At one time it could have been argued that my portfolio was light on financial companies. In light of the make up of the Canadian market, I don’t necessarily see this as a bad thing.
Fortunately, I’ve been finding a lot of value in financial names since started writing here. I was introduced to Integrated Asset Management. IAM is now consistently trading around $1.48, offering a 5.4% yield and buying back shares while I wait for better operating leverage. I bought into E-L Financial, trading at a 38% discount to book value and producing very good earnings. I would be happy to add more since the stock has not moved after reporting its year end results. With the uncertainty of the proposed GGP deal, I’m once again seeing a lot of value in BPY.UN. I think Fairfax Financial is trading below intrinsic value.
The problem is, while I do not want to make any market calls, I am hesitant to overweight financials/real estate. But financials, real estate, and commoditites are where I’m seeing value. In that vein, a friend of the blog recently implored me to look at Mainstreet Equity Corp (MEQ). After a very quick look I liked what I saw.
Mainstreet Equity Corp was started by Bob Dhillon, and I have no problem admitting a lot of what I like about Mainstreet is him. I’m a sucker for a success story like his, and I love to align myself with a CEO who has created so much value for shareholders even if I’m a bit late to the party. Since going public in 1998, Mainstreet has grown from 272 rental units to over 11,000 while keeping the share count static. The market value of its portfolio has increased 100x in 20 years. There are plenty of interviews with Mr. Dhillon out there, so it’s easy to see he certainly talks the talk of a great capital allocator.
This is how Mainstreet describes its business:
Mainstreet positions itself as a value creator by purchasing under-performing properties, renovating them to a branded standard, improving operating efficiencies and repositioning them in the market for greater returns. Mainstreet currently owns and operates properties in Surrey, BC; New Westminster, BC; Abbotsford, BC; Calgary, AB; Cochrane, AB; Edmonton, AB; Lethbridge, AB; Fort Saskatchewan, AB; Regina, SK; and Saskatoon, SK.
The model obviously works. Buy downtrodden buildings, renovate them a bit, lower operating costs, then raise rents. Mainstreet minimizes competition by being in markets where the cost of buying properties is lower than the cost of building new ones, and by buying buildings too big for small investors but too small for large REITs. There is also a lot of rental demand in the cities where Mainstreet operates as rental units are in short supply.
This slide is in the latest investor presentation as an example of how Mainstreet improves profitability of its units while also improving the environment for the tenants.
For the purpose of my valuation, I will consider all options as shares. All of the options are very much in the money (exercisable at $5.51) so as far as I’m concerned they are equal to a share at this point. The shares outstanding number I’ll be using is 9,660,505. If you want to see it broken out, there are 828,200 options outstanding and exercisable.
It’s also noteworthy that the company recently announced the board had approved a new stock option plan, but:
Based on feedback received from certain institutional shareholders, the Mainstreet Board has made a determination to revoke its approval of the 2018 Plan and defer the matter for re-consideration at some time in the future.
The current option plan does not allow options to be granted after March 24, 2017. The new plan would have allowed 1,760,000 options to be issued, representing 19.9% of shares outstanding. I can only speculate what these shareholders disliked about the plan, but I certainly appreciate them voicing their concern. One of the most reasonable ways to value Mainstreet is on NAV per share, so anything that reduces shares outstanding is a good thing. I’m probably more opposed to options than most people though.
Mr. Dhillon owns 39.5% of the company. Insiders besides him own another 2.8%.
In the twelve months ending December 31 2017 (Mainstreet’s fiscal year ends September 3oth), Mainstreet had funds from operations (FFO) of $2.88 per share, so MEQ is trading at 13.9x FFO. That’s not fantastic objectively, but it’s pretty good compared to its peers. Here are what the other apartment REITs in Canada trade at:
- Boardwalk – 21x
- CAPREIT – 20.6x
- InterRent – 23.9x
- Killam Apartment – 15.4x
- Morguard North American Residential – 11.5x
- Northview Apartment – 12.4x
These aren’t apples to apples comparisons, but if it’s unfair it is unfair to Mainstreet. I did not look at the capital structures of these peers to see if there were options/debentures/etc to add to the share count. You can see that Mainstreet is trading at a reasonable, borderline attractive multiple of FFO even after weighing down its per share numbers.
I also see that I need to look closer at MRG.UN and NVU.UN. All I’ve done is look at FFO multiples but they look cheap so far.
The valuation of Mainstreet gets more interesting when we look at net asset value. Before we get to that though, here are the cap rates Mainstreet has used to value its properties:
- Surrey, BC – 4.05%
- Abbotsford, BC – 4.70%
- Calgary, AB – 4.84%
- Edmonton, AB – 5.74%
- Regina, SK – 5.95%
- Saskatoon, SK – 6.67%
- Total – 5.22%
I’ll let you decide if you think those are fair. As a point of reference, Boardwalk values their properties using an average 5.29% cap rate, so I don’t think this estimate is completely out to lunch. Using a cap rate of 5.22% on its investment properties, the net asset value of Mainstreet is $82.91 per share. If we take that as accurate, shares are trading at a 51% discount to book value (using 5.29% Boardwalk trades at a 27% discount to NAV). My NAV number is different than the number on the slide below since I accounted for options.
Even if I use 5.97% as the cap rate, and including $134 million of non-mortgage liabilities, I calculate net asset value to be $44.82. Mainstreet is trading at a 10.5% discount to this.
Full disclosure, I haven’t looked at the peers to see if a discount to NAV is endemic to the apartment sector. The reason is partly laziness, I can’t just look at the unit price and last news release since some of the REITs don’t put the NAV in them. But the bigger reason is it doesn’t matter to me whether all apartment operators trade below their NAV or not. For what it’s worth though, this InterRent presentation suggests that trading anywhere from 90%-100% of NAV is typical.
If for some reason you don’t like my NAV calculation, the “consensus” NAV for Mainstreet is $47.74.
I don’t want to speak to the accuracy of these NAV numbers, as they are based on consensus estimates for which I do not know the inputs. But if we use my conservative estimate for Mainstreet and take these numbers at face value, Mainstreet still compares favourably. Since Morguard is the cheapest on the above chart, I looked to make sure using 5.97% as my cap rate is conservative, and MRG.UN values its properties using a weighted average cap rate of 4.9%. These are higher quality buildings and geographies than Mainstreet’s (best as I can tell), but it made me comfortable I was being fair with my cap rate.
Based on today’s valuation, and comparisons with its peers, I would say that Mainstreet is attractively priced.
I’d also note that anyone reading this ought to look at some of the other apartment REITs. I only ever really paid attention to CAPREIT, which I always thought was overvalued. I’m adding MRG.UN, NVU.UN to my watchlist. Turns out there could be some value in the sector yet!
While Mainstreet Equity is probably underpriced today, what makes today’s price attractive is how much the business can/will be improved in the future.
Remember that Mainstreet’s model is to buy underperforming buildings, renovate them, and raise rents. Management differentiates buildings they consider “stabilized” versus those that they are in the process of improving. Today, 11.6% of the portfolio is in the process of “stabilization”. Below is the property portfolio broken out:
If you go up and look at the case study of a building in Edmonton and this table, it’s easy to see the stabilization process adds a lot of value to Mainstreet. The unstabilized units in Edmonton for instance have a 45% vacancy rate! Just getting those 318 units to a 25% vacancy rate at their current rent results in over $900,000 in revenue.
I ignore the last column. Mainstreet defines optimum conditions as a 5% vacancy rate and charging market rent, which is probably unrealistic and definitely shouldn’t be used for an investment thesis. But if in 2 years the unstabilized portfolio can perform similarly to the stabilized (9% vacancy, 90% of market rent), revenue would increase over $4 million, or 4% absent any other improvements or acquisitions.
Even the properties classified as stabilized have the potential to be better utilized. As can be seen below, in Mainstreet’s two largest markets by units owned, vacancy rates are above average.
Dhillon states that the focus for 2018 is on buying back shares and stabilizing the portfolio. As luck would have it, these the two best uses of Mainstreet’s capital right now. It is estimated the company has roughly $150 million of liquidity, and it is also working to finance buildings without mortgages to lock in low interest rates and increasing liquidity. There is plenty of money to buyback shares, fix up the portfolio, and acquire new buildings if the opportunity arises.
In spite of the proposed and then cancelled option plan, Mainstreet prides itself on its share count. Dhillon has boasted about growing the company so much without issuing shares, and it is mentioned on the company website in several places. It is just a hunch of mine, but I predict shares will be bought back such that options being exercised does not increase the share count at all. MEQ does not pay a dividend, but I expect significant capital will be returned to shareholders via buybacks.
As for how stabilization will increase FFO, I don’t want to guess. I don’t want my glasses to be any more rose coloured than the 4%over two years number I hinted at above. I’m pretty sure there is upside I’m not accounting for though.
By annualizing Q1’s results, I calculate full year 2018 FFO will be $2.93, up 1.7% year over year. I’ll predict stabilization increases rental revenue $750,000 at a 30% FFO margin, and that Mainstreet buys back 2% of shares outstanding. I think a 15x FFO multiple is fair when you consider stabilization will have improved the portfolio, so Mainstreet should be trading at $45 on September 30th. Upside of 12.5% over the course of six months isn’t bad but I’m also not writing home about it.
Mainstreet apartments appear to have a bad reputation. I did not look hard, but found an entire (very small) blog dedicated to Mainstreet sucking, with some horror stories in the comments. I also found this Reddit thread, and this one. I really can’t say whether these criticisms are fair, but there is definitely a reputation risk with Mainstreet. If potential tenants ask online or search for reviews; and get answers like these or read these same stories, I figure it has to have an impact on vacancy rates and the rent that can be charged. People can’t complain about bed bugs, mould, and huge rent hikes without hurting the bottom line a little bit.
To his credit, Dhillon knows about the problem:
One of the negative comments we get is that ‘You guys are slum landlords,’” Dhillon says. “But what they don’t understand is that we buy slum properties and transform them. Per capita, we’ve spent more money on [capital expenditures] than anyone else. They see the old – they don’t see the new. And there’s always a lot of old coming through the pipe, so they stereotype all these buildings.
The perception is probably a bit right and a bit wrong. Mainstreet buildings likely do have pest problems, the whole business model is buying neglected buildings with problems. And even after renovating some units, issues will persist for some time until the whole building can be brought up to standards. Tenants do have clouded vision though. Any rent increase will be viewed as an affront. Any pest or maintenance issue at all will be the biggest deal in the world to a tenant. And internet reviews will always skew negative. If anybody has personal experience with a Mainstreet building I’d love to hear it, but as it stands I don’t think there’s any ethical concerns here.
Mainstreet Equity Corp is cheap when compared to its peers, and the business model comes with a few levers that I think will be pulled in the near future to increase FFO. Apartments are in style right now, they’re seen as a way to play the expensive Canadian housing story (“Canadians can’t afford houses, bet they’ll rent!”). But Mainstreet has not seen the multiple expansion that most of the sector has. The reasons the market is discounting it – the locations, the high vacancy rates, low rents, crummy buildings, etc – are the exact reasons that I think Mainstreet will be rerated going forward. Management has shown that they can execute their business model, which is fixing the vacancy rates, low rents, and crummy buildings.
Personally I’d much rather own Mainstreet a 11% vacancy rate, than any of the other guys at 3%-5% vacancies. Good things happen when occupancy and ROE increase, and at Mainstreet there’s a much greater chance of occupancy going up than down.
If you read enough about Bob Dhillon, you will see the term counter cyclical quite a bit. The past couple years Mainstreet has bought a lot of properties when nobody else wanted to. The next couple years these investments should start paying off. Above I predicted the share price should increase $5 over the next six months, a solid but not exciting return. Buying Mainstreet is not a six month decision however. I don’t want to buy Mainstreet because the share price will be $45 in October 2018, I want to buy it because the share price will be $85 in October 2021. This is a wonderful business trading slightly below its fair price.
Disclosure – No position in MEQ yet. Might initiate a position this week.