Canadian Apartment Properties REIT: Strong Fundamentals And Solid Execution Drive Performance

|
About: Canadian Apt Pptys (CDPYF), Includes: PMULF
by: John Lawlor
Summary

REITs are a valuable asset class. While REIT prices may fluctuate, income investors are rewarded with steady distribution payouts superior to the low interest rates on fixed-income instruments.

Multi-family residential REITs are one of the best inflation hedges and also one of the best hedges against rising interest rates.

I particularly like multi-family residential REITs because they appear to have it all: capital appreciation in a hot real estate market and generous payouts for income-thirsty investors.

Strong demand for apartments is pushing up rents, particularly when new tenants move in and CAPREIT can implement increases above rent-control guidelines.

CAPREIT has demonstrated a consistent ability to generate industry-leading organic growth, driven by high, stable occupancies, steadily increasing revenues, prudent cost management and enhanced operating efficiencies from its growing size and scale.

Investing in real estate, whether commercial or residential, seems like a sure bet. But sinking money directly into property can be a disaster for those lacking the experience and expertise. Inexperienced investors can be overwhelmed by market fluctuations, maintenance costs and tax considerations that can turn can’t-miss investments into money-losing debacles.

Real investment trusts, or REITs for short, are publicly traded companies that own income-producing real estate, such as residential, commercial or industrial. REITs are a valuable asset class. While REIT prices may fluctuate, income investors are rewarded with steady distribution payouts superior to the low interest rates on fixed-income instruments, such as government and corporate bonds, in the low interest rate environment we have experienced since the Great Recession.

The real estate sector relies heavily on leverage. Higher borrowing costs dampen profitability and the rate of return for investors. However, higher interest rates are also a response to economic growth, which normally lifts real estate prices.

Short-term borrowing rates have risen but the longer-term rates have not risen substantially and so the yield curve has flattened. A flat yield curve can indicate that there is uncertainty around the longer-term economic outlook. REITs, given the contracted defensive nature of their cash flows, can be an attractive place for investors. I struggle with the notion that a 3% bond yield with no growth can serve as a viable investment alternative to the average Canadian REIT yield of around 5% and 5% earnings growth, which, if multiples were to hold, would imply a return in the 10% range.

In a rising interest-rate environment, retail demand for single-family residential properties is reduced in favor of rental units. Multi-family residential REITs may be one of the best inflation hedges and also one of the best hedges against rising interest rates. Higher borrowing rates lead to higher mortgage rates, which keeps prospective home buyers in the rental market. The move in interest rates has a dampening effect on investor sentiment and even small moves can shift investor preferences. However, rates would have to increase significantly beyond current levels to represent a real alternative.

I particularly like multi-family residential REITs because they appear to have it all: capital appreciation in a hot real estate market and generous payouts for income-thirsty investors in the decade-long interest rate drought. They provide exposure to a diversified portfolio of rental apartments that are managed professionally. You collect the monthly distributions, while the REIT looks after all the messy things like vacancies, leasing, repairs and difficult tenants. As traditional low-risk sources of stable cash flow, apartments continue to command premium multiples to most other property segments.

I own 38 publicly traded securities in my portfolio. This includes smaller positions in a handful of preferred shares and two bond ETFs. REITs are also a staple of my defensive, dividend-growth portfolio: they tend to pay above-average distributions which increase over time, provided you select your REITs carefully.

I own units of two multi-family REITs: Pure Multi Family REIT (TSX: RUF.UN) (OTC: OTCQX:PMULF) and a much larger position in Canadian Apartment Properties REIT (TSX: CAR.UN) (OTC:OTC:CDPYF), or more simply, "CAPREIT," as part of my personal equity portfolio. CAPREIT is the grandaddy of Canadian multi-family REITs and has grown steadily to become my sixth largest position. I have held CAPREIT since the turn of the century as another of my "forever stocks."

Chart CAR.UN data by YCharts

High Occupancy and Rising Rents

When people can’t afford to buy homes, they rent. Rising home ownership costs continue to drive demand for comparatively affordable multi-family units and, as supply of this product continues to lag, capitalization rates for existing multifamily stock are expected to remain low. Low cap rates mean high property values.

The national average multifamily vacancy rate in Canada is expected to continue to hover around 3%. In Toronto and Vancouver, it currently sits near 1%, with no breathing room expected in the near term.

Strong demand for apartments is pushing up rents, particularly when new tenants move in and CAPREIT can implement increases above rent-control guidelines. Long-standing policy in the Residential Tenancies Act provides property owners and managers the right to raise rent beyond the rent-control guidelines in order to recoup costs of certain capital expenditures or "extraordinary" increases in taxes. In CAPREIT's second quarter, for example, average monthly rents jumped 9% on suite turnovers, compared with about 2% on lease renewals.

Source: CAP REIT Q2 2018 Earnings Call Slides

Reflecting favorable supply and demand dynamics in the Greater Toronto Area (GTA) and other major markets, leasing spreads on turnover have been accelerating rapidly over the past seven quarters. That is not good for tenants, but it is good for CAPREIT investors.

More About CAPREIT

From CAPREIT's IR website:

Canadian Apartment Properties Real Estate Investment Trust (CAPREIT) is a growth-oriented investment trust owning freehold interests in multi-unit residential properties, including apartment buildings, townhouses and land lease communities located in or near major urban centres across Canada.

CAPREIT's objectives are to provide unitholders with long-term, stable and predictable monthly cash distributions, while growing distributable income and unit value through active management of our properties, accretive acquisitions and strong financial management.

One of Canada’s largest residential landlords, CAPREIT is a fully internalized, growth-oriented investment trust owning almost 51,000 residential rental suites and leased-land sites. Some 44% of its apartment units are located in Ontario, with more than two-thirds of those in the fast-growing Greater Toronto Area; however, its operations stretch from coast to coast in Canada, with buildings located from Halifax on the Atlantic Coast to Vancouver on the Pacific Coast.

Population growth in the GTA is strong and housing prices have skyrocketed. Owning a single-family home is beyond the reach of many in Canada's largest cities. Rent controls in Ontario are likely to continue to limit supply. This has pushed market rents up over the last two years and the outlook continues favorable for CAPREIT, which is in a good position to capture stronger leasing spreads.

There are two main factors that should drive strong investment returns in CAPREIT's units. First, when you look at the underlying fundamentals in Ontario, there is a shortage of affordable housing options in the province. Therefore, there should continue to be strong leasing demand in the Ontario apartment sector that benefits from a lack of affordable options, plus population growth within the province, particularly in the GTA.

Second, there is an imbalance between demand and supply in the province, which should continue to be positive for market rental rate growth. What we have been seeing over the last several months is market rent growth accelerating in Ontario in the apartment sector. So from a fundamental perspective, CAPREIT is very well positioned due in part to its geographic concentration.

Development remains a key component to CAPREIT’s future growth strategy and the REIT is in the early stages of a large development program, as it has recently begun to monetize development opportunities on more than 80 properties. Through a mix of infill and redevelopment, CAPREIT believes this could add over 10,000 net new apartment suites to the portfolio, principally in Ontario and British Columbia.

CAPREIT has a growing presence in the Netherlands and owns an 18% stake in Irish Residential Properties REIT PLC. Further enhancing diversification, its rental portfolio is spread across the "affordable," "mid-tier" and "luxury" rental segments. CAPREIT has a long track record of undertaking both profitable acquisitions and property developments, having grown from just 2,900 units when it went public in 1997.

Record Q2 2018 Financial Results

CAPREIT has demonstrated a consistent ability to generate industry-leading organic growth, driven by high, stable occupancies, steadily increasing revenues, prudent cost management and enhanced operating efficiencies from its growing size and scale. This record of organic growth is continuing in 2018 with same property net operating income (NOI) rising a strong 7.4% through the first six months of this year.

CAPREIT continued its string of record results from 2017 into 2018. The second quarter of 2018 demonstrated even stronger performance than the first quarter of this year. In fact, the second quarter was one of the most successful in the REIT's 20-year history. This was due in large part to the strong rent increases it is achieving across the entire portfolio and continued effectively "full occupancy" levels.

Much like the first quarter, the theme was strong top-line growth and a steep decline in same-property operating costs. The decline in same-property operating expenses was in part driven by lower utility expenses, due to reduced consumption because of sub-metering and the positive impact of other energy saving initiatives.

A string of successive and increasing leasing spreads of greater than 10% on suite turnovers indicates that market rents are well above CAPREIT's in-place apartment average monthly rent (NASDAQ:AMR) of $1,061, which, in turn, points to a sizable mark-to-market capture opportunity, pointing to several years of strong top line growth. With annual turnover at about 20%, CAPREIT should be able to post a number of years of solid revenue growth.

Through the first half of 2018, expense control has been very good, leading to record 65% NOI margin in Q2 2018 (previous high was 62.8%) and 63% for the first half of 2018 (previous high was 60.9%). With the capex program slated to ramp in the second half of 2018, we should expect more tempered margin improvements in the second half of the year.

NOI rose a very solid 12.3% in the second quarter due to higher revenues, coupled with lower utility costs and wages. Normalized funds from operations (NFFO) rose 20.8% in the quarter, driven by the growth in revenues, and NFFO/unit of $0.535 increased 14.1% year-over-year from Q2 2017’s $0.469 and was 11% above Street consensus of $0.49.

Same-property AMR growth was also strong, up 4.5%, including a 10.5% increase from suite turnovers. Occupancy levels were strong as well at 98.9%, up 30 basis points for both quarter-over-quarter and year-over-year.

Source: CAP REIT's Q2 2018 investor presentation

For the first half of 2018, revenues were up 8.3% compared to last year, stemming from the positive contribution of acquisitions, above-average rent increases and stable, high occupancies. Average monthly rents increased by a solid 4.5% compared to the same period last year, while occupancy rose to 98.9%. Same property NOI rose a strong 7.4%, stemming from higher revenues, lower vacancies and reduced utility costs and wages.

All-in-all, a very solid second quarter and first half of 2018.

Source: CAP REIT's Q2 2018 investor presentation

A Strong and Flexible Balance Sheet

Turning to the balance sheet, CAPREIT continues to maintain a strong and flexible financial position as shown on the slide below, with conservative leverage, strong coverage ratios and a further reduction in interest costs.

In the first quarter of this year, CAPREIT successfully completed a bought-deal equity offering, raising gross proceeds of $172.6 million. Most of the proceeds went towards paying down its credit facility. This reduced CAPREIT’s leverage of debt to the gross book value ("D/GBV") to 42% , down from 44% at the end of 2017 and the lowest in the REIT's history to that point in time. D/GBV reached a new all-time low of 40.5% in the second quarter of 2018, placing the REIT in an excellent position for future acquisitions and development.

With the proceeds of the successful offering, as of the end of the second quarter 2018, CAPREIT had approximately $162 million available in borrowing capacity on its various credit facilities, giving it the flexibility to make acquisitions, or to grow through developments or intensifications of existing sites.

From CAP REIT's Q2 2018 investor presentation

It is also important to note that some $315 million of CAPREIT's properties are not encumbered by mortgages as of the end of the second quarter 2018, providing further flexibility to fund growth and investment programs going forward. Development remains a key component to CAPREIT’s future growth strategy. CAPREIT's balance sheet gives it the potential to build more than 10,000 net new apartments, much of which are by way of infill on vacant land it already owns.

From CAP REIT's Q2 2018 investor presentation

A Growing Distribution

CAPREIT has raised its monthly distribution in each of the past six years, at a compound annual rate of about 3%, but because of its growing cash flow driven by acquisitions and rising rents, the payout ratio has fallen from 74% of FFO in 2016 to 72% in 2017.

CAPREIT's yield of 3.6% is modest for a REIT, but the falling payout ratio indicates that the distribution is well-protected and has ample room to grow. If you are looking for relatively safe, solid and growing distributions, and you like the idea of owning real estate without getting your hands dirty, CAPREIT may be for you.

Reasonable (But Not Inexpensive) Valuation

With CAPREIT trading at about 19x estimated 2018 FFO, the units are not cheap, but I believe the premium valuation is warranted given CAPREIT’s strong growth prospects and high-quality portfolio that churns out stable cash flow.

CAPREIT should continue to generate above-average price appreciation driven by strong NAV per unit and AFFO per unit growth. I believe CAPREIT should continue to be one of the top performing Canadian real estate entities on the TSX over the next 12 months. It had a very strong total return performance in 2017 and it is continuing this solid performance in 2018.

Conclusion

There are two main factors that should drive strong investment returns and strong potential for growth for CAPREIT's units. When you look at the underlying fundamentals in its primary market of Ontario, there is a shortage of affordable housing options in the province, and given that, there should continue to be strong leasing demand in the Ontario apartment sector that benefits from a lack of affordable options, plus strong population growth within the province, particularly in the GTA.

There is also an imbalance between demand and supply in the province, which should continue to be positive for market rental rate growth. What we have been seeing in Ontario and Vancouver over the past few years is market rent growth accelerating in the apartment sector. So from an underlying fundamental perspective, I believe CAPREIT is very well positioned due in part to its geographic concentration.

Second, CAPREIT has a very strong track record of creating value through implementing value-add strategies. CAPREIT focuses on acquiring and owning properties that are very well located and in growing property markets where management can implement active management strategies such as repositioning assets through capital improvements and thus driving strong improvements in rental income.

In conclusion, I am very confident in the future for CAPREIT. It has demonstrated its ability to capitalize on continuing strong fundamentals in the apartment business through all economic cycles. It continues to maintain a strong financial position with the flexibility and resources to continue its growth and sustain its monthly distributions over the long term.

Greg Newman, director, portfolio manager & senior wealth advisor at Newman Group Scotia Wealth Management discusses CAPREIT on BNN Bloomberg's Market Call Tonight on June 21, 2018.

Potential Risks

There is no such thing as a risk-free stock. In fact, there is no such thing as a risk-free return. Most people only associate risk with loss. While stuffing money under the mattress will avoid stock market risk, it simply exposes that money to other risks, such as purchasing power risk, or inflation risk. In other words, the "risk of avoiding risk."

Primary risks to the investment thesis for CAPREIT include those associated with the ownership of real property, including general economic conditions, local real estate markets, competition for tenants from other landlords and condominium investors, and the home ownership alternative.

Specific risks include the following:

  1. Access to debt and equity capital;
  2. Rental competition from other landlords and the home ownership alternative;
  3. Potential regulatory changes;
  4. Adverse weather and energy expense volatility;
  5. Geographic concentration. Approximately 55% of CAPREIT's NOI is generated within the Ontario. Any factors that result in a slowdown in economic growth in the province could lead to lower rental demand, driving vacancies higher and potentially adversely affecting rents and the income derived from CAPREIT's properties.

I enjoy researching and writing articles on quality companies for Seeking Alpha. Investing is a hobby of mine, as is writing, and it is rewarding to be able to combine productively the two hobbies.

The true value of my articles stems from the insightful comments from Seeking Alpha members, and I continue to learn from the comments of Seeking Alpha readers of my articles. Collectively, your comments give me a prized opportunity to tap into the "wisdom of the crowd." SA members' comments continually reinforce for me how investing decisions must revolve around our personal investment and financial goals, which are as unique as we are.

I recognize that CAPREIT may not be for every investor, as each individual investor has their own unique investment and cash flow objectives. To understand why I recommend and continue to own CAPREIT and why I consider the units to be a long-term hold, it is helpful to have knowledge of my investment approach, which can be summarized in four compound words: quality-value, large-cap, dividend-growth, long-term. For additional details, please refer to my interview with The Globe and Mail newspaper, entitled "A Long-Term Outlook Helps This Investor Weather Market Volatility."

I focus on companies that fit this four-phrase description. CAPREIT fits this mold, and I will continue to hold my full position in the company, ideally forever.

The focus of my articles for Seeking Alpha is on attractively valued, large-cap, dividend-growth stocks with sound business models, strong management teams and wide economic moats - "Forever Stocks." I strive to provide an in-depth analysis of the companies I research. I wrote this article from the perspective of a long-term investor who follows a straightforward, four-part strategy:

1. Identify a company with strong competitive advantages.

2. Satisfy myself its competitive advantages are enduring.

3. Invest in this company when it is trading at a fair price.

4. Hold the stock "forever," unless there is a significant change to the fundamental investment thesis associated with the company.

If you found this article helpful, please "Follow" me on Seeking Alpha to receive notification whenever I publish a new article.

Thank you,

John

Disclosure: I am/we are long CAR.UN, RUF.UN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.