Shares of Canadian Apartments REIT (OTC:CDPYF) ("CAPREIT") remain stubbornly undervalued, even though management continues to make smart capital allocation decisions and as the underlying business performance remains robust.
Since I recommended shares in October, they have lost about 2% of their value (before considering dividends) relative a 1.5% return of the S&P 500 (SPY). To that end, there hasn't been much, if any, alpha from a return perspective in CAPREIT shares. However, on a risk-adjusted basis, I would posit that these shares remain lower risk at current levels than the broad market given the attractive asset base to which it is levered.
In my view, continued uncertainty relative to global monetary policy is obfuscating the underlying value of CAPREIT. At the end of the day, CAPREIT runs a very understandable business: it is a growth-oriented investment trust owning interests in 39,242 residential units, comprising 35,372 residential suites and 18 manufactured home communities comprising 3,870 land lease sites across Canada and in Dublin, Ireland. Cash inflows come from recurring monthly rent roll, and cash outflows from normal operating expenses incurred as a property manager.
Other Value Investors Circle The Asset Class
I am not the only one seeing value in Canadian REITs. One of my favorite funds, Horizon Kinetics, released a white paper in December describing the disparity between US and Canadian REIT prices.
Horizon Kinetics writes:
The Canadian REITs yield considerably more than the American REITs despite having lower dividend payout ratios and much more conservative balance sheets. Typically, they pay out 80 percent of earnings. Yet, there is no US‐listed exchange‐traded fund ("ETF") for Canadian REITs, even though there are over three dozen publicly‐traded REITs in Canada. The market capitalizations of the Canadian REITs are too small to make such a fund a first‐order profit opportunity.
It follows, then, Canadian REITs remain undervalued partly because they have been excluded from the evolving ETF universe for lack of adequate size. While that is not a firm-specific issue, I do believe that a lack of coverage and institutional capital flowing into Canadian REITs is a very real reason why price remains depressed.
Meanwhile, as it relates to CAPREIT, the business continues to perform very well. CAPREIT is growing both organically and through acquisitions. Same unit net operating income was up 4.8% on the back of rent increases and lower occupancy, and up 17.8% when considering acquisitions. Speaking of acquisitions, CAPREIT recently acquired a new portfolio of assets in Prince Edward Island, thereby expanding its geographic reach across Canada.
The payout ratio continues to decrease as well, to 71% from 74%. In my view, investors should expect another dividend increase in 2014 - the 11th straight year - and I think the dividend bump could be as high as 25%, which would bring the payout ratio to a comfortable 80% of my estimated 2014 FFO figure. A 25% dividend hike would suggest a $1.45 annual dividend and a 6.7% dividend yield at current prices. At some point, the market price will respond to CAPREITs growing value, and I suspect a substantial dividend increase would be one indicator for investors to re-rate this business.
Horizon Kinetics goes on:
The Canadian REIT business is not radically different from the U.S. business. Leasing commercial property in Canada is not a different exercise than leasing commercial property in the U.S-the leasing laws may vary, but only slightly. The business practices are what vary, because the Canadian REITs are much less leveraged and have much more conservative dividend policies.
Despite the risks (including taxes and currency translation), the Canadian REITs will probably provide a much higher total return than the U.S. REITs. Furthermore, it is worth mentioning that, given the valuation of U.S. REITs and their leveraged balance sheets, the U.S. REITs are not without their own risks.
In my view, the currency and tax ramifications for US-based investors are the key risks in owning Canadian REITS such as CAPREIT. However, because CAPREIT has an attractive debt profile, I believe the currency risk is counterbalanced by this effect.
CAPREIT is Modestly Levered, Low Risk
CAPREIT has done a great job of capitalizing on the interest rate environment to lock in low rates for long time horizons. As one can see from the chart below, CAPREITs weighted average interest rates are down and durations extended. Worth noting is that in excess of 95% of the mortgage debt is fixed. This bodes well for equity holders over the next several years, who essentially have a free call option on currency devaluation and rising interest rates.
Every metric has improved over the prior year. Debt to asset values are down, interest rates are down 24 basis points, duration is up a half-year and interest coverage ratios are higher than the year-ago period.
Meanwhile, a key driver of value for REITs, FFO, continues to scale on the back of the operating and financial leverage in CAPREITs business. Based on last quarter's run rate, I think annualized FFO can approach $2/share in 2014, pricing CAPREIT at about 11x my estimate of 2014 FFO. Generally speaking, given the stable nature of residential real estate and the under leveraged balance sheet of CAPREIT, this asset class should fetch between 15 and 20x FFO.
Putting it all together, CAPREIT still looks like a compelling investment opportunity today. Investors are paid to wait for a multiple re-rating, and it is looking to me like management has the flexibility to significantly raise the dividend for an 11th straight year.
While the macro environment remains challenging for REITs, I think that in a normalized environment, where investors are less concerned about monetary policy, that CAPREIT still has room for significant capital appreciation. Meanwhile, investors are paid to wait, and I suspect a dividend increase may be on its way because the payout ratio continues to fall as FFO continues to grow.
One way or another, I expect shares of CAPREIT to slowly climb the equity escalator after it fell down the wall of worry in 2013. There is value in these shares and a competent management at the helm. Those two conditions in concert are generally auspicious for appreciating security prices.