Description

Overview

Automotive Properties is a small cap REIT with a 8% yield and has an opportunity to consolidate the auto dealership real estate space in Canada. Although it trades at a slight premium to the NAV, the consolidation opportunity within the highly fragmented auto dealership presents a unique opportunity for future growth. The yield appears solid and the balance sheet is reasonable. The shares trade at a discount to the industry average in terms of P/FFO (Funds from operations) and the yield seems stable with a payout ratio that is in line with the industry's average.

Automotive Properties completed a $75MM IPO (July 22, 2015) of 7.5 million shares at $10. The REIT acquired real estate properties from 26 dealerships from the Dilawri Group located in Ontario, Saskatchewan, Alberta and British Columbia. This is a growth focused entity with the primary objective to own income-producing automotive dealership properties located in Canada.

The consolidation play in the automotive dealership space is an attractive opportunity, which is garnering attention from smart investors. In October 2014, Warren Buffett’s Berkshire Hathaway bought Van Tuyl Group, America’s largest privately held car dealership chain. The new company was renamed Berkshire Hathaway Automotive.  After the acquisition, Buffett said that he operation has the ability to be scaled up and pointed to the consolidation opportunity.

In Canada, AutoCanada has been quite successful in making a public play based on its attempt to consolidate the auto dealership space. Automotive Properties is a play tied to the same concept, with real estate angle, with Dilawari Group at the centre of this strategy.

The Company was recently recently listed on the Toronto Stock Exchange and does not have any street coverage. As this story becomes more known and gets attention from research analysts, there could be added interest, which can help to strengthen the stock price.

Properties

The 26 dealerships are split amongst the Greater Vancouver Area (6), Calgary (4), Regina (8) and the Greater Toronto Area (8).  The properties encompass 958,000ft2 of gross leasable area (GLA) on 88 acres. The portfolio is weighted towards the GTA, with 46% of total GLA, the remainder is divided roughly equally between the other regions. The portfolio is also predominantly serving the mass market with 64% of Cash NOI, out of which 23% comes from Honda sales.

For all intents and purposes Dilawri is the REIT’s only tenant and has structured all leases as triple-net, meaning the tenant is responsible for all costs relating to repair and maintenance, realty taxes, property insurance, utilities and all non-structural capital improvements. The leases have a Weighted Average Lease Expiry (WALE) of 15 years and have an automatic escalator of 1.5% per year.

The aggregate portfolio was purchased for $354 million comprising an appraised value of $343 million and a 3% portfolio premium. This value falls in line with other transactions of the same nature in similar jurisdictions and implies a 6.4% Cap Rate on Net Operating Income (NOI) of $22.5 million. Implied Cap Rates were 6.2 – 7.1% in the GTA, 6.9 – 7.1% in Regina, 6.9 – 7.1% in Calgary and 6 – 6.3% in the GVA.

The properties are located on major transportation arteries in Canada’s major cities that have exhibited strong population and income growth. It is worth noting that the performance of Calgary dealerships could suffer from the downturn in the oil market. Regina has stayed remarkably stable with population only increasing 8% over the last 10 years. Toronto and Vancouver especially have historically low Cap Rates which could leave relatively limited room for further capital appreciation.

That being said, organic growth is not the focus of this REIT as there are 3,469 dealerships in Canada with only 315 being owned by the top 10 dealership groups (Dilawri being the biggest). This is a fragmented market with room for consolidation. If the REIT is able to acquire additional properties at attractive valuations, take advantage of scale and capital, these should be accretive for unitholders.

There are a number of significant advantages that multi-dealership owners have over single-point owners including economies of scale, sharing of best practices, diversification across brands and improved access to capital.

Financials

The REIT is expecting to generate a NOI of $25.9 million, providing $18.2 million in Funds From Operations (FFO) and $15.5 million in Adjusted FFO (AFFO) for the 12 months ending June 30, 2016. From this income, distributions will be $0.067 per Unit paid monthly representing a dividend yield of 8% and a 90% payout ratio.

The company has total debt of $194 million at a weighted average interest rate of 3.2%, maturing in five years. Debt will comprise 57% of Gross Book Value (GBV) representing a Debt-Service Coverage Ratio (DSCR) of 4.2x. The unitholders Net Asset Value (NAV) is approximately $69 million ($9.17/share) excluding Dilawri’s 57% interest, in the form of Class B units.

The below chart comprises Canadian Commercial REITS with market capitalization under $1 billion. The NAV values used are based on book value not market value of assets and were calculated as shareholder equity. Based on the portion attributable to unitholders excluding Dilawri the REIT is trading at 1.2x NAV, above the industry average of 0.8x. That being said if the company is able to deliver on the forecasted numbers there should be room for multiple appreciation as the company is trading at a discount to its peer group in terms of both P/FFO and P/AFFO while maintaining a payout ratio in line with the industry average. The Canadian REIT universe is trading between a P/AFFO multiple of 7.3x to 14.2x with an average of 9x. Dividend yield is also in line with the industry.

Auto Industry

In 2014, Canadian automobile sales reached a record 1.85 million vehicles due to factors including age of vehicles on the road, high prices for used cars and low interest rates. In 2014, the Canadian automotive retail industry generated sales of approximately $120 billion, representing 24% of Canada’s overall retail sales and roughly 6% of GDP. The auto industry has shown consistent growth with a 20 year CAGR of 5%, with 8% growth in 2014. Not only is the industry a big part of GDP but it is a large employer making roughly 5% of the Canadian workforce.

Automobile dealerships have undergone considerable change since their inception. The first dealerships were small businesses, usually located in downtown areas, which sold one product line and offered no ancillary services. As demand increased dealers expanded their product offering and located in the suburbs. Dealerships located in close proximity to existing dealerships to gain market acceptance and exposure, creating “auto rows”.  The dealership is an integral component of the distribution channel through which automotive manufacturers sell new vehicles. Since 2005, the weighted average gross profit margin of publicly listed automotive dealership groups in North America has averaged 16%.

Dilawri Group

The initial terms of leases with the Dilawri Group will range from 11 to 19 years, with a Cash NOI weighted average lease term of 15 years. Consequently, the Dilawri Group will be the REIT’s only tenant and its most significant tenant for the foreseeable future, with members of the Dilawri Group occupying 87% of the REIT’s GLA. The Dilawri Group was formed over 30 years ago and has been in the business of owning and operating automotive dealerships in Canada since that time, growing to become the largest automotive dealership group in the country. The Dilawri Group owns 57 franchised automotive dealerships representing 30 automotive brands located in urban centers throughout Quebec, Ontario, Saskatchewan, Alberta and British Columbia. Dilawri had combined revenues of approximately $1.6 billion and Adjusted EBITDA of approximately $75 million for the 2014 fiscal year. The Dilawri Group has, on average, opened or acquired five new automotive dealerships in each year for the last five years, including, on average, two to three automotive dealership properties. In particular, 12 of the 26 Initial Properties were either opened or acquired by Dilawri within the last five years.

Risks

The most significant risk to the REIT over the short to medium term would be increasing interest rates. Increases in interest rates generally cause a decrease in demand for real property. Higher interest rates and more stringent borrowing requirements, whether mandated by law or required by lenders, could have a material adverse effect on the REIT’s ability to sell any of its properties. Given the historically low interest rates, there is a risk that interest rates will increase. An increase in interest rates could result in a significant increase in the amount paid by the REIT to service debt, resulting in decrease distributions to Unitholders. The REIT implemented a hedging program to offset the risk of revenue losses and to provide more certainty regarding the payment of distributions.

Conclusion

The value of a REIT is, first and foremost, a function of the value of the assets it owns, and thus based on the NAV is trading around fair value. This is due to the capital structure, REIT shareholders own Class A shares which carry a beneficial interest of 43% in the underlying assets and are currently trading at 1.2x NAV. A number of catalysts should increase the REIT price and subsequently reduce the premium to NAV. These include the probable acquisition of two new dealerships from Dilawri and contracting Cap Rates for dealership assets as investors become more familiar with the asset class, bringing them in-line with other commercial real estate assets in Canada.  With regards to other metrics the Company trades at below average P/AFFO levels of 5.3x and has a payout ratio in line with other commercial REITS. The REIT does own properties with a strong tenant base providing stable cash flows of 15 years. For income oriented investors the 8% dividend is stable and one should look to accretive acquisitions for the biggest lift in shareholder equity. There are numerous acquisition candidates amongst the 3,469 Canadian auto dealerships, 65% being owned by owners with fewer than five locations. The capital intensive nature of the business coupled with low per sale margins lends itself to strong consolidation opportunities.

Catalyst

A number of catalysts should increase the REIT price and subsequently reduce the premium to NAV. These include the probable acquisition of two new dealerships from Dilawri and contracting Cap Rates for dealership assets as investors become more familiar with the asset class, bringing them in-line with other commercial real estate assets in Canada.  There are numerous acquisition candidates amongst the 3,469 Canadian auto dealerships, 65% being owned by owners with fewer than five locations. The capital intensive nature of the business coupled with low per sale margins lends itself to strong consolidation opportunities.