CDPYF - Canadian Apartment Properties: Huge Rent Uplifts Offset NAV Pressures

2023-11-10 13:26:00 ET

Summary

• We had shifted to a hold on Canadian Apartment Properties Real Estate Investment Trust in our last update.
• The REIT has moved lower and delivered an excellent Q3 2023.
• We analyze the valuation and give you our take.

Note: All amounts discussed are in Canadian Dollars.

On our last coverage of Canadian Apartment Properties Real Estate Investment Trust ( CAR.UN:CA , CDPYF ), aka CAPREIT, we shifted our stance right back into the neutral zone. It was not that we did not like the REIT or its strategy, it was just that the valuation looked a bit ahead of where we would want to be for a buy rating.

We highlighted this problem in our conclusion.

We are still hesitant to slap another buy rating here with the stock trading near 22X FFO. Yes, that is cheaper relative to what we have seen in the past, but there are far better opportunities today in the REIT world than what we are seeing in the case of CAPREIT. We are downgrading this to a "hold" and would get interested on the long side under $45.00

Source: "Solid Execution Despite Interest Rate Headwinds."

This has worked out well as the stock had already peaked and is now down double digits.

We examine the Q3 2023 results and tell you whether we are actually interested now that the stock is below the $45.00 mark.

Q3 2023

There is a housing shortage in Canada, and it is pretty unreal how the poor immigration policies keep making it worse. CAPREIT is, of course, a prime beneficiary of that lack of space, and it showed once again in extraordinarily strong occupancy levels (98.9%) and yet another quarter of overall rents rising.

One of the biggest figures that the REIT released was the rent uplifts on turnovers. At 27.2%, this is one of the biggest and most dramatic increases we have seen in rents.

It is important to note that due to a lack of housing, turnovers are extremely low. Pretty much everyone knows that the rent they have is low relative to the market and moving out will be at their own peril. CAPREIT also attributed this low churn rate relative to peers as a mark of the quality of their portfolio.

Kyle Stanley

That -- I think that makes perfect sense. You mentioned just turnover remaining low. Some of your peers this quarter have noted maybe a little bit higher turnover in the third quarter specifically than they had expected. Is that something that you might have witnessed this quarter? Or has your outlook for turnover, I guess as we go into 2024 shifted at all? Or is it still kind of trending in that maybe lower-teen level?

Mark Kenney

No listen, we've got great peers but we -- CAPREIT has done such an exceptional job of our locations that our churn is right in the heart of the housing crisis. So our churn will always stay a bit lower due to the -- I would call the superiority of the market locations that we have. And again, it's a complete correlation between churn and leasing spreads.

Source: CAPREIT Q3-2023 Conference Call Transcript .

Zooming out of those figures which focus on value extraction over time, CAPREIT's overall numbers were stellar as well. We would focus below on the fact that net operating income, or NOI, expanded at a 7.1% year-over-year rate and NOI margin moved up as well.

This was an impressive feat in light of the fact that expense inflation has been quite strong over the last 12 months and CAPREIT has had to CAP RENTs in Ontario and British Columbia on non-turnover suites.

CAPREIT still managed to grow funds from operations ("FFO") despite some incredible headwinds from interest rate changes. It also grew FFO per unit faster as it deployed cash towards buybacks. Overall, it is hard to find anything remotely wrong with the core performance or the company based on Q3 2023. If there was something negative to see here, it was in the NAV per unit. It dropped due to expanding cap rates on its portfolio. This was despite some accretive, below-NAV, buybacks. This of course is a subjective measure as exact cap rates that might be obtained are a theoretical exercise. We will add here that the stock is trading about 20% below that reduced NAV as well.

Outlook

CAPREIT has focused on realigning the portfolio towards younger builds. 2023 saw primarily dispositions of old buildings.

Some examples were shown in the company presentation.

CAPREIT's liquidity remains adequate and its FFO payout ratio is under 60%.

What you have to weigh here is how the current interest rate regime will alter the company's FFO over time. Our take is that this should not be a material issue as CMHC pretty much offers debt at modest spreads to the Government of Canada yields. Alongside that, only 8% of the company portfolio comes up for renewal in 2024.

So far in 2023, CAPREIT has completed mortgage refinancing of over $600 million at a weighted average interest rate of 4.4% and a weighted average term to maturity of 6.9 years. Interest coverage ratio of 3.5X is good enough alongside those terms. So, removing existential risk, there are only two questions. One, is the valuation good enough? Two, is there anything better? CAPREIT is trading at 17.5X 2024 FFO and also trading below the lowest NAV estimate on the street.

We would say that the valuation is getting there, and if we had written this on the day it hit its 52-week low ($40.52), we might have said it is already there. On the "is there something better" front, we would have to say yes. Whether you look at the residential space itself, in U.S. or Canada, or in the diversified REITs having residential exposure, we think CAPREIT is not the most attractive. Even amongst the whole REIT asset class, Canadian industrial REITs have better fundamentals (zero rent caps and no expenses side pressures), and so CAPREIT will struggle to be a top name. We are maintaining this at hold/neutral and would give it a buy under $40.00, all things remaining equal.

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