To Sherlock Holmes she was always “the woman”. Irene Adler, the antagonist in Sir Arthur Conan Doyle’s short story A Scandal in Bohemia, was one of the few characters to outwit Holmes. Adler Group, on the other hand, is a German property company that is caught up in its own, rather less Bohemian scandal. Adler’s shares are down 83% in the past year, its auditors have bailed out, and its future is uncertain. Its rapid rise and fall is a fine case study in how investors turn a blind eye to red flags in every boom and the perils of doing so.The background to Adler’s situation is complicated, to the point where it would tax even Holmes. In brief, however, over the past decade an obscure real-estate firm called Adler Real Estate became a major player in residential property, owning about 70,000 flats across Germany at its peak. This growth was funded through debt rather than issuing equity, and as the real-estate market boomed, Adler Real Estate’s shares rose from around €0.50 to a peak just above €15.5 by 2018.In 2019, Adler Real Estate acquired a 33% stake in a better-capitalised German real estate company called ADO Properties, using a bridging loan. ADO then went on to buy Adler Real Estate and a third company, Consus Real Estate, in all-share deals, before being renamed as Adler Group. This transaction makes little sense on the face of it – borrowing to acquire shares in a rival, and then persuade the rival to make a bid for your own shares and a third company (Consus). Many minority investors in ADO were unhappy.Then in October 2021, a short-seller – Fraser Perring at Viceroy Research – published allegations about Adler. These claimed that an Austrian investor called Cevdet Caner was closely involved in key decisions at the group (Caner had previously presided over one of Germany’s biggest real-estate bankruptcies. He was acquitted of fraud in 2020 after a decade-long criminal case in Austria). They also alleged that Adler had engaged in a series of related-party transactions that benefited investors with links to Caner, and that the value of its assets was significantly inflated.Shares in Adler Group tumbled. Adler denied the allegations (as did Caner, who has filed a lawsuit against Perring and Viceroy) and it hired KPMG, its auditor to investigate the allegations. It later postponed its results, due in January, until the investigation was complete. KPMG’s report was published at the end of April: it concluded that Adler’s rental portfolio was fairly valued, but that there was a risk of writedowns on the property-development portfolio. KPMG also said that it could neither confirm nor refute some of the allegations, in part because Adler had withheld around 800,000 emails, but noted governance issues and found evidence that Caner was involved in making decisions. It also set out some questionable transactions, including a 2017 sale where full payment has still not been made and where KPMG argued that the remaining €60m should be written down. (The buyer has done multiple deals with Adler and owed it €249m as at mid-2021.)The following week, KPMG declined to sign off on the annual results, saying that management had “denied us access to certain information” and so it could not “obtain sufficient appropriate audit evidence”. Adler published the results anyway, which showed a net loss of €1.2bn, mostly due to around €1bn of writedowns on Consus’ property-development portfolio. The board members who were in office in 2021 offered to resign, with four standing down immediately and three staying on until the annual general meeting (AGM) at end June.In mid-May, KPMG said that it was dropping Adler as a client, just hours after Adler’s chair said that it was planning to reappoint the firm for 2022. Ratings agency S&P downgraded Adler’s credit rating from B- to CCC with a negative outlook. BaFin, Germany’s financial regulator, has begun looking into Adler Real Estate’s accounts, while prosecutors in Frankfurt have opened an investigation, reportedly into the sale of a building in 2019.Vonovia tries to take controlA key outcome of the Adler/ADO/Consus merger was that an investment holding company called Aggregate, controlled by Günther Walcher, a friend of Caner, became the largest shareholder in the enlarged Adler Group, by dint of having a controlling stake in Consus. (Adler, in turn, owned bonds issued by Aggregate – something covered in the KPMG report. These are now trading at around a third of their face value.)However, that position has now unravelled in a way that has left Vonovia – another residential landlord and Germany’s largest property company with total assets greater than €100bn – owning just over 20% of Adler Group’s shares. Vonovia came by this shareholding because last year it lent €250m to Aggregate to refinance a margin loan that Aggregate had with a group of banks. This loan was secured against Aggregate’s Adler shares. When Adler’s share price dropped at the end of January and Aggregate failed to meet a cash collateral call, Vonovia seized €250m of shares. It appears that Vonovia was considering bidding for Adler (the loan terms also granted it an 18-month option on half Aggregate’s stake), but the continued fall in Adler’s share price means the value of the seized shares is now less than €100m, so it’s not obvious that it got a good deal. In any case, Vonovia is now Adler’s largest shareholder, while Cevdet Caner’s wife Gerda holds 7.4% and Aggregate retains 6.1%. And in a twist that nobody saw coming, Aggregate last week appointed Cevdet Caner as chief executive.How all this resolves is anybody’s guess, although it seems likely that banks and property companies will want to avoid a forced liquidation and the associated systemic risks. Stefan Kirsten, the former finance director of Vonovia, was appointed chair of Adler in February; he presumably hopes he can turn all this around. At the AGM at the end of June, the accounts were approved by shareholders despite the lack of an auditor. The three board members who had resigned in April were reappointed until 2025. The group is selling assets to pay down debt; its rental portfolio has shrunk to under 30,000 flats. Still, the headwind in the market is increasing and share prices are signalling broader concerns in the whole sector. Vonovia’s shares are down 39% in the past year; Grand City Properties, another big residential landlord that has not been associated with Adler’s problems, is down 43%.In the UK, we tend to assume residential property can protect owners from inflation. In reality, property price rises have been driven by the decades-long trend of falling government bond yields and banks’ willingness to lend. This is even more true in Germany where tenants are well protected by long-term contracts and rent controls have been in place since the 1980s. Local authorities compile an index of rents, which is supposed to serve as a benchmark for rents on new tenancies (a system called the Mietspiegel or rent mirror). Despite these controls, attempts to raise rents have led to protests. In a September 2021 referendum of Berliners, 56% voted in favour of expropriating large landlords with more than 3,000 properties. The referendum was non-binding, but it appears that German landlords will struggle to raise rents to keep up with inflation.A slump in the market will also hurt banks. Before the financial crisis German banks funded Irish and Icelandic banks in the wholesale markets, bought Greek government bonds and snapped up subprime mortgage securities from US investment banks. Chastened by those losses, this time they have been focused more on domestic lending, including lending to the likes of Adler, Vonovia and Grand City Properties. Until recently this has been perceived as lower risk. Now even the European Central Bank has already taken a hit. It had bought Adler’s 2024 bond as part of its quantitative easing programme, but last month it took the rare step of selling, saying that the bond no longer meets its collateral framework criteria (the ECB bought near par and the bond now trades at 66 cents on the euro, so it’s sitting on a decent loss). Given all the focus on the risk of propping up the bonds of Mediterranean countries, it is slightly embarrassing that the ECB has managed to lose money in a German corporate bond.Beware mark-to-model accountingObviously, this is a costly mess for investors. Yet while most concerns only emerged recently, there were signs well before the ADO deal that Adler was a risky bet.I first looked at Adler Real Estate in 2014. At the time, it had 21,500 flats, which were worth over €1bn. Back then, its largest shareholder was a Luxembourg entity called Mezzanine IX Investors and there was no way of knowing who the beneficial owner of Mezzanine IX was. It was only in 2019 that rule changes by Luxembourg prompted the disclosure that Gerda Caner had a stake in Mezzanine IX.Still, one could look at the accounting policies. In 2014, 69% of the company’s accounting book value was a “fair value” write up. That is, Adler had supposedly bought flats at below the market price, and had immediately written up the value using “mark-to-model” accounting. My concerns were not allayed when Adler bought Estavis, a Berlin-based property company with a similar strategy. The purchase price was at a 41% discount to the acquired company’s accounting book value. Estavis had issued a one-year bond paying 11%. The high cost of debt and the discounted price that the shares traded at suggested that some participants in financial markets felt that all was not well at Estavis. Yet Adler immediately wrote up the “fair value” for Estavis to reported book value, rather than the 41% discount price that it had paid to buy it.As it happens, with long bond yields falling (pushing up the value of assets priced relative to bonds, such as real estate) and increased occupancy from Syrian refugees, the value of residential properties in Germany rose in subsequent years. Thus Adler could claim that it was always correct – the market was wrong and that real estate had gone the way it expected. Still, the accounting was clearly not conservative at the time.Fair value accounting involves judgement on management’s part. In the BBC adaptation of A Scandal in Bohemia, Irene Adler tells Holmes that “the big problem with a disguise is that however hard you try, it’s always a self-portrait”. The main lesson from the Adler saga is that the choice to write up valuations can be as revealing as the figures themselves.
