Aareal Bank AG
XETRA:ARL
Earnings Call Analysis
Q3-2023 Analysis
Aareal Bank AG
IR Bank Group held its earnings call to discuss the third-quarter and nine-month performances and provide a full-year outlook for 2023. CEO Jochen Klosges and CFO Marc Hess recapped the company's results, emphasizing stable operating performance and resilience despite challenges, and shared details on strategic initiatives and an overview of financial health.
The bank has managed to maintain a stable performance year-over-year, even with significant investments into its subsidiary Aareon and creation of loss allowances. The commitment to efficiency improvements and a strong earnings power has allowed the bank to manage costs effectively, achieving a profit before provisions increase of 28% over the first nine months. Rapidly rising net interest income by 35% and net commission income by 13% underscore the company's financial strength.
IR Bank Group continued its cautious expansion in property financing, achieving new business volumes of EUR 2.4 billion in Q3, and is on track with its annual target despite maintaining conservative risk profiles. With diversified property investments and the addition of a new alternative living properties team, the bank maintains strategic growth in specific sectors like hotel properties which have seen a post-pandemic resurgence.
Digital solutions arm Aareon is showcasing strong performance with sales revenue and recurring revenue growing considerably. Aareal Bank boasts a strong liquidity position, reflected in their success with deposit generation from the housing industry and retail deposits reaching over EUR 2 billion. The bank continues to navigate the competitive deposit marketplace successfully, reflecting robust client loyalty and industry standing.
The bank's loan portfolio stands at EUR 32.8 billion, meeting its target range for the year and showing a diversified mix across regions and property types. IR Bank Group exemplifies prudence by exiting riskier geographies like Russia and China and focuses on sustainable lending, significantly growing its green loan portfolio. Despite challenges, particularly in the U.S. office property sector, the bank is actively managing its nonperforming loans, maintaining a stable NPL ratio and conservative loan-to-value standards.
IR Bank Group projects an operating profit at the lower end of the EUR 240 million to EUR 280 million range, primarily due to geopolitical and macroeconomic uncertainties, and potential significant increases in full year risk provisions given the U.S. office market challenges. The company expects a strong net interest income performance and a net commission income of EUR 315 million to EUR 325 million for the full year.
The bank is well-capitalized with a CET1 ratio of 19.4% and is planning for a stable future by issuing covered bonds and potentially senior non-preferred notes in the coming year. As part of their forward-looking strategy, they are focusing on organic growth, with no immediate M&A activity planned for their structured property finance segment, and continuing to uphold strict underwriting criteria for new financing ventures.
In closing the call, CEO Klosges highlights the strong financial position of the bank and its operational resilience. Despite the uncertain environment, the bank remains committed to its medium- and long-term strategic goals, actively managing its business lines, and maintaining robust capital ratios and liquidity. The bank underlines its ability to take advantage of market opportunities while also increasing operational efficiency, exemplified by improved cost/income ratios.
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Good morning, everybody. I'm pleased to welcome you to today's conference call. And today's agenda will cover our results for the third quarter and the first 9 months and as well an outlook for the full year '23. I'm joined by our CEO, Jochen Klosges, our CFO, Marc Hess. They will take you through the presentation, which will be followed by a question-and-answer session. Now I'm pleased to hand over to Jochen. Jochen, the floor is yours.
Thanks, Jurgen. Good morning, everybody. I would also like to welcome you to our conference call. Today, my colleague, Marc Hess, and I would like to review IR Bank Group's third quarter and 9-month performance and provide you with an update on how we view the current situation of our business. Let's look at the key points on this first slide here. We continued our strong operating performance in the third quarter. Our results were stable compared with both last year's third quarter and with the first 9 months of last year. We achieved this despite investments to increase efficiency at Aareon and the loss allowance totaling EUR 120 million in the third quarter. Profitability in our operating business has reached levels that allowed us to offset these costs. Net interest income rose by 35% year-on-year in the third quarter and net commission income increased by 13%, mainly driven by Aareon's growth. Our strong earnings power underlines our resilience and allows us to actively manage our 3 business segments. Among other things, we were able to keep our portfolio of nonperforming loans at a stable level. This was achieved by actively reducing NPLs, while adding some exposures because of the current strain office in property markets in the U.S. However, we remain vigilant and in the light of the ongoing political and economic uncertainties, we'll focus on even more conservative risk standards. I will give you more details on that later. Further good news in the current environment is that our funding activities were very successful in the first 9 months of the financial year. Deposits generated from the housing industry remain above projections. Our liquidity position is comfortable, and retail deposits generated by online platforms have already passed the EUR 2 billion mark of the short. Aareal Bank also continues to have a very solid capital base. At 19.4%, our CET1 ratio remains at a high level despite our portfolio growth. We are therefore well prepared if geopolitical and economic conditions become even more adverse. And at this point, I would like to hand over to Mark, who will be guiding you through the key financial indicators for the third quarter and the first 9 months of this year. Over to you, Mark.
Yes. Thank you, Jochen, and good morning. Welcome to my side, too. As Jochen just said, we have been able to maintain our strong income growth in the third quarter. And on Slide #3, you can have a good overview of our key P&L figures. I think it is first of all, that our pre-provision profit is up by 28% in the first 9 months. And this is after substantial investments of EUR 75 million into Aareon. And I think this is a clear evidence of how much we have strengthened our operating resilience over the last couple of years. This is what helped us to deal with this year's higher risk provisions, to even achieve the results that we showed last year. Looking into the P&L lines. Jochen just mentioned that interest income. It reached EUR 248 million. That's a record in the third quarter, and that's up 35% versus the third quarter last year, which really all in all, made a decisive contribution to the results. Net commission income is also up by 13% in the first 9 months. At the same time, we have kept our costs under control. This allowed us to end the third quarter with stable results for both the first 9 months as well as for the quarter. So now let's turn to the next slide that show you the details of the main P&L lines, starting with net interest income on Page 4. It increased by 38% in the first 9 months. that was driven by portfolio growth, solid new business margins, much above what we had last year and especially what we had pre-COVID and also our diversified funding mix helped here. Normalized interest rate levels, together with the high volume of client deposits had also a positive impact on our deposit-taking business. We are also pleased with the increase of the fee income shown on the lower half of the slide, both in BDS and Aareon. They both contributed with 15% in total, which mainly comes from Aareon, of course, the share of recurring revenues compared to Aareon's total sales, and that's an important indicator for software companies has gone up to 78%. In absolute terms, Aareon increased the recurring revenues by 21%. And that, of course, includes the revenues generated by our SaaS solutions. So let's go to the next slide. Here, you can see the admin expenses that have gone up at least at first site. We have invested EUR 70 million in Aareon's efficiency program, which now includes the cost for replacing the hunting line, that's our credit facility that we gave to Aareon to finance M&A. And this has now been replaced by external credit facilities. The investments in efficiency measures at Aareon are starting to pay off. We are expecting an annual cost savings of up to EUR 20 million as a result of those measures going forward. Costs at the bank remained stable with the cost/income ratio in the banking business of only 31% in the first 9 months of the year. And I think even a better number in the third quarter, we have really reached very good levels here. Looking at risk provisions, which remained at a high level in the third quarter. This reflects the persistent headwinds coming from the U.S. office market, as you know. We continue to monitor the portfolio closely and have prepared for further NPL reductions during the first quarter as well. So we booked risk provisions totaling EUR 120 million in the third quarter, of which EUR 18 million are reported in the fair value and P&L lines. Risk provisions for the first 9 months amounted to EUR 316 million with EUR 262 million in the risk provisioning LLP line and EUR 54 million in the fair value and P&L line. During the third quarter, we increased risk provisions for the swift reduction of our NPL portfolio from approximately EUR 60 million to close to EUR 100 million, and this includes the loss arising from the sale of our remaining Russian exposure in the second quarter and really puts us into position to manage our NPL stock actively. And now I would like to hand back over to Jochen.
Thanks, Mark. Now let's turn to our 3 business lines and start with Structured Property Financing. We continued to pursue our selective approach as in the previous quarters and originated new business with conservative risk profiles. New business volume amounted to EUR 2.4 billion in the third quarter and to EUR 6.5 billion for the first 9 months of this year. This means we are on track to achieve our new business target for the year of EUR 9 million to EUR 10 billion. Conservative risk standards remain an important factor. At 53%, the average new business loan-to-value ratio were at a very conservative level. We also continue to achieve attractive gross margins that average approx 290 basis points and that we were not only above the target, but also clearly above previous year's level. Our new business is diversified by region and sector, with hotel properties accounting for the largest share in the first 9 months of this year. This asset class is growing and remains attractive. Something you probably noticed if you try to book a hotel room over the summer. We are now seeing the rewards of our persistence during the pandemic. Our hotel clients appreciate that we state by their site, our specific expertise in this sector and across all phases of the cycle is now paying off. We also established a dedicated new team in September to increase our exposure to financing alternative living properties. We are aiming to expand financing activities in this growth segment, which comprises student housing, micro apartments and co-leading properties. We will leverage our expertise in the hotel segment and in our already established student housing activities. At the end of the day, we are talking about the type of assisted living for people who don't need or can afford larger flats. Instead, they prefer larger terminal areas and all kinds of services such as laundry and housekeeping services at concierge [ service ]. As you can imagine, this has a lot in common with hotels. With the lending volume exceeding EUR 1 billion, Aareal Bank is already one of the leading financing partners in this alternative living sector, and we want to build on that. This brings us to the Banking and Digital Solutions segment, where normalization of interest rate levels and the volume of client deposits may lately had a positive impact. Deposits from the industry averaged EUR 13.5 million during the first 9 months, which remains above our high level of EUR 13 billion. The structure of our deposits is granular because we execute payment transactions for 3,700 at industry clients, managing 8 million rental units. These deposits largely reflect the housing industry's working capital, and we benefit from a deep integration into our clients' payment processes. As expected, due to the higher interest rate levels, we and other banks are observed a growing shift to term deposits, yet in our books, also observed a drawing proportion of tenant rental deposits, which are generally managed over the long-term horizon. This means we are holding up despite increased competitive for deposits. This reflects our strong client loyalty and strong route in the housing industry. Moving on to Aareon. Aareon is also performing well. Sales revenues grew by 13% in the first 9 months, including revenue from Software as a service. Recurring revenues rose by 21% year-on-year, raising their share of total revenue to a very good 78% on average for the past 12 months. The picture on the earnings side is also positive. Aareon's adjusted EBITDA for the first 9 months rose by 37% year-on-year with the adjusted EBITDA margin showing an increase to 26%. Aareon continued its acquisition growth path. In the third quarter, we acquired IESA, the leading provider of property management software solutions in Spain. Aareon also succeeded in winning initial partners for the new Aareon Connect partner program in the U.K. and more clients on partners in Germany as well. In the third quarter, Aareon refinanced the facility provided by Aareal Bank with external long-term debt. This will reduce Aareal Bank's future net interest income by a low double-digit million euro amount per annum, but will be offset by positive effects of around EUR 20 million annually from Aareon's efficiency enhancement program. We are anticipating the first cost savings of around EUR 10 million from the efficiency program already this year. Let's turn to the next slide. Solid new business during the course of the year has allowed us to increase the portfolio volume as planned to EUR 32.8 billion as of end of September this year. This means we have already reached our target range for this year. Our portfolio composition has not changed much compared to the end of '22. It continues to be broadly diversified across regions and property types. After we finally exited Russia in the previous quarter, we have now decided not to renew a final and last exposure in China. We are focusing on countries with credit and legal standards that are in accordance with Western jurisdictions. We do not offer loans for project developments. Hence, we are thankfully unaffected by issues which have been making recent headlines. Yet we continue to provide financing specifically for properties that require innovation to improve the energy efficiency and enhance sustainability. This is evident in our growing green loan portfolio, which has reached a volume of EUR 3.4 billion, more than doubling within a single year. For example, last month, we completed an exciting new initiative in this area in Brussels. Tim is a project which is a former office building that has been converted to a sustainable mixed-use property. The building is a prime example of a change in the use of commercial real estate. It combines now office use with residential space, retail and storage space and the hotel. The office part has already been leased long term to the Flemish government. It is noteworthy that 2/3 of the concrete from the old high-rise building will be reused in the new property. This is how the circular economy works. And we are supporting this transformation with a green loan. Let's now take a look at the KPIs in the credit portfolio. The overall picture is, in fact, better than in 2019. Despite the strong headwinds on the U.S. office property market, the average loan-to-value ratio of 56% is at a very conservative level. It provides a good cushion in turbulent times like these. Moreover, at 9.6%, the yield on that has once again improved significantly. As pointed out, hotels are doing very well now with strong cash flows, thanks to the clear pickup in travel after the coronavirus pandemic now in the second year. The retail sector is also recovering faster and more strongly than expected, benefiting from catch-up effects due to post-corona normalization of life. Retail sales have increased significantly across Europe. In some cases, they are back or above 2019 levels. Allow me to say a few words about office properties. This sector has been in the spotlight for some time, especially with regards to the topics of working from home and offers occupancy. Let me be clear at this point, offices in good locations, which satisfy more on standards, especially in terms of energy efficiency, remain attractive investments. That said, let's take a closer look at our U.S. portfolio and specifically the U.S. office portfolio on the next few slides. The U.S. portfolio totaled EUR 8.6 billion with offices at 50% and total at 32% being the 2 main asset types. For 90% of our entire use exposure, delayered LTV is below 60% and less than EUR 90 million have an LTV above 80%. In the U.S., we are only feeling headwinds in the office sector. The other asset types are fairly stable. Let's move now on to the U.S. office portfolio. All values have been reviewed during 2023 with 56% of these portfolio valuated externally. These external valuation shows a decrease of 20% to 44% in the nonperforming portfolio and a decrease of around 80% on average in the platforming portfolio. At the end of September, we stress tested our portfolio for a further 20% decline in value. The stress has showed that the average LTV of our office portfolio would increase from 68% to 85% in such a strong scenario. On this basis, less than EUR 60 million would have an LTV over 100%. In summary, the results shows that we have headroom even under very conservative stress conditions. Let's briefly turn to the European office portfolio. When we presented our results for the previous quarter, we looked into the question of whether the current situation in the U.S. was going to spread to Europe. As you can see in the chart below on the left, LTVs in our European portfolio are still at a very comfortable level in all regions. We continue to enjoy significant buffers here. In Europe, we only finance offices in prime locations. In France, for example, only in Paris city locations where in addition to existing properties, we also finance conversions into green offices. This accounts in the meantime for around 1/3 of all of our office property financings in Paris.Likewise, our financings in the U.K. are mainly concentrated in the city of London. It is also worth noting that we see considerable structural differences between the two continents. Let's now take a look at the group's portfolio of nonperforming loans. The NPL ratio remained stable at 4.1% compared to the previous quarter, and this despite additions from the U.S. office property sector. This is because we successfully continued our swift reduction of legacy NPLs. We will not let up in this respect. So NPLs worth another EUR 300 million are currently being prepared for resolution. And as already mentioned, we have increased provisions for the Swift NPL reduction. So Mark will now look at our funding activities and our capital base and then explain our outflank to you. Over to you, Mark.
Thank you, Jochen. Let's take a look at our balance sheet structure on Page 17. We can certainly say we are well funded. Our EUR 24 billion of long-term funds have longer maturity than our CRE lending book. And in addition, with our housing industry payment deposits of around EUR 13 billion and retail deposits over now EUR 2 billion. We have established a well-diversified and stable funding and liquidity base. You can see our liquidity and funding ratios here. The LCR stood at 206% and the NSFR at 116% at the end of September. The ternary portfolio investments are in very liquid, mainly public sector bonds, and we hedge our balance sheet against interest rate change risk. Thus, we have no significant unrealized losses within the portfolio. On the funding side, you can see that on the next slide, we continue to benefit from our broadly diversified funding mix. This makes us somewhat less vulnerable to prevailing high capital markets volatility. As you know, we have been working diligently over the recent years to broaden our funding sources. And as a result, we have attracted new investors, for example, through our cooperation with Raisin and through the launch of a commercial paper program. At the end of October, Fitch reaffirmed our ratings with the senior preferred A- with an unchanged negative outlook. Fitch especially referred to Aareal's good geographical diversification relative to peers, our sound capitalization, adequate funding and liquidity and the resilient profitability. Fitch also noted that the benefits from rising net interest margins have so far offset higher loan impairment charges in the bank's U.S. portfolio as you have heard today from us again. Let's turn to capital. Our capital ratios remain very solid. Our CET1 ratio is at 19.4%, and it's slightly up compared to the end of 2022 and unchanged to the second quarter of '23. And this is despite the portfolio growth and the macro headwinds that we have seen. The leverage ratio is at 6.3%, and you can also see the fully phased ratio would be at 13.4%. So that brings us to the outlook on Page 22. Overall, we continue to anticipate that we can achieve and operating profit at the lower end of the range between EUR 240 million to EUR 280 million. On an adjusted basis, that is excluding what we mentioned, the extraordinary expenses for the investments in Iron and the Swift NPL reduction budget that would all in all, correspond to more than EUR 350 million. We now anticipate an investment of around EUR 90 million into Aareon, including the external refinancing costs of the hunting line for the full year. Of course, we have to say that significant geopolitical and macroeconomic uncertainties continue the effects of which are, of course, difficult to assess, unfortunately. If we look into the P&L lines, NII is expected to come in above the original guidance due to the strong year-to-date results. Net commission income is expected to be between EUR 315 million to EUR 325 million. However, given the challenges facing the U.S. office property sector, we are assuming that the full year risk provisions will significantly exceed the forecast from the beginning of the year, just how much this is going to be is, of course, currently difficult to assess. And with that, I would like to hand back over to Jochen for the concluding remarks.
Thanks, Mark. In conclusion, allow me to summarize. Firstly, the current environment is challenging, and there is great uncertainty regarding future political and economic developments. However, we're in a strong financial position. We have built strong earnings power over recent years, which enables us to absorb a variety of costs. All this shows our increased resilience. Secondly, our capital ratios are robust and our funding is broadly diversified. We are in a position to actively manage our activities across all business segments, and we are maintaining our conservative risk standards with a watchful eye. And thirdly, even in a challenging environment, we are sticking to our medium- and long-term goals to see increased efficiency and consistently implementing our strategy in our 3 business lines. And now we look forward to your questions. Thank you.
Ladies and gentlemen, at this time, we will begin the question-and-answer session. [Operator Instructions] The first question comes from Lougovtsov Alexei with Bank of America.
I just wanted to ask you about next year funding plan and what bonds you will be using to meet maturities.
Yes. Thank you very much for your questions. I think we had some interference, but I hope everybody on the line understood your question. Just to repeat it, it was about next year's funding plan. I think it would not differ very much from this year. We are an active issuer of covered bonds. So we plan to issue a series of cover bonds next year, probably beginning very early in the year. Then we also said not for liquidity reason. But in order, let's say, to keep our thresholds for our rating, we would need to issue some senior nonpreferred. So this is certainly also something that you could expect for next year. And then a little bit further down the road, we may look at Tier 2, but this has not yet decided whether this is something for next year or for the years to come.
And therefore, a senior nonpreferred, what kind of size you think will be required?
Well, certainly benchmark size, but not excessive volumes, so to say.
So benchmark for you is 500 or...
500. Yes. That's 500. In the Euro.
And on the senior preferred?
Well, as I just outlined, we are very happy and successful with the deposit gathering that we have on the cooperation with Raisin. So now we are at EUR 2 billion. We are also expecting, let's say, to increase that number slightly probably not with the same dynamics as over the last 15 months as we only started last year. So we are not taking any overnight money. This is all term and therefore, it's a good replacement for senior preferred. And therefore, as of today, I wouldn't say that we go out with the senior preferred.
[Operator Instructions] The next question comes from Christian Leukers with CQS.
I was just wondering about sort of M&A or any acquisitions or anything that you might have room for. Is there -- I mean, I know you've had quite an ownership change and sort of setting down of potential selling area and that sort of thing going on. But so just looking at your structured property finance book and thinking there might be some opportunities to buy portfolios or anything else. And would that be in your current outlook for growth? I mean, obviously, you got a bit of growth put in for next year. But basically, is there additional room to maybe do some acquisitions or smaller bolt-ons?
So if I understood your question correctly, it's about M&A activities at Aareon. You see we -- the in the bank -- M&A activities in RF is currently not on our agenda. So we are pursuing here a strategy which clearly steers interaction of organic growth, and we have ample of opportunities to grow our business in various property sectors and regions. So there's nothing on our ready screen in terms of M&A for structured property financing.
First has your underwriting criteria has changed on the structured property finance for the new -- for the front book?
So if I understood correctly, you're asking for the underwriting criteria of the -- in the Commercial Retail business. So you see, finally, we tried to take opportunities in various market situations. We had quarters where we did less new business, quarters where we did more new business. Finally, you can see that we achieved a much higher gross margins of about 290 basis points. This year, clearly above previous years and clearly above our targets, our plans. And in the same time, we are very strict on LTV. I guess the average LTV of new business was 53% during the first 9 months, and we will definitely stick to that very strict underwriting policy for the next quarters.
There are no further questions at this time. I hand back to Jochen Klosges for closing remarks.
Okay. Thanks, everybody, for participating. These are still challenging times. But I think you might see, if you take a closer look at our figures that we are doing both things. We're trying, obviously, to cope with all the challenges, which arise in various situations. We are now in the fourth year of, let's say, challenging environment starting in 2020, now in the year '23. At the same time, it's important for us to really build on our strategy to invest in our businesses to grow the business, obviously, always very much risk oriented and to increase our efficiency, you can see that clearly, when you take a look at our cost/income ratio, for example, we maintained very good capital ratios, a very confident liquidity position. And it's going to be the way we manage the bank forward, seeing taking opportunities being careful at the same time trying to increase the value of our franchise operations and our operations. So finally, I could only invite you if you have further questions, I guess, Jurgen and his team are ready to take further questions and happy to answer your questions. And yes, I hope to see you soon, and thanks for participating again. Thank you very much.
Ladies and gentlemen, the conference has now concluded, and you may disconnect your telephone. Thank you for joining, and have a pleasant day. Goodbye.