Melcor REIT report

Melcor Real Estate Investment Trust

(There is no graph of the growth in revenues and earnings per unit because the REIT has only about four years of history.)

Melcor Real Estate Investment Trust (MR.UN, Toronto)
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) hold no shares
Based on financials from: Dec ’17 Y.E.
Last updated: 12-Mar-18
Share Price At Date of Last Update:  $                               8.07
Currency: $ Canadian
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): Buy rated at $8.07
SUMMARY AND RATING:  We do not show a graph of revenue and earnings per share growth since the REIT has only been existence for about four years. The Value ratios would support a rating of “Buy” or “(higher) Buy”.  Management quality appears strong . The insider trading signal is positive. The executive compensation is not excessive. Given existing leases, the adjusted earnings is likely to be relatively stable to slightly down in the short term even in the face of the Alberta recession (from which Alberta is emerging). Recent modest additions to the portfolio of buildings should be accretive to earnings per unit. However, there will likely be some additional market value reductions on the buildings in the short term due to a higher availability of competing office buildings in Edmonton and due to higher interest rates and/or perceived risks regarding Alberta. In the longer term the REIT’s income should continue to grow unless market rental rates decline relatively permanent, which we do not expect.  The business of owning commercial real estate (in general and not specific to Alberta) should be a stable business with acceptable but relatively low returns in the long term. For many years REIT returns in general had been boosted by declining interest rates but that could not continue indefinitely. The fact that the units are trading at about 70% of book value (which is driven by the estimated market value of the buildings) and that the payout ratio is about 86% of adjusted earnings, provides some margin of safety. Overall we rate this as a Buy for those seeking income.
DESCRIPTION OF BUSINESS: (As of Q3, 2017) This Real Estate Investment Trust represents a 43% minority equity ownership in 37 commercial properties. All management and staff is effectively contracted out (mostly to the majority 57% equity owner, Melcor Developments). The entity has no employees. The Net Operating Income is 50% from office properties (20 buildings of low to medium rise), 43% from retail properties (13 properties 5 power centers, eight neighbourhood shopping centers), 5% from 3 industrial properties and 2% from a land lese community (trailer home park). Geographically, 62% of the properties by value are in Northern Alberta (Edmonton area plus Red Deer), 30% are in Southern Alberta (Calgary area plus Lethbridge) and 11% in Kelowna and Regina. Many of the Retail properties are relatively new while some are older. The majority of the office properties are older buildings. The largest office tenant is the government of Alberta including health services with 9 locations leased. Melcor Developments leases three office locations. Tenants include 3 Shoppers Drugmart locations, Approximately 8 bank branches (TD and Royal), and 3 Brick warehouse stores.
ECONOMICS OF THE BUSINESS: This business generally provides relatively low returns (even with the use of substantial debt leverage) but the return is generally stable and reliable. We will assume that Adjusted Funds From Operations is a fair representation of the adjusted or economic earnings. On that basis the return on equity is relatively modest but acceptable at 6.7%. It is possible that the returns will exceed that if the market value of the locations increases despite the aging process. (But the opposite could happen as well). The business is heavily tied to the strength of the commercial business conditions in Alberta including vacancy rates in competing properties and the valuation is heavily affected by interest rates.
RISKS: The biggest risk is vacancies and pressure to reduce rent based on a weak economy and an excess of space for rent in the short and (possibly) long term. There is also a risk that the parent company (Melcor Developments Ltd.) will take actions that treat the public unit holders of the REIT unfairly. See annual report for additional risks.
INSIDER TRADING / INSIDER HOLDING: (Based on September 1, 2017 to March 12, 2018) Six insiders bought modest amounts of units at prices from $8.15 to $8.80 with most around $8.50. An independent Trustee bought 50,000 shares in late September at $8.64 to $8.80 for her corporation to hold none. This was initially reported as a buy and not corrected for almost three months. Based on this, the insider trading signal is positive . There is also substantial insider ownership which is also positive.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand and predict (pass as the ownership of commercial office and retail rental property is a simple business) has favorable long-term economics due to cost advantages or superior brand power (marginal pass as it is affiliated with a developer of properties), apparently able and trustworthy management (pass given their long-term record at Melcor Developments), a sensible price – below its intrinsic value (pass), Other criteria that have been attributed to Buffett include: a low debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (pass) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass)
MOST RECENT EARNINGS AND SALES TREND: Revenues per unit in the past four quarters starting with the most recent, being Q4 2017 have grown at 1%, 2%, minus 2%, and 2% and minus 3%. In 2017, revenues per unit were up 1%, In 2016, revenues per unit were up 1%. In 2015, revenues per unit were up 18% but this may have been affected by the start-up nature of the operation at that time. Adjusted earnings per unit in the past three quarters were down 3%, unchanged, up 1% and up 5%.  In 2017 the growth in adjusted earnings per unit was 3%. In 2016 the growth in adjusted earnings per unit was 3%. In 2015 the growth in adjusted earnings per unit was 11%. The recent earnings trend displays modest growth in adjusted earnings per unit and essentially flat revenue peer unit.
 INDUSTRY SPECIFIC STATISTICS: As of Q4 2017, the occupancy level is 91.8% down slightly from the 92.4% level of one year earlier.
Earnings Growth Scenario and Justifiable P/E:  This REIT which distributes about 86% of its adjusted earnings could justify a P/E of 12 assuming an 7.0% required return  and no growth. With modest growth of 2% it could justify a P/E of 17.
VALUE RATIOS: Based on a unit price of $8.07. The price to book value is calculated as 0.70. This is attractive assuming that the market value of its properties is not going to decline materially due to the Alberta recession and an excess of office space for rent partly due to new building. Our price to book value is calculated to include Melcor Development’s ownership since the GAAP book value of the public units is currently significantly inflated by the treatment of Melcor’s equity as a liability. Note that the adjusted earnings is based on management’s view of adjusted funds from operations – which does appear to us to be a reasonable view of “true” earnings. The adjusted P/E ratio is quite attractive at 10.3. The ROE is only modest at 6.7%. There has been little growth in adjusted earnings per unit in the past year (and a decline of 3% in the latest quarter) due to the recession in Alberta and an excess of office space. We calculate the intrinsic value to be $8.36 per share if adjusted earnings can be expected to grow at 0% per year (no growth) and the P/E remains at 10 and $10.95 if adjusted earnings per share grow at 2% per year for five years and the P/E rises to 13. Overall, the value ratios would support of rating of Buy or (higher) Buy.
Symbol and Exchange: MR.UN, Toronto
Currency: $ Canadian
Latest four quarters annual sales $ millions: $66.6
Latest four quarters annual earnings $ millions: $0.7
P/E ratio based on latest four quarters earnings: 284.1
Latest four quarters annual earnings, adjusted, $ millions: $20.2
BASIS OR SOURCE OF ADJUSTED EARNINGS: Uses management’s view of adjusted funds from operations
Quality of Earnings Measurement and Persistence: The adjusted earnings figure appears to be reasonably measured and should be relatively persistent unless there is a prolonged and deep recession in Alberta that materially curtails general commercial activity (which does not appear likely at this time as Alberta is emerging from a recent recession) or a sharp decline in market rental rates (which could occur due to over-building in the office sector).
P/E ratio based on latest four quarters earnings, adjusted 10.3
Latest fiscal year annual earnings: $0.7
P/E ratio based on latest fiscal year earnings: 284.1
Fiscal earnings adjusted: $20.2
P/E ratio for fiscal earnings adjusted: 10.3
Latest four quarters profit as percent of sales 30.3%
Dividend Yield: 8.4%
Price / Sales Ratio 3.12
Price to (diluted) book value ratio:                                         0.70
Balance Sheet: (As of Q3 2017) Assets consist almost entirely (96%) of investment properties. These assets are valued at their estimated market value which is based on the value of expected future cash flows discounted at a market-based capitalization rate. An additional 3% are investments in tenant inducements and investments in lower rents in the early stages of rental contracts. Less that 1% of the assets relate to cash and short-term receivables and pre-paid amounts. It is essential to note and understand that the investment properties have been “marked-up” to recent market value based on (as we understand it) the rental income less operating costs multiplied by a the market multiple that is typically paid to acquire net rental revenue. Or based on a forecast of future net rents and a terminal value discounted to present value. It is important to understand that the  calculated (estimated) value of the properties changes annually and is subject to possible significant decline if the rents decrease due to vacancy or the market multiples or discount rates change due to factors including higher interest rates. The original costs to construct and later improve the properties is not disclosed. These assets are financed as follows: 51% by debt plus an additional 1% line of credit, 45% by equity and the remaining 2% by tenant deposits and other minor liabilities. This is a strong balance sheet as long as the market value of the properties do not decline significantly.
Quality of Net Assets (Book Equity Value) Measurement: As an investment in commercial properties, the book value per share is an important valuation number. The book value of equity is subject to the estimated value of the buildings which itself is subject to changes with market conditions including interest rates, vacancy rates on the properties and vacancy rates on competing properties (which affect market rental rates). Such changes are then amplified by debt that is slightly larger than the equity level. Overall, the book value per share should be relatively reliable but is subject to change with market conditions.
Number of Diluted common shares in millions:                                  25.8
Controlling Shareholder: The REIT is controlled by Melcor Developments which, in substance, owns about 53% of the REIT units. Melcor in turn is controlled by the Melton family.
Market Equity Capitalization (Value) $ millions: $207.9
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 44.0%
Interest-bearing debt as a percentage of common equity 116%
Current assets / current liabilities: 0.6
Liquidity and capital structure: Liquidity appears to be good with access to low cost borrowing. It is however, reliant on its line of credit.
Latest four quarters adjusted (if applicable) net income return on average equity: 6.7%
Latest fiscal year adjusted (if applicable) net income return on average equity: 6.7%
Adjusted (if applicable) latest four quarters return on market capitalization: 9.7%
X years compounded growth in sales/share not available
Volatility of sales growth per share:  Stable
X Years compounded growth in earnings/share not available
X years compounded growth in adjusted earnings per share not available
Volatility of earnings growth:  Stable
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? Too new to say
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 0.9%
More conservative estimate of compounded growth in earnings per share over the forecast period: 0.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 2.0%
OUTLOOK FOR BUSINESS: There are likely to continue to be some market value losses on properties in the short term. In the short term most of the properties are under lease with about 10% of the space coming to the end of its lease each year. This should provide reasonable stability in adjusted earnings for the next few years though their could be a decline if the recession and a surplus of space for rent lowers the renewing rents or prevents re-leasing. In 2018 it should get a small boost in FFO per unit (all else equal) due to recent acquisitions from Melcor Developments. In the short term after that  it is not clear whether or not the REIT will add much to its existing portfolio of properties. In the longer term the REIT expects to expand its portfolio  quite materially over the next ten years. The low unit prices may (and should) make the REIT very reluctant to issue new units to fund expansion.
LONG TERM PREDICTABILITY: The predictability of Melcor REIT depends to a large extent on the predictability of the Alberta commercial economy. That predictability is currently somewhat questionable. The REIT’s prospects also depend heavily on the level of surplus office and retail space that may develop near its buildings. The REIT believes it will grow significantly due to purchasing building from Melcor Developments.
Estimated present value per share: We calculate  $8.36 if adjusted earnings per share grow for 5 years at the more conservative rate of 0% (no growth) and the shares can then be sold at a P/E of 10 and $10.95 if adjusted earnings per share grow at the more optimistic rate of 2% annually for 5 years and the shares can then be sold at a P/E of 13. Both estimates use a 7.0% required rate of return.
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. Barriers to entry (marginal pass at best, there are few barriers to those wishing to purchase commercial rental property, however there may be little ability for anyone to construct new retail space at basically the same location as the REITs retail properties.). No issues with powerful suppliers (pass, as there are many buildings to be bought and many lenders). No issues with dependence on powerful customers (pass as there are many different tenants?), No potential for substitute products (pass, space is needed) No tendency to compete ruinously on price (fail as companies will tend to reduce rents very aggressively in times of surplus space given the fixed cost nature of the buildings). Overall this industry, based on these characteristics does not appear to be a particularly attractive industry even for established incumbents although it can be attractive when there is no surplus of rental  space in the market..
COMPETITIVE ADVANTAGE: Melcor REIT has the advantage of first access to properties developed by Melcor Developments. It also has access to the economies of scale of Melcor Developments. It likely has no particular advantages in attempting to market its space although it claims to provide superior service to tenants resulting is being a landlord of choice.
COMPETITIVE POSITION: The Melcor REIT is a small player in a large and fragmented market. However, since property locations, especially retail locations, are not interchangeable, the REIT is not necessarily in a weak competitive position.
RECENT EVENTS: In early 2018, the REIT purchased from Melcor Developments several buildings which adds about 12% to the value of assets and 6% to gross leasable area. This purchase was financed in a manner that limited the issuance of new fund units to some extent. There were some market value losses on properties in the past couple of years mostly due to more office space coming available in Edmonton which has put some downward pressure on rental rates and also due to some increases in capitalization rates used in valuation. The REIT sold one smaller industrial property in 2017 for a gain.
ACCOUNTING AND DISCLOSURE ISSUES: Accounting rules (which are no fault of the REIT) create some accounting complexities. The GAAP earnings figure is rendered essentially meaningless due to the requirement to include the market value changes of the properties in earnings, the lack of a depreciation expense, and the requirement to treat Melcor Development’s 53% ownership as a liability on the balance sheet and value the liability based on the unit price and to include the change in such valuation in GAAP earnings. Management appears to provide a reasonable figure to use as adjusted earnings which they refer to as adjusted funds from operations. This figure removes the impacts of changes in the market value of properties and  the unit price and does include a deduction for normalized capital expenditures. The GAAP figure for book value per unit is also rendered meaningless by the accounting to Melcor’s ownership as a liability. We correct for this by treating that ownership as equity. In terms of disclosure we would like to see the age of the properties and the original dollars invested in each property since and including its construction.  We would also like to see a disclosure of the calculation of adjusted FFO per unit in each quarterly report. We think that in general the disclosure and FFO adjustments could be explained more clearly.
COMMON SHARE STRUCTURE USED: Generally normal, one vote per unit. But Melcor Developments the majority owner does have some special voting rights.
MANAGEMENT QUALITY: Management appears to be reasonably high quality based on their history at the parent company, Melcor Developments Ltd. We do however have some concern that Melcor seems to have a history not being able to prevent its share price from deviating quite a bit from true value. We think they could do a better job there.
Capital Allocation Skills: Much of the success of the REIT will ultimately arise from decisions around the properties it purchases and the price paid. It is too early to judge the skills in this regard. Management’s decision to repurchase of at least a modest amount of units in 2015 at attractive prices (averaging $8.08) appears to be a wise use of capital. However, the REIT failed to repurchase any units at the attractive prices available in early 2016 and did not repurchase any units in 2016 or 2017.
EXECUTIVE COMPENSATION: Technically, the REIT does not appear to have any direct employees. The compensation for the two officers is from Melcor Developments and the REIT contributes to this to this indirectly through its management fee to Melcor Development. Overall, we have no concerns with executive compensation.
BOARD OF DIRECTORS: Warren Buffett has suggested that ideal Board members be owner-oriented, business-savvy, interested and financially independent. There are seven Trustees. Three, including the chair are Melcor Development appointees. All are well qualified. But this Board of Trustees would likely have a difficult time acting independently of Melcor Development’s interests. Therefore, it is not a great board from the perspective of the public unit holders of the REIT.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, earnings growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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