Relative to the US market, Canadian companies are considerably undervalued. Yet, weak commodity prices, a frothy housing market and a relatively weaker economy give possible credence to the Canadian market's discount. Since it is our job to take advantage of price inefficiencies, we decided to examine whether the Canadian economic discount was also present in Canadian-listed companies that predominantly owned US-based assets/businesses. (For example, in the US stock market, Avon, which is a US company, sells at a significant discount to US peers, partly due to its heavy exposure to Latin America and emerging markets. The discount in Avon is the reflection of an efficient market at work.)
Therefore, in a truly efficient market, Canadian companies with US business would trade at a significant premium and more in line with US-based corporations. However, to our delight, the Canadian small cap market offered an assortment of inefficiencies. It is our belief that if the Canadian-listed stocks (with US assets or businesses) were listed in the US markets, they would be valued at a substantial premium to their current price. Furthermore, the Fund firmly believes that through our Canadian investments, we are essentially buying rock-solid US assets and businesses at an irrational discount.
As a brief example, one of our Canadian plays was centered on Canadian REITs with US real estate portfolios. We thought real estate would provide the perfect test of efficiency, as developed real estate is an asset that is relatively hard to misprice. Again, in an efficient market, the REITs we purchased would sell at a premium to Canadian REITs that owned Canadian properties, and in-line with US-listed REITs that owned US properties. However, Pure Multi-Family REIT (PMULF), a Canadian-listed Residential REIT with 100% of its real estate in the US (primarily in the strong Texas market), sells at just 10x Funds From Operations (FFO), yields 8% with a 96.7% occupancy rate. On the other hand, at the end of Q2 2014, US-listed Residential REITs (VNQ) on average sold for 17x FFO and were yielding only 3.5%.
Heading into Q3, Agellan Commercial REIT (ACRVF) still trades at a discount to NAV, sells at less than 8x Funds from Operations (FFO) and yields over 8%. Meanwhile, US-listed Commercial REITs entered Q3 selling at over 15x FFO and yielding just 3.6% on average. As a further comparison, Mack Cali REIT (CLI), one of the lowest-valued US-listed REITs, trades at 10.5x FFO, and yields over 4.5%. Yet, Mack Cali's revenues have been in decline in each of the last five years, and the REIT has cut its distribution in each of the last three years. On the other hand, Agellan, which trades at a significant discount to Mack Cali, has managed to increase its revenues in each of the last five quarters, and continues to maintain its attractive distribution. For more information on Agellan, below is a link to a recent investor presentation.
Heading into Q3, Pure Multi-Family still sells at a slight discount to NAV, trades at just under 10x FFO, and yields 7.8%. As a further comparison, Home Properties Inc. (HME), one of the lowest-valued US-listed Apartment REITs, trades at 14.5x FFO and yields just 4.5%. It is worth noting that Bill Ackman's Pershing Square Capital felt this was a compelling valuation, as they added Home Properties Inc. to their concentrated portfolio of just ten holdings. For more detailed info on Pure, below is a link to its most recent Investor Presentation.
Pure Multi-Family Investor Presentation
Due to their Canadian listing and small size, it is unlikely the yields on both REITs will compress to the 3.5% yield garnered by US-listed REITs. It also goes without saying that, in our opinion, the current valuations of US-listed REITs are nearing the point (if not already there) of being priced to perfection, and do not represent a "fair value" benchmark. However, in a world where the 10-year treasury yields 2.5%, junk bonds yield less than 5%, and utilities yield less than 3.5%, it would be rational for both our REITs to yield somewhere between 5.5%-6.5% and 12x-15x FFO (depending on growth). This range would equate to a potential of 25% upside appreciation from the current price, in addition to the 8% annual distribution. Furthermore, Pure Multi-Family is insulated from a rising interest rate environment, as 97.5% of its debt is fixed at 4% for the next eight years. Pure could also see price appreciation of well over 25%, if continued rent growth in the Houston and Dallas markets enable it to further increase its distributions per share. In conclusion, we firmly believe that shares of both Agellan and Pure Multi-Family are currently in the process of working their way toward significantly higher valuations, where investors will benefit from a potential of 25% capital appreciation and 8% annual distribution.
Disclosure: We are long Agellan Commercial REIT and Pure Multi-Family REIT
