Description

Summary and Thesis:

Motivated sellers can make for good investments. Disgruntled and relatively unsophisticated sellers can make for better investments.

At current levels, we believe that Dream Hard Asset Alternative Trust (TSX:DRA.UN) represents a highly compelling risk/reward profile. We maintain that view despite the kitschy name of the security. DRA.UN is a recently organized investment vehicle managed by Dream Unlimited (TSX:DRM). DRM is a well respected Canadian real estate development and asset management company that manages more than $14.5bn in total assets including three other listed vehicles with total market capitalization of $5.4bn.

DRA.UN trades at <70% of NAV (TBV) and a (close, though not perfect) stub position can be established to create the security at 57.5% of NAV. The other vehicles managed by DRM trade, on average, at 100% of NAV. DRA.UN’s broader peer group of Canadian REITS and Canadian Mortgage Investment Corporations (MICs) trades, on average, at ≈105% of NAV. We believe that clearly identifiable transitory issues have resulted in substantial amounts of very motivated selling (simply, liquidity starved investors were forced into a vehicle for which they did not originally subscribe). Once those dynamics pass, we believe that DRA.UN is likely to trade, conservatively, at 90% of NAV. In owning the units outright, therefore, investors can generate a ≈35% total return and in creating the stub security, investors can generate a ≈65% return. Given that DRA.UN’s assets are relatively high quality and safe, we believe that downside is very limited and, if appropriate, low risk hedges can be employed to further buttress downside protection. Moreover, management is thoughtful, shareholder oriented, and high incentivized in seeing the stock trade at significantly higher levels. Meaningful open-market purchases by the CEO buttress that view.

In short, we believe that DRA.UN represents an opportunity to earn attractive absolute returns in a low risk, low beta, and uncorrelated situation.

Background:

Much more than is the case for most investments, understanding the background of DRA.UN is a very large part of understanding the investment opportunity in DRA.UN.

DRA.UN began trading on July 8, 2014. However, the entities underlying DRA.UN have existed since 2007. DRA.UN is the result of the reorganization of four entities (ROI Canadian High Income Mortgage Fund (TSX: RIH.UN); ROI Canadian Mortgage Income Fund (TSX: RIL.UN); ROI Canadian Real Estate Fund (TSX: RIR.UN); and ROI Institutional Private Placement Fund) – all of which were originally non-traded – that were launched and managed by ROI Capital, a Canadian asset manager focused on non-traded income producing vehicles (http://www.roicapital.ca/).

The ROI funds were launched as open ended non-traded investment vehicles focused primarily on Canadian mortgages, similar to non-agency commercial mortgage REITs in the US. The ROI funds were originally structured to provide unitholders with the option of redeeming their units at any time at NAV and to distribute a monthly tax-efficient dividend. In retrospect, of course, the potential issues associated with offering liquidity options for entities owning non-liquid assets are obvious. But such were the times.

The ROI funds were overwhelmingly sold by brokerage firms and wealth managers to retail investors. Because of the very high loads and lucrative ongoing fee streams associated with such products, brokerage firms were highly incentivized to sell the products to their clients (and keep their clients invested in the products). As a result, in many cases wealth advisors allocated wholly inappropriate amounts of ROI funds to their clients’ portfolios. Indeed, the ROI funds were often used as holistic solutions for clients’ fixed income and real estate exposures. Clients were kept content by daily NAV increases, regular distributions, and the illusion of stability provided by a lack of a daily market price.  

In March 2012, the ROI funds faced their first roadblock. A large brokerage firm, alerted to a regulatory inquiry at ROI, requested a $50mm redemption. Although ROI was able to satisfy that redemption, the funds decided to halt redemptions thereafter as they would not have been able to orderly support the wave of subsequent redemptions to follow.

In December 2012, in an attempt to solve the problems it was facing, ROI decided to list the funds (with the exception of the ROI Institutional Private Placement Fund) on the TSX. ROI established a new redemption program (but now limited it to 15% of aggregate NAV on an annual basis) and also committed to a share repurchase program to maintain share price levels at NAV. The situation was not sustainable, however, because in order to satisfy both programs ROI was forced to sell its most liquid assets (mortgage loans) and the portfolio became increasingly concentrated into much less liquid assets (income producing properties and real estate development assets). Then, to exacerbate matters, in March 2013 the ROI funds faced another hurdle when the Canadian government announced changes to the law that had allowed recharachterization of interest income into capital gains and thereby enabled ROI to structure its distributions in a highly tax efficient manner.

Through the combined effects of the above, unitholders lost confidence in the ROI funds and units traded down significantly to 20%-25% discounts to NAV. Liquidity dried up and unitholders – many of whom, as mentioned, had far greater than appropriate allocations to the trusts – were left holding the bag.

To finally remedy the situation, in 1Q14 an arrangement was struck between ROI and DRM whereby the 4 trusts would be reorganized into a single entity (DRA.UN) of which DRM would assume management. The restructuring would provide liquidity to unitholders and enable a tax-efficient structure for the new entity. On June 16^, 2014, ROI unitholders overwhelmingly voted in approval of the reorganization and DRA.UN began trading on July 8, 2014.

The reorganization and listing of DRA.UN provided many unitholders with their first opportunity at unfettered liquidity – i.e. outside of the liquidity provided by ROI through redemptions at NAV and share repurchases – since the ROI listing in December 2012, making motivated selling very likely. To compound the situation, there was no IPO road show and the only public marketing event was a conference call on July 29^th.[1] Selling pressure, therefore, was accompanied by little buying interest. Units immediately traded down to ≈$7 at which level they have remained.

A few additional items worth highlighting which the July 29^th call brought into focus:

1)     The frustration of long-term unitholders was manifest (vocal)

2)     Key sell side analysts participated in the call, but none have yet picked up coverage (although we expect they will in the near future)

Based on our discussions with the Company as well as with other people knowledgeable about the shareholder base in the original ROI vehicles, we believe that the motivated sellers have most likely substantially completed their liquidation.

Assets:

DRA.UN currently has ≈$1.0bn in assets and NAV of ≈$725mm. DRA.UN’s assets fall into 3 buckets:

1)     Income Producing Properties (≈$255mm on a NAV basis)

2)     Real Estate Loans (≈$220mm on a NAV basis)

3)     Real Estate Development (≈$160mm on a NAV basis)

In addition, DRA.UN has cash and short term investments of ≈$90mm.

It is critical to note that as part of the reorganization and prior to assuming management of the assets, all assets were analyzed and valued internally by DRM as well as appraised by a 3^rd party firm. We believe that given DRM’s motivation to see units perform well (NAV growth and sustainable dividend on NAV) so that they can ultimately raise additional equity, DRM had no incentive to be aggressive in marking the assets.

Income Producing Properties:

The vast majority of DRA.UN’s income producing properties are owned in partnership with Dream Office REIT (TSX:D.UN). D.UN currently trades at ≈86% of NAV. At NAV, D.UN units are valued at a 6.2% cap-rate (a 6.7% cap-rate at market price).[2]

Our diligence indicates that DRA.UN’s properties are quality buildings in attractive locations with strong tenants. That said, we do view D.UN as a very close proxy for DRA.UN’s portfolio (although D.UN certainly owns other properties outside of the partnership with DRA.UN) and we like the option of hedging out exposure to the income producing properties by shorting D.UN and creating the DRA.UN stub at 57.5% of NAV.

Real Estate Loans:

DRA.UN’s real estate loans are generally first mortgages with attractive interest rates and relatively short duration. The loan portfolio consists of 25 mortgages and 1 corporate loan. First mortgage investments represent approximately 82% of the portfolio.

DRA.UN’s real estate loans have an average interest rate of ≈7% and an average duration of <1.5 years.  Based simply on the maturity profile of the loan portfolio, ≈70% of loans should repay by the end of 2015. That number should be considerably higher after taking into account prepayments.

Our diligence indicates that the credit quality and underlying collateral of the portfolio is strong. Further, certain smaller loans with the weakest credit profiles at the time of reorganization have either (unexpectedly) repaid or are on a path towards repayment.

Longer term, DRA.UN views traditional mortgage loans as providing an attractive source for base return while the Company seeks more attractive risk-adjusted return opportunities elsewhere. The Company does anticipate focusing to a greater degree on development and other special situation real estate lending which offers highly attractive risk-adjusted returns.

Real Estate Development:

DRA.UN’s real estate development portfolio is the portion of the Company’s asset which gave us the greatest pause. However, we have diligenced the portfolio – and in particular the largest exposures in the portfolio – and have gotten very comfortable that the reported balance sheet valuations represent conservative currently realizable valuations. 

DRA.UN’s development assets are comprised of:

1)     $88.0 million of equity value in seven primarily retail projects currently in various stages of development co-owned and managed by Villarboit Development Corporation

2)     $65.0 million of equity value in two separate residential projects in the greater Toronto area that are in pre-development and co-owned and managed by Empire Communities

3)     $9.0 million of equity value in a mixed-use pre-development project in Toronto co-owned and managed by Castlepoint Studio Partners

Within the three groups above, DRA.UN’s two largest specific development assets are:

1)     Villarmark (9999 Highway 48, Markham, Ontario)  (part of the Villarboit portfolio) – book value of $37mm. Villarmark is a 32 acre land parcel located in Markham, Ontario slated for a large scale retail development. Zoning is substantially complete and discussions are ongoing with potential mid-box anchor tenants. The implied valuation of the parcel is $1.38mm/acre in an area where land zoned for residential acreage sells for $1mm/acre on average. Base case assumptions for Villarmark yield a ≈10% IRR (1.6x MOIC) and therefore justify that the current book value of the assets [See Appendix 1].

We believe it is likely that DRA.UN disposes of certain development assets. In particular, we believe the Company may be interested in selling those assets with the longest lead times before full activation, such as Villarmark. While the Company does intend to remain involved in development on a longer-term basis, it does desire both a lower overall allocation and less concentration than currently exists in the portfolio.

Management:

As mentioned, DRA.UN is managed by Dream Unlimited (TSX:DRM). DRM was founded in 1994 and has grown to become amongst the largest and most respected Canadian real estate development and asset management companies.

Dream is led by Michael Cooper. Upon the formation of DRA.UN, Cooper announced that he would be stepping away from his position of leadership at D.UN to devote attention to DRA.UN. As a demonstration of his commitment and of his view that the stock is materially undervalued, Cooper has purchased >300,000 shares of DRA.UN and has indicated that he will continue to acquire shares.

Perhaps most importantly: Cooper and the rest of DRM management fully realize that in order for DRA.UN to work for DRM, DRA.UN’s share price needs to be materially higher – i.e. at or very close to NAV – so that additional equity can be issued. As an indication of support, DRM has committed to allocating $50mm to DRA.UN equity, with the expectation of serving as the lead investor in future equity issuances. Cooper owns 30% of DRM so a substantial percentage of capital DRM invests in DRA.UN is Cooper's, creating further alignment.  

Other Topics of Note:

Portfolio Repositioning:

DRA.UN is focused on optimizing their portfolio to achieve higher risk-adjusted returns. To do so, DRA.UN is likely to sell certain assets and redeploy the proceeds elsewhere. In our view, certain of the co-owned office properties as well as certain of the development assets are the most likely candidates for sale. Moreover, the maturation and repayment of traditional mortgage loans will accelerate the portfolio repositioning process.

DRA.UN anticipates that a meaningful % of the portfolio will eventually be in renewable power projects.  Renewable power projects are structured with entities possessing low credit risk, provide a fixed rate of return for 20-25 years, and are levered with non-recourse debt. DRA.UN believes that it can generate ≈12% levered returns on such projects with very favorable tax characteristics. DRM has been involved in the industry for eight years and has deployed ≈$1.5bn in the space. 

Presented below is a snapshot of DRA.UN’s future portfolio:

The analysis below provides a snap-shot of expected returns (levered, i.e. on NAV) by asset class and the implied stabilized ROE on NAV – the major upshot is that the stabilized portfolio should generate a ≈8.0%-10.0% ROE on NAV, or a 11.5%-14.0% ROE on the current stock price:

Tax Efficiency of Distributions:

As a result of the reorganization and structure of DRA.UN, the Company’s distributions will be highly tax efficient. Specifically, the Company estimates that 75% of 2014 distributions, 90% of 2015, and a very substantial % going forward will be considered return of capital. Similar to an MLP, distributions will reduce an investor’s basis in the units they own, but only a small portion of the distributions will be considered eligible dividends for tax purposes. Very critically: amongst its peers DRA.UN is unique in its favorable tax characteristics. We believe that DRA.UN’s tax efficiency should attract investors to the Company.

Valuation:

As referenced, on a stabilized portfolio DRA.UN should generate an 8%-10% ROE on NAV, fully supporting a valuation at 1.0x NAV. Of course, it will take some time to achieve a stabilized portfolio – but we think a valuation of .9x NAV is reasonable over the next 6-12 months as motivated selling subsides and DRA.UN makes progress towards optimizing its portfolio.

We believe the most relevant comps for DRA.UN are other DRM vehicles, various Canadian mortgage investment corporations, and various Canadian REITs. Very critically: per IFRS accounting, all assets must be held at fair value on the balance sheets of Canadian companies. Accordingly, DRA.UN and its relevant peers revalue their assets on a quarterly basis. Therefore, in our view, P/NAV (P/TBV) is the most relevant metric to consider. As presented below, the mean/median for DRA.UN’s comp set is 1.04x/1.00x TBV vs. DRA at .68x:

In short, we believe that DRA.UN represents an opportunity to earn attractive absolute returns (30%-60%+) in a low risk, low beta, and uncorrelated situation.

Catalysts:

1)     Forced selling dissipates (time and normalization)

2)     Sell-side analyst initiate coverage

3)     Portfolio turnover, optimization, and stabilization

4)     Increase in dividends

Appendix 1 – Villarmark:

Appendix 2 – Eau du Soleil:

Catalyst