Equity Research Model
Canadian Apartment Properties Real Estate Investment Trust (Q3/19) (Update)
A Initiating Coverage, Further Expansion into the European Real Estate Market - Target Price: C$56.34; Recommendation: Hold; Risk: Low
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(all currencies are in CAD$ unless otherwise noted)
Event: Canadian Apartment Properties Real Estate Investment Trust (“CAPREIT” or “CAR.UN”) reported Q3/19 results on Nov 14, 2019. The following is an initiating report by Modelyze Investments on CAR.UN. Overall Q3/19 was a good quarter from earnings, cash flow and operational efficiency perspective. The company continues expanding its footprint in the European real estate market. After reverse acquisition (the “Acquisition”) of European Commercial Real Estate Investment Trust (“ECREIT”) and renaming it European Residential Real Estate Investment Trust (“ERES”), Canada’s first Europe-focused multi-residential REIT in Q1, CAPREIT completed the sale of all Netherlands properties to ERES by September 30, 2019 and currently owns approximately 73.6% of the issued and outstanding ERES units, with 26.4% held by non-controlling unitholders (“ERES external unitholders”).
Highlight: CAPREIT is Canada’s largest residential real estate landlord with respect to number of units managed and owned (59,844 units) and market capitalization ($8,705 million) as of 2019Q3. CAPREIT is the majority holder (73.6%) of ERES, Canada’s first Europe-focused multi-unit residential REIT. Institutional investors own 30.5% of CAPREIT. Growing through accretive acquisitions, the company continues to assess opportunities in most profitable real estate markets in Canada such as Vancouver and Toronto. The company has been providing unitholders with long term, stable, bond like cash flows and distributions are taxed at unitholder level with no tax consequence for Canadian earnings before tax.
Financial Analysis: Modelyze Investments considered numerous financial and operating metrics to determine the earning quality, cash flow quality, balance sheet strength, operating efficiency and valuation risk of the business. Operating cash flow (“CFO”) to net income over the last three years has been consistently positive and though volatile ranging from 287% in 2016Q4 to 92% in 2019Q3; earing quality is high and there are no signs of earning manipulation. Debt service coverage ratios (“DSCR”), interest coverage ratios (“ICR”) and cash flow return on invested capital (“CFROI”) are used to determine the cash flow quality of CAPREIT. CAPREIT has a minimum limit of 1.2 x DSCR and minimum limit of 1.5 x ICR against which its financial performance is measured. Though the ratio has been volatile historically, CAPREIT has met its covenants (with some exception in DSCR) and cash flow quality is strong. Net margins are strong and at 166% as of 2019Q3, NOI margins are stable and at 67% as of 2019Q3, overall portfolio occupancy has been high holding an average of 98.56% over the last three years, FFO per unit has been stable and growing and FFO payout ratio has been stable and at 62.6% as of 2019Q3. Margins look great and operating efficiency is very good. Moving forward, Modelyze Investments assumed FFO payout ratio of 70%. With available liquidity (“tangible net worth”) of $7,498 million as of 2019Q3, CAPREIT has satisfied its covenant of at least $2,100 million tangible net worth historically and over the last three years. CAPREIT has met the debt to gross book value (“GBV”) of a maximum 70% throughout the last three years holding an average debt to GBV of 42%. This ratio stands at 37% as of 2019Q3. Net debt to capitalization is at 35% as of 2019Q3. With on-going acquisitions, it is expected that CAPREIT increase its credit facility limits continuously. CAPREIT focuses on maintaining capital adequacy by complying with investment and debt restrictions in its DOT, Large Borrower Agreement with CMHC (“LBA”) and the financial covenants in its credit agreement. These are all comprised of an acquisition and operating facility which includes Euro LIBOR and US LIBOR borrowings (“Acquisition and Operating Facility”), a non-revolving term credit facility, and the ERES unsecured credit facility (collectively, the “Credit Facilities”) (source: company financial statements). Extension of facility limits is required moving forward. CAPREIT has a strong balance sheet and it meets all covenants. Historically CAPREIT has traded at above REIT market and peer median P/FFO multiple as displayed below. This however is not an indication that the stock is overvalued since a statistical approach to multiple analysis based upon fundamental drivers of P/FFO such as risk, return on equity and growth states otherwise. The market has priced the stock due to its premium placement in the REIT market with number of units managed and owned.
Valuation: Marketable assets such as real estate is almost always priced hence it is apparent that pricing and cap rates play an important role in this valuation. In order to value CAPREIT, Modelyze Investments built a comprehensive financial model forecasting all line items of the financial statements determining the performance of the REIT historically and on a forward basis. This analysis is addressed in the Financial Analysis section of the report. Modelyze Investments considered the last twelve months (“LTM”) NOI, 2019F NOI and 2020F NOI and the average cap rate of CAPREIT portfolio of assets across Canada and Europe, all integrated in an Asset Based Valuation of the REIT. Value of rent generating operating assets is derived by diving the NOI by a cap rate of 4.15% (this rate was presented as the average cap rate of the portfolio as of 2019Q3 in company’s financial statements). Averaging out the FY1 and FY2 net asset value per share in today’s dollar given a return on equity of 4.4%, Modelyze Investments arrived at a price of C$56.34 per share. The following tables display the sensitivity of the share price as a function of cap rates. It is expected that cap rates in certain regions of Canada decrease in 2020 as real estate bubble continue to expand. Looking at comparable REITs across the sector, the median 2019F P/FFO mean estimates is 19.57x and median 2020F P/FFO is at 20.24x as of this report release date (mean estimates are sourced from Refinitiv). Based on Modelyze Investments forecast, CAPREIT is trading at 2019F P/FFO of 25.99 x and 2020F P/FFO 18.00x as of the analysis date.
Risk to Target Price: Risks associated with investing in CAPREIT includes but not limited to interest rate risk, commodity price volatility risk, cyclicality nature of the operating expenses (higher utility expenses and commodity exposure in Q1 and Q4), bad debt expense of tenants, rent control and regulations, taxation related risks, inability to refinance mortgages and senior debt at favorable terms, foreign currency and exchange rate risk, fair value adjustments and appraisal risk, illiquidity risk, operating and asset management risks, and climate related risks. From a risk management perspective, CAPREIT has managed the interest risk exposure of the mortgage portfolio by reducing average interest rates and mitigated refinancing risk by managing the average term to maturity of the portfolio and staggering the maturity dates. Since the primary focus of CAPREIT is multi-unit residential real estate in Canada, it is eligible for government-backed insurance for mortgages administered by CMHC, benefiting CAPREIT through lower interest rate spreads for mortgage refinancing and decreasing mortgage renewal risks as the mortgage insurance coverage is transferable between approved lenders and is effective for the full initial amortization period of the underlying mortgage ranging between 25 and 35 years.
Conclusion: Modelyze Investments believes CAPREIT is a stable, dividend paying stock with bond like characteristics. CAPREIT has strong financials and a growing, diversified portfolio of assets. Modelyze Investments assigns a HOLD recommendation with a LOW risk rating at a target price of C$56.34 and return to target of 11% as of the date of the analysis.
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