CHCI - Comstock: Own The Growth Of The Washington D.C. Metropolitan Area

2023-06-16 17:01:15 ET

Summary

• Comstock provides asset management and real estate services for mixed-use development, residential apartment buildings, and parking developments in the Washington D.C. metropolitan area.
• Comstock's asset-light model and high ROIC make it a unique way to invest in real estate, with its value based more on cash flows rather than property or land values.
• I believe an investment in Comstock could offer high returns due to the stock's current low earnings multiple, high revenue growth with high ROIC, and the D.C. area's demographics.
• Risks include a potential crash in the commercial real estate market and the company's associations with entities owned by its CEO. I go into detail on these risks in the article.

Comstock Holding Companies, Inc. ( CHCI ) provides asset management and real estate services for mixed-use development, residential apartment buildings, and parking developments in the Washington D.C. metropolitan area. While these lines of business provide the bulk of revenue from operations, the company is also a minority owner in some of the properties that it manages.

Interestingly most of the properties that this company is involved with are owned by companies that the CEO of Comstock, Chris Clemente, owns. Clemente also owns about a third of Comstock's equity. At first glance, I was questionable about these ties but after more research, it is not something I am concerned about (more on this later).

Normally in order to get investing exposure to real estate, one must invest directly into real estate or in funds that invest in real estate. Comstock does have direct investments in real estate but it's a different type of investment in that the bulk of its value comes from cash flows related to managing real estate developments. The company promotes this as an asset-light model with little debt, which it is, but an investment in Comstock is still very much tied to the real estate market, both for mixed-use, commercial, and apartment style developments. The main thing I like about this model is that I am personally better able to value the business as the value is based on cash flows as opposed to the value of the real estate or land.

I believe that Comstock is an attractive investment for two main reasons. The first being that it is an investment in the growth in population and demand in a few key locations in the Washington D.C. area and second, it is trading at a cheap earnings multiple despite growing revenue over the past few years at a good rate and providing high returns on invested capital. These reasons lead me to believe an investment in the equity will provide very good returns going forward.

Location, Location, Location

One of the reasons Comstock piqued my interest is because I am from the Washington D.C. area and I've seen firsthand the growth and development of certain locations along the metro lines. The areas where many of Comstock's managed buildings are have been built up massively over the past few decades. Areas such as Rockville, MD, and Arlington, VA, which are just outside of D.C., have seen particularly good growth.

One reason for growth in the areas outside of D.C. is the growth in the Washington D.C. population which has grown .75% per year since 2011 versus U.S. population growth of .53% per year. While this difference isn't huge it is significant enough to drive up rent in the city and cause outward expansion along the metro line. What really amplifies the rise in prices in the city is the Height of Building Act of 1910 which restricts building heights in DC along residential streets to 90 feet and a maximum of 130 feet along commercial corridors.

This prevents taller buildings from being developed which largely prevents an increase in housing supply in the city and leads to increased rent costs as the population grows. Add to this the fact that many in the D.C. area are employed by the government which tends to be a bit more of a recession-proof employer and the need for expansion into areas surrounding D.C. rises.

The buildings Comstock has ownership in are located in these adjacent areas. The Hartford is an office building in Arlington, VA just off of the Clarendon metro stop and the BLVD Forty Four and BLVD Ansel are just off of the Rockville metro stop.

While these developments will continue to benefit from the growth in the D.C. population, the bulk of Comstock's growth will come from the management of its Anchor Portfolio, which consists of two large mixed use developments located along the Metro's newly completed silver line.

I have personally seen some of these developments while driving on the Dulles Access Road, most notably the development which houses Google offices along with offices of SolarWinds (SWI) and Rolls-Royce (RYCEY).

These Anchor Portfolio properties in Reston and Loudon are attracting many large companies.

These developments in the Anchor Portfolio are located at the Wiehle-Reston East and Loudon Gateway metro stops on the east end of the Silver line. While they are relatively far away from the city, the Silver line goes right through the heart of D.C. at the Metro Center stop so there is a direct connection. This makes these developments attractive as those in D.C. can commute to them and those near the developments can commute to D.C.

Importantly, these companies are signing leases despite the uncertainty the pandemic caused with working from home and commercial real estate in general. Just as SolarWinds signed a lease at the end of 2022, Google leased an additional floor of the Comstock managed property at the Wiehle-Reston East stop in early 2021.

To me, all of this points to a long-term trend of both commercial and residential demand for developments along the new Silver line, just as trends built up Arlington, VA, and Rockville, MD over the past few decades.

Finally, there are many properties that are currently being developed and in the development pipeline that Comstock will manage. This pipeline, along with the long-term demand trend I described above, leads me to believe that Comstock has a long runway for growth.

Valuation

Although Comstock is very much tied to the commercial and residential real estate markets, it can be largely valued on earnings as the revenue generated from managing properties are relatively recurring and steady in nature. However, despite the recurring nature of revenue, earnings look lumpy when viewed by quarter. For example, in Q3 2022 operating income was $3.9m on $12.8m in revenue. Prior to that in Q2 2022, operating income was $1.1m on $8.5m in revenue, and after in Q4 2022, operating income was $1.6m on $9.3m in revenue.

Why is this the case when the revenue stream from managing these properties is recurring? The answer lies in its agreement with Comstock Partners, LC, one of the entities controlled by CEO Chris Clemente not to be confused with Comstock Holding Companies, Inc., the company I am analyzing in this article. This agreement lays out the management of the Anchor Portfolio which contains the developments along the Silver line in Reston and Loudon.

Per this agreement, the fees Comstock receives are based on certain percentages of the Anchor Portfolio revenue and certain fixed amounts. These are the recurring streams of revenue. What causes the lumpiness are incentive fees based on the imputed profits of developments which are determined by the fair value assessment of those properties. These fees are triggers when uncertainties associated with the value of the properties are resolved. One of these fees caused the big jump in revenue and earnings in Q3 2022.

There is not much more detail on these triggering events, but according to the 2022 annual report, the Q3 2022 triggering event was the first in a series of triggering events that are scheduled each October 1 through 2024.

I am fairly confident that these triggering events will occur given my thoughts on the long-term demand trends I described above. But even without the triggering events, Comstock looks to be trading at a cheap valuation.

I see the last two quarters as relatively normalized and without the effect of the incentive fee. Operating income in these quarters was $1.6m and $1.30m respectively. Taking the midpoint of these numbers, I estimate normalized operating income of $1.45m per quarter or $5.8m annualized. Based on this estimate and compared to an enterprise value of $37m, Comstock is trading at an EV/EBIT ratio of 6.4. This looks cheap to me, especially when considering the revenue and earnings growth over the past few years, and the high ROIC Comstock is earning. For reference, operating income in 2019 was $2.2m. ROIC, as calculated by my estimate of annualized operating income after taxes divided by net working capital plus PPE is 40.6%.

Assuming normalized operating income grows 20% in 2023, normalized operating income for the full year would be $6.7m. If the EV/EBIT multiple expands to 9.2, which is the average peer-adjusted EV/EBITDA multiple that Comstock calculates in its investor presentation, the enterprise value by the end of 2023 would be $64m, for a bit under 100% upside by the end of the year. This does not take into account the potential incentive fees which could boost earnings by $2m in Q3 2023 as it did in Q3 2022 which would lead to much more upside.

Risks

The biggest risk is if the commercial real estate market crashes. This has been a much discussed issue in 2023. Although the company does not have debt and does not own much real estate, it is still very much tied to the commercial real estate market as much of Comstock's value is from its agreement to manage commercial real estate developments in the Anchor Portfolio. A crash in this market would send Comstock's earnings plummeting.

I have no ability to predict what will happen to any real estate market so I won't try to. I acknowledge that these risks exist as they always do, but I won't let that deter me from investing in stocks that I think will offer high returns due to business fundamentals and a long runway for growth due to demographic trends in the D.C. area.

Investing involves considering expected values and the best way to mitigate left tail risk is position sizing. With correct position sizing a commercial real estate crash that sends Comstock's equity plummeting would detract from my portfolio but won't wipe me out. However, if high ROIC growth continues as I believe it could, I will achieve good returns although not life-changing.

Regarding Comstock's capital structure, they have about $7m in operating lease liabilities but the $9m cash balance covers more than enough of these liabilities. They have also been cash flow positive since 2017 so I don't believe they will issue debt or issue shares to raise capital as the current cash balance and the cash generated from operations will be able to cover all liabilities and capital expenditures. Although I believe this is the case, it is important to keep an eye on the capital structure going forward and to determine if there will ever be a need to dilute shareholders.

Comstock's associations with entities owned by its CEO Chris Clemente are not something I am worried about. My first thought, when I saw this association, was that it could lead to questionable decision making especially due to the size of the company. However, after spending more time researching the company and the structure, it simply seems like a way to diversify his assets and real estate portfolio. He also owns nearly a third of Comstock's equity so his incentives are surely aligned with outside shareholders.

What really put these concerns to rest is an investment into the business by Schar Holdings, LLC, an entity owned by Dwight Schar, the former CEO of NVR, Inc. ( NVR ), a large homebuilding company headquartered in Reston, VA. Dwight Schar also owns a third of Comstock's equity after this transaction. I believe that Clemente and Schar have large ownership stakes because they believe in the long-term value of the business and the growth in demand along the Metro's silver line. However, it's always good to understand these risks when investing in small micro-cap stocks such as Comstock.

Finally, Comstock's equity is quite illiquid with about $80 thousand worth of shares traded per day on average. This makes the stock difficult to sell without driving the stock price down if the investor has a sudden need for cash. This risk can best be mitigated by controlled position sizing and investing only with a long-term horizon. If there is any chance you may need to sell shares quickly, it is best not to invest in an illiquid stock at all.

Final Thoughts

I believe an investment in Comstock could offer high returns going forward based on the currently low earnings multiple the stock trades at, the high ROIC earned from business operations, and the potential for long-term growth due to the demographics of the Washington D.C. metropolitan area. These potential returns, however, must be considered alongside the risks of an investment tied in large part to the commercial real estate market.

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