We thought we'd go fishing for value in real estate. The group is way down since the credit crunch hit, so there might be some bargains. A lot of analysts like Canadian Apartment Properties, a real estate investment trust, down 31 per cent. We do not, and here's why.
Real estate is generally a long-term investment. Here's how a really good entrepreneur does it. First, he buys in a good location at a good price. Then, he invests in the property to bring it up to snuff. That does two things: it makes for higher rental income and it increases the value of the property, meaning banks will lend him even more money against it. He uses the rising rental income and increased borrowing room to buy another property, and so on.
From an investor's perspective, private real estate - buying a rental property for instance - makes all this pretty straightforward. But when real estate goes public, it opens up a whole world of financial engineering. There's plenty of that at CAP.
In the second quarter, CAP announced that it would buy back units, which, we were told, were attractively priced at around $19, or yielding 5.7 per cent. That's not exactly a tantalizing coupon, especially when you consider that the annual distribution - $1.08/unit - hasn't gone up at all since 2004 and is up only 3.5 cents since the turn of the millennium.
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But yield isn't the only yardstick. There's also book value, market value and appraised value. Book value is based on the price paid for the properties less debt. Market value is the market cap. Appraised value (sometimes called net asset value) is based on up-to-date assessments of what the properties might fetch if they were sold.
Real estate firms generally have their properties appraised every year so they can refinance their debt (i.e. add more). Most of them find that their appraised or net asset value is higher than their market price, and they tell anyone who'll listen. CAP has its properties appraised annually but doesn't disclose the number. It does claim that its appraised value is "significantly higher" than book value. And a few analysts say it's trading at a big discount to net asset value.
When CAP said it would buy back units in the second quarter, they were trading at a discount of around 15 per cent of true value, according to a couple of analysts, so if you put any faith in their work, buying back stock was a good idea.
But in October, having bought back very little stock, CAP sold 5.3 million new units for about $18 a piece, less than it was buying back for just a little while before. The proceeds from the sale were used to pay down debt and make acquisitions, but the question remains: Why would management now sell stock that was supposedly too cheap beforehand?
As it turns out, it was a bad deal for the investors who bought the new units since they quickly slid to under $15. Looks like management has a nose for value after all.
The units now yield 7.3 per cent. Are they a bargain? Be careful about that. CAP says its payout ratio is 91 per cent. The so-called enhanced payout ratio looks even better at 74 per cent. What's the difference? The latter factors in all those investors who take part in the dividend reinvestment program, whereby they take their distributions in new units, which they get for a small discount. About a fifth of distributions are paid this way. Management thinks this is a good thing. That's true if the units are trading at true value or above. But aren't they trading for a discount? If so, it's harmfully dilutive. What is clear is that the reinvestment program saves cash, which is great for management because it must save cash.
Let's go back to those payout ratios: that 91 per cent starts with cash flow from operations and subtracts distributions declared. But CAP has to invest money in capital expenditures to fix up buildings. Those millions of dollars are somehow not included in the math for distributable income.
Cast a conservative eye on the cash flow statement and you'll find that CAP was short of cash to the tune of $30-million in the first nine months of 2007 and almost $20-million in the year-earlier period.
It can skate around that problem with a bit of financial engineering, tapping into the rising value of its properties by borrowing more. But we don't know if they're going up, or by how much. And since they're mostly in Quebec and Ontario, rather than Western Canada, they're probably not going up too fast (which explains the lack of distribution increases.) Maybe that's about to change. We don't know enough about regional real estate to know.
But we have one final concern about this company. Insiders as a group own only 5 per cent of the equity. But they help themselves to lucrative related party transactions.
For example, two officers, who are also trustees, control a "construction management" company overseeing the renovation of CAP properties. In the most recent period, these insiders were paid $1-million, up 50 per cent year over year. Though permitted, that's a conflict of interest that might lead them to care less about accretive deals and concentrate more on financial engineering aimed at increasing the number of properties they can fix up.
There are better real estate investments out there.
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