental income per square meter and vacancy rate trends, total portfolio size, maintenance and administrative expenses, and operating expenses. The capitalization and discount rates are influenced by prevailing interest rates and risk premiums. When discount rates and capitalization rates increase, the market value decreases, and vice versa. Even small changes in one or some of these factors can have considerable effects on the fair value of our investment properties and on the results of operations. In 2010, gains/losses from fair value adjustments of investment properties amounted toS47.2 million (representing 26.2% of EBIT), being the primary reason for an increase in EBIT byS57.4 million from S122.9 million in 2009 toS180.3 million in 2010. In contrast, the gains/losses from fair value adjustments of investment properties amounted to negative S276.5 million in 2008, reflecting the deterioration in the economic environment in Germany due to the global economic and financial crisis.
Costs of Financing and Reduction of Financial Liabilities
Our business is largely debt-financed. Therefore, we depend on the availability of debt and our results of operations are materially affected by financing costs. Accordingly, entering into financing agreements on favorable terms, especially low interest rates, is of considerable importance to our Group.
We used a large portion of the proceeds from our rights offering which closed on October 9, 2009 to reduce our net financial liabilities (non-current and current financial liabilities including convertible bonds minus cash and cash equivalents) by 14.5% fromS2,072.6 million as of December 31, 2008 to S1,772.2 million as of December 31, 2009 and by another 1.9% toS1,738.5 million as of December 31, 2010. In the first nine months of 2011 our net financial liabilities increased toS1,867.3 million as of September 30, 2011 due to debt incurred in connection with acquisitions. The overall reduction in net financial liabilities led to a significant decrease in our LTV ratio from 70.6% as of December 31, 2008 to 62.1% as of September 30, 2011 (60.6% as of December 31, 2010; 61.5% as of December 31, 2009). Our LTV ratio is thus slightly above our target of 60%. The reduction in financial liabilities helped us to reduce current interest expenses by 8.9%, fromS107.3 million in 2008 to S97.7 million in 2009 and by another 11.8% to S86.3 million in 2010. Current interest expenses in the nine months ended September 30, 2011 amounted toS59.8 million, compared withS64.5 million in the nine months ended September 30, 2010. The early redemption of loans, however, triggered one-off prepayment penalties ofS6.2 million in 2009 and S8.3 million in 2010 for the termination and refinancing of loans and additional prepayment penalties of S15.3 million for the termination of interest rate swaps ahead of maturity in 2010.
Impact of Interest Rate Changes
Changes in interest rates affect our business in a number of ways. Interest rates impact capitalization and discount rates, which in turn influence the fair value of our investment properties. Moreover, lower interest rates in Germany tend to increase demand for residential properties, resulting in higher acquisition costs but
lower interest expenses. Conversely, rising interest rates lead to economically less favorable financing terms and negatively impact the sale of properties. In addition, changes in interest rates impact our cost of financing. They affect the conditions at which we may obtain fixed rate financing and impact interest payment obligations under our floating rate debt obligations. We have engaged in significant hedging transactions to reduce the risk of interest fluctuations. As of September 30, 2011, the nominal value of our interest hedges and fixed rate loans amounted toS1.5 billion. We fulfill the requirements of the IAS 39 hedge accounting rules applicable to accounting for hedging instruments (interest rate swaps) in hedging against cash-flow risks from variable interest loans. When interest rate levels fluctuate, the fair value of the interest rate swaps also fluctuates. For interest rate swaps that have been entered into by our Group to hedge against cash-flow risks from variable interest loans and that are an asset, increases in interest rate levels lead to an increase in the fair value of the interest rate swaps and vice versa. Under hedge accounting, changes in the fair value of hedging instruments that are part of an effective hedge relationship are recognized directly in equity. Only those portions that do not meet the effectiveness requirements of IAS 39 are recognized in the consolidated profit and loss statement.
DB 14 Right of Sell-out and Acquisition of Majority in DB 14
On the basis of individual agreements, Rhein-Pfalz Wohnen GmbH (a Deutsche Wohnen Group company) has granted the limited partners of DB 14 a right of sell-out for their limited partner interests. Under these agreements, our Group is obliged to acquire the shares initially (in 2005) at 105% of the paid-in capital on request. The purchase price for the shares increases annually by three to seven percentage points starting from 2005. While the assets and liabilities of DB 14 were already fully consolidated in the past, the increase of our stake in DB 14 by more than 40% in 2010, which resulted in the ownership of a majority of the interest in this closed-end real estate fund, led to the inclusion of DB 14’s residential properties in our residential portfolio in our core regions. Prior-period comparative figures for our vacancy rate and in-place rent have been restated accordingly. As of September 30, 2011, we held 84% of the capital of DB 14. The corresponding liabilities to limited partners in funds comprise the net present value of the remaining annual instalments calculated using a discount rate of 5.0%.
In the nine months ended September 30, 2011,S7.7 million was paid to the limited partners of the fund (nine months ended September 30, 2010: S5.3 million), S28.4 million in 2010, S1.3 million in 2009 and S6.1 million in 2008. These payments relate both to the interests subject to the sell-out and the dividend payment by DB 14 to the limited partners. For additional information, see above “Risk Factors—Risks
Related to Our Business—The exercise of the right of sell-out held by the limited partners of DB Immobilienfonds 14 Rhein-Pfalz Wohnen GmbH & Co. KG could impair our profitability and negatively impact our liquidity.”
Payments Related to EK 02 Inventories
Within our Group, there are various housing companies with significant EK 02 tax liabilities, resulting from a change of tax status from non-profit status to general taxability. The EK 02 tax is generally to be paid either within a period of ten years from 2008 to 2017 in ten equal annual installments or at present value in a one- off payment. Our EK 02 tax liability amounted to approximatelyS96.0 million, on the assumption that the tax amount is paid in ten equal annual installments of approximatelyS9.6 million per year from 2008 to 2017. In the unaudited condensed consolidated interim financial statements as of and for the nine months ended September 30, 2011, a liability of approximatelyS51.1 million is recognized as current and non- current tax liabilities.
Income Taxes
Income taxes contain current tax expense and deferred taxes. For corporations domiciled in Germany, corporation tax of 15% is due in 2010, 2009 and 2008, plus a solidarity surcharge of 5.5% (2010, 2009 and 2008) of the corporation tax due. These companies are also subject to trade tax, the amount of which depends on tax rates set by local authorities. The anticipated nominal income tax rate for our Group’s parent company, Deutsche Wohnen AG, is 31.93% for 2010, 2009 and 2008.