Cromwell (ASX: CMW) has contracted to sell its European funds management platform and its coinvestments in associated assets, including the Cromwell European REIT and the Italy Urban Logistics fund. This is unexpected, as we assumed the group’s desire for a capital-light business model would involve increasing funds management, including in Europe.

It’s not ideal to sell assets when markets are under pressure. Nevertheless, the positives of exiting Europe are that post-completion, expected in the September quarter, gearing should be comfortable at 25%. The business will also be simpler and focused on Australia and New Zealand.

With the balance sheet strengthened, we no longer assume an equity raise, which boosts our valuation by $0.10 per security. However, we strip out earnings from the European fund platform and assets, which we think were sold at a discount, and this depresses our valuation by $0.19 per security. The net effect is that our fair value estimate declines $0.09 to $0.66.

That said, the business is now more predictable as an Australian business with balance sheet risk ameliorated. Therefore, we have improved our Uncertainty Rating to Medium from High. Our rating on Cromwell moves to 4 stars, down from 5 stars after Cromwell securities rallied 8% on the day of the news, but we still see them as undervalued.

Cromwell management estimates the European funds management sale will diminish net tangible assets by roughly 8%, as the disposal price was at a discount to book value. The recent sale of Polish assets did not change the net tangible assets (“NTA”), as the sale price was in line with the book value. We estimate Cromwell’s NTA will decline to about $0.66 on this deal, other things being equal. Share are currently trading at $0.46. 

Our new fair value estimate aligns with our NTA estimate, adjusted for the pending asset sales.

Business strategy and outlook

Cromwell Property Group is an Australian property company that currently generates most of its income from rent on properties it owns, and a lesser amount from property funds management. The latter includes property management services, investment management, and property acquisitions and development, in collaboration with customers. The group tends to own co-investment stakes in funds or properties that it manages for clients, particularly in its wholesale business. This provides a degree of alignment with clients, as well as providing another indirect source of rental income.

In 2024, the group simplified its business by selling its European assets and funds management business, instead focusing on its assets and third-party funds in Australia and New Zealand.

Its directly held property investments are nearly all offices, backed by reasonably long leases to a solid mix of tenants. Many of the assets are of secondary quality, meaning there is some leasing risk longer term as leases expire. The office portfolio has significant exposure to less supply constrained areas such as fringe central business districts, or CBDs, or suburban sites in Sydney, or less built-up capital cities such as Canberra.

Relative to its largest rivals, this makes Cromwell more exposed to economic and property market conditions. Increasing CBD supply and cautious businesses could particularly hurt tenant demand in suburban and fringe locations. Reassuringly, government accounts for circa half of Australian rent, and a decade-long lease to Qantas another big chunk. A minority of earnings is from funds management activities. This segment generates a high return on equity because while it relinquishes rental income, it frees up capital for use elsewhere, while still generating management fees.

Risk and uncertainty

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We assign Cromwell a Medium Morningstar Uncertainty Rating. Uncertainty was greatly reduced once the group sold its European business, with the proceeds used to pay down debt, thereby restoring balance sheet strength.

A big chunk of Cromwell’s earnings are defensive given property portfolio revenues are secured by long leases. As of Dec. 31, 2023 Cromwell's directly held property portfolio had a weighted average lease expiry of 5.3 years, which is longer than most rivals.

Even so, Cromwell could feel some pain from ongoing weakness in office rents given most of Cromwell’s portfolio is in secondary locations. Property is a cyclical industry and when sentiment turns down, there are often unforeseeable and multiplying consequences.

The group historically undertook some speculative ventures. For example, it developed a seniors living portfolio via a joint venture with LDK Healthcare and subsequently disposed of the assets in 2022. It bought near AUD 990 million of Polish retail investors from clients departing one of its funds, assuming it would own the assets briefly, but the values subsequently halved before being sold in 2024.

Cromwell's stronger balance sheet means the group could move in a few directions. We think the most likely course is to expand its funds management business, possibly spinning off its office assets into a separate REIT.