Vision Capital Corporation is the Manager of the Vision Opportunity Funds, private equity funds focused on investments in publicly-traded securities in the real estate sector.
Vision targets inefficiencies that result in buying real estate cheaper in the stock market than the property market and with less risk and superior liquidity compared to direct property investments. The Funds invest primarily in North America to benefit from unique inefficiencies inherent in the pricing of Canadian and select U.S. publicly-traded real estate securities. Vision utilizes a value-based approach, employs a long-short strategy to also benefit from over-valuation or poor fundamentals, and selectively utilizes active investing strategies to improve returns.
A Pure Opportunity
Vision seeks to identify unique opportunities to buy high-quality real estate through the stock market at a discount to what one would pay in the private market. These opportunities often present themselves in listed REITs or real estate operating corporations overlooked by other investors. Pure Multi-Family REIT LP exemplifies this market inefficiency. Pure is a Canadian publicly-traded REIT that invests exclusively in U.S. multi-family rental apartments located in key Sunbelt markets including Dallas, its largest market representing over 55% of its asset value, as well as in San Antonio, Houston, Austin and Phoenix.
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The REIT completed its IPO in the summer of 2012 with two properties, totaling 390 apartment units in Dallas, Texas. Similar to other Canadian REITs that are exclusively focused on U.S. real estate, the REIT went public in Canada as it was too small to list in the U.S. and the REIT had an external management rrangement, a feature U.S. capital market participants generally view negatively. Unlike many of its peers, however, Vision believed that the REIT’s external arrangement was fair to its unitholders. The arrangement allowed the REIT access to a strong management team and was structured with no recurring fees; rather a pre-determined fixed equity interest for the manager at a set market capitalization. Today, Pure owns 17 properties with approximately 5,800 apartment units and its asset management is internalized.
Pure’s management has demonstrated a track record of adding value for the REIT’s unitholders, yet only in the past few months has Pure hit radar screens of institutional investors and generated increased quality research coverage. U.S.-based REIT investors generally do not look for U.S. opportunities listed in Canada. Additionally, Canadian investors are generally less familiar with the favourable supply and demand dynamics of Pure’s markets and tend to focus on their Canadian backyard.
The premise for Vision’s significant position is fourfold: (1) the favourable supply and demand fundamentals of the multi-family sector in the Sunbelt region, (2) the high quality and newly constructed nature of Pure’s assets (3) the compelling valuation of the REIT’s units and (4) catalysts and opportunities for this value to be realized.
The Sunny Outlook
Fundamentals for U.S. Sunbelt apartments remain particularly strong, benefiting from a combination of a secular trend of a new “renter nation” postfinancial crisis, as well as low new supply relative to historic norms, as construction lending has become much more disciplined this cycle. Texas has been the second fastest growing state in the U.S., with three of the nation’s top five most rapidly expanding cities and a technology talent labour pool larger than Silicon Valley, according to CBRE. Due to its pro-business tax policies and its deep labour resources, Texas, and North Dallas specifically, has experienced an influx of recent national head office relocations including FedEx, Toyota, Liberty Mutual, JP Morgan and State Farm, and is now the home to 54 Fortune 500 corporate headquarters. This trend underscores the region’s increasing attractiveness as an employment centre and its trajectory for continued economic growth. In 2015 Texas created over 165,000 jobs, more than all of Canada, and added another 194,000 jobs last year.
The U.S. has experienced a significant decline in the home ownership rate as individuals increasingly prefer a renter’s lifestyle, and criteria by mortgage lenders have become stricter. Unlike previous generations, millennials do not view home ownership as the American dream but rather prefer the lifestyle and flexibility of renting. The U.S. millennial cohort, with a population of approximately 80 million including a 66 million cohort – larger than the baby boomer cohort – of 20 to 34 year olds – is the prime cohort to form new households and has a 60- 70% propensity to rent. There are more Americans in their early 20’s today than at any time in U.S. history. While the U.S. has experienced substantial growth in household formation over the last decade, all of the growth has been driven by the rental category. The number of U.S. owner-occupied households has been falling since its peak of 76.7 million in 2006. In stark contrast, 9 million new rental households have been formed since 2006.
Further underscoring this trend: the median age at first marriage of women has increased from 21 years of age in 1970 to 27 years old in 2014, and the average age of first time mothers has increased from 21 years old to 26 years. Young adults are also living at home for longer, representing significant pent-up demand for rental housing; over 22 million young adults aged 18-34 were living at home in 2014, as compared to less than 18 million in 2001. All of these factors have led to significant demand for, and absorption of, new and affordable rental housing.
Pure has focused its portfolio to capitalize on the aforementioned favourable supply and demand backdrop in the U.S. Sunbelt and is concentrated on Class A mid- to-high-rise buildings and garden-style communities in fast-growing sub-markets with affordable rental levels. Since 2014, the REIT has sold six properties in Dallas with an average year of construction of 1991 and reinvested the proceeds (on a tax-deferred basis by way of the U.S. Tax Code 1031 like kind exchange program) into newly-built Class A apartment communities. This asset recycling program has shifted the average year of construction for the portfolio from 1993 (as at the end of 2013) to 2005 today. Vision has toured every property owned by the REIT over the past year and found the quality of the assets and on-site management to be amongst the best Vision has ever observed.
Pure achieved this transformation while taking advantage of the investment demand for Class B apartments, and effectively upgraded its portfolio with a minimal yield spread of 30-40 basis points (versus a more typical historical spread of 150 basis points). Not only do newly built apartment properties provide higher rents than older alternatives, but they also require less ongoing maintenance and capital investment. This inherently increased the REIT’s operating margins, reduced the maintenance and total capital expenditures required to support the REIT’s cash flow growth, and narrowed the gap between Funds from Operations and Adjusted Funds from Operations per unit, thus enabling higher distributions at any given FFO level. This is in stark contrast to virtually all other Canadian-listed apartment REITs.
Vision believes that analysts and other investors in the publictraded real estate area are not sufficiently underwriting the long-term capital requirements of REITs and real estate companies with portfolios substantially older than Pure’s. When considering these factors Pure becomes an even more compelling investment relative to its peers.
Growth At An Attractive Value
While the growth profile of the REIT’s cash flows are fundamental to Vision’s thesis, the core premise for Vision’s significant position is the same as the core focus of the Vision Funds in general: the ability to access quality real estate more cheaply through the stock market than one can in the property market. With the REIT trading at a substantial discount to its underlying Net Asset Value, there continues to be a significant spread between the high-5% cap rate implied by its unit price as compared to the market cap rates that comparable properties are transacting at in the private market. While there is an abundance of individual asset and portfolio comparable property sale transaction data to support the argument that Pure’s portfolio would trade at a 5.0% to 5.25% cap rate in the private market, one need look no further than the REIT’s own disclosure for substantiation. The REIT’s two most recent assets sales, which were older assets constructed in 1991 and 1998, respectively, were valued on the REIT’s balance sheet under IFRS accounting most recently at 5.5% and 5.25% respectively and were sold at estimated 5.0% cap rates. Furthermore, while the current average IFRS cap rate utilized by Pure is 5.4%, the REIT’s IFRS investment property valuations have proven to be conservative as the sale price of the six assets sold by the REIT represented a 5% to 20% premium to their previously disclosed IFRS valuations.
Vision’s thesis was further underscored by the announcement earlier this year that Milestone Apartments REIT was being acquired by Starwood Capital Group. Like Pure, Milestone owned and operated apartment properties in the U.S. Sunbelt region and was listed on the Toronto Stock Exchange. Unlike Pure, Milestone was focused on older Class B properties, with an average age of over 25 years and an average monthly rent of US$975 versus Pure’s average of over US$1,240 per month. Starwood’s bid for Milestone ultimately translated to a 5.7% cap rate versus Milestone’s previously disclosed IFRS cap rate of 6.1%, a full 40 basis points lower. This compares to an approximately similar cap rate ascribed to Pure’s real estate assets implied by the current price of Pure’s units, despite the fact that Pure owns a higher quality and younger portfolio with greater concentration in markets with superior supply and demand and growth fundamentals than Milestone’s portfolio. Subsequent to the closing of the Milestone transaction, Pure is the only pure-play U.S. apartment REIT in Canada.
What “The Street” is Missing
While the research analysts that cover Pure are unanimously positive on this REIT with buy recommendations and published targets representing substantial expected total returns that generate a total return of 15-20%, for the most part, they are, in Vision’s view, overly conservative. One sell-side analyst identifies Pure as her “Top Pick” and the other six analysts that cover the REIT maintain buy ratings. The consensus NAV per unit of US$6.85, utilizes an average assumed cap rate of 5.6%. For reference, several analysts have indicated that their NAV estimates would be greater than US$8.00 per unit at a 5.25% cap rate. Vision would note that this disconnect is likely due to the fact that, at the current unit price, the analysts’ NAVs and targets are already implying 15%+ 12-month returns; while the analysts may believe the true NAV of the REIT’s units is significantly greater than their reported estimates, they may prefer to keep their estimates low and gradually increase them as the REIT’s units outperform. We also do not believe that analysts have sufficiently recognized or included in their assessments both the absolute and relative merits of the growth in Pure’s markets, its superior Class A portfolio and its lower future capital expenditures relative to other comparable REITs.
Where do we go from here?
There are several initiatives on the near-term horizon anticipated to bolster Pure’s value and growth and serve as catalysts to surfacing a higher stock price. With Milestone, previously Pure’s direct publicly traded comparable, now privatized, more focus and light is being shone on Pure. Recent meetings with REIT management leave Vision confident that Pure will execute compelling portfolio acquisitions in the next quarter and effectively employ the proceeds of its most recent C$92 million equity offering which Vision believes is currently serving as a stock market overhang on its stock price. Pure has begun to internalize a best-inclass property management platform. This development will not only lead to operational and corporate level savings but will create an operating platform within the REIT, complementary to what institutional investors are seeking and prefer. The REIT is also in the process of listing its units on the Toronto Stock Exchange, upgrading from the junior Venture Exchange, which would increase the accessibility of its units to a broader base of investors and increase the liquidity of its units therein. Moreover perhaps, savvy, riskaverse and growth-oriented investors continue to actively seek acquisitions of apartment portfolios in Pure’s Sunbelt markets. As such, should the REITs stock price continue to trade at a discount to its private market value, it is ripe as a takeover target. The REIT’s units are widely held and control of the REIT is available in the market.
Pure provides investors with a unique opportunity to access amongst the highest quality apartment portfolios in North America with exposure to the right growth markets at an attractive valuation. With a valuation based on the recent trading price of its common stock that implies a greater than 25% discount to the true net asset value of the REIT’s properties, the REIT’s units not only provide downside protection due to this undervaluation, but also potential for substantial stock price appreciation.
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