Education Realty (ticker: EDR) is a REIT that owns, develops, and manages student housing communities located on or off university campuses.  As of 3Q11, it owns 21,482 beds and a development pipeline with an additional 2,208 beds that will come online in the summer of 2012 and 2013.

Investment Thesis: Short EDR because

1. The company reports a lower capex number that overstates earnings
2. Earnings multiple is out of touch with reality even without adjusting for true capex
3. 8.7% dilution for equity holders in the next 14 months as the company is aiming to de-lever itself to obtain an investment grade credit rating by 1Q13.

The Business Model

• Universities are only able to house a small % of their enrollment, and for profit companies such as EDR fill the void.
• Provide housing to university/college students in exchange for rental income. 
• Also has a development business for 3^rd parties that are immaterial to earnings.
• Acquire/develop well located, near campus with stable or increasing student populations and high barrier to entry.
• Leasing season begins in November and ends in August.  Renewal season is between November – January.
• Lease is by the bed, not by the unit.  Each individual therefore is not liable for a roommate’s rent.
• Parent/guardian is required to act as guarantor to reduce credit risk.

Moat

EDR has two economic moats.

1. On-Campus housing and referrals by the university

• Translates into higher occupancy and rent.  EDR has been upgrading its portfolio into more on-campus beds with its “the ONE Plan.”

2        Existing relationships

• When a university selects a developer or partner for new apartments, cost is not the only factor.  Trust, reliability, and track record also come into play.  EDR has established and maintained relationship with universities.  The relationships have worked out well for EDR in the last several years and are evident in its development pipeline.

Capex

EDR reports its “recurring capital expenditure” for the last 3 preceding years in each of its annual report.  The number is broken down into “per bed” basis and exclude discontinued operations to give investors better comps.

Source: annual report

American Campus Communities (ticker: ACC), EDR’s listed competitor, also reports a recurring capex number.

Source: annual report

The difference between the two companies’ capex number is small enough to be reasonably explained away by timing of capex, age of the property and selection of starting date etc.  So far so good, at least that’s what I thought until I dig deeper into ACC’s annual report.  EDR does not really define “recurring capex” other than saying it excludes “renovations, community repositioning and other major capital periodic projects”. 

Below is ACC’s definition of non-recurring capex.  Look closely on how they define the non-recurring part.

“Non-recurring capital expenditures include expenditures that were taken into consideration when underwriting the purchase of a property which were considered necessary to bring the property up to "operating standard," and incremental improvements that include, among other items: community centers, new windows, and kitchen/bath apartment upgrades.”

Source: annual report

Now, common sense tells me that windows, kitchen and bath do wear down.  While they do not require upgrades every year, they should count as part of “maintenance capex” because just like the hotels, the new windows, kitchen and bath are part of the appeal to students.

So I decided to calculate capex on a cash basis.

Please note the avg # of beds is different because the company reports on a continuing basis which excludes discontinued operations.  I just use the opening # of beds + the ending # divided by 2

Now it’s clear that the “renovations, community repositioning and other major capital periodic projects” that EDR exclude from “recurring” capex is much higher than the recurring number itself.  The ACC full capex number confirms that I am not way off-base with EDR.

True maintenance capex should be somewhat lower – but not by much - than full capex because both companies are acquiring beds and capex are needed to bring those beds “up to standard”.  ACC number is much higher because it is growing its # of beds at 30% CAGR.  I believe each property has to be renovated every 6 – 8 years.  EDR’s full capex should be quite close to true maintenance capex as its # of beds has been relatively stable since FY2006.

Valuation

Using management’s recurring capex number, EDR’s FCF/share should earn $0.37/share in FY2012.  Calculations are shown in Appendix A.  The P/FCF multiple is 28.6x or FCF yield of 3.45% with the stock trading at $10.72.  By any measure this is an expensive stock.  I would have expected this company to be a monopoly with huge revenue or earnings growth.

Define as total rental revenue (including discontinued operations) divided by average # of beds.  This excludes expense reimbursements and 3^rd party development/management service.

Some might argue total revenue is not comparable to EDR’s forward operations as EDR has bought and sold properties.  May be the “continuing operations” would show a different trend?

Source: annual report

Historic revenue growth rate certainly cannot explain why EDR is trading at such high multiples.  In 2009, EDR introduced its “the ONE Plan” which is code for upgrading its portfolio from off-campus housing (no moat) to on-campus housing (moat).  Future growth rate should be higher but by how much? 

Fortunately ACC reports its on-campus housing number separately.

Define as total rental revenue (including discontinued operations) divided by average # of beds.  This excludes expense reimbursements and 3^rd party development/management service.

So on-campus housing has the ability to grow its revenue 5 – 5.5% annually.  If all of EDR’s properties are on-campus, I can see why people would pay 20x multiple for its earnings.  With EDR’s current asset mix and growth potential, I believe anything above 14x multiple would be overvalued.  A 14x multiple without adjusting for true capex equals a price of $5.18/share.  (0.37 * 14)

Further Dilution

First, let’s take a look at some EDR’s numbers.

The number of shares outstanding almost quadrupled in less than 6 years.  This is not necessary harmful to shareholders if the company is using the proceeds to make new investments or paying down its debt.

Depreciation is added back and operating lease is capitalized when calculating asset at cost

Clearly, the numbers suggest that the expanded asset base and operating FCF did not benefit shareholders due to equity dilution.

Below was taken from EDR’s 3Q11 earnings call transcript

“Obtaining an unsecured credit facility completes step one in our goal of achieving an investment grade rating of our corporate debt, which we anticipate to achieve within 18 months.”

<Q - Alexander D. Goldfarb>: Okay. And then as far the 18 months, is that just based on your view of how long it will take you to get your unencumbered asset base to where it needs to be or where does the 18 months come from?

<A - Randall L. Churchey>: Yeah. There's three areas that we feel we need to focus on; one of which you just mentioned, the unencumbered asset base to gross asset. Randy mentioned we need to reduce the – our reliance of secured debt, and we're definitely working on that. And then the third is the company size. So I think we have a plan laid out that will enable us to achieve all of those and improve all those metrics over that 18 month period.

<Q - Alexander D. Goldfarb>: And then where are you now with the unencumbered assets and secured assets and where do you need to be?

<A - Randall L. Churchey>: We're at about 33%. We need to be 50% or better.

Source: 3Q11 earnings call

Management has stated that they are actively seeking acquisitions and developments.  Therefore, shrinking the balance sheet is not an option.  The call took place October, 2011.  So the 18 month timeline management refers to will be April 2013. 

As of 3Q11, secured debt outstanding is $335.9m.  To increase unencumbered asset from 33% to 50% of gross assets, EDR needs to pay off $85.4m of debt.  Assuming a secondary can be done at today’s price of $10.72, the number of shares would increase by 8mm or 8.7% in the next 14 months.

Moreover, EDR is highly levered.  (Net interest bearing debt + operating lease) / adjusted EBITDA = (335.9 + 487.9 – 47.34 – 4.6) / (60.3 + 11.5) = 10.75x.  Perversely, an equity dilution to pay down the debt is actually beneficial to shareholder in the context of reducing risks.

Appendix A

Earnings Power

Major expenditures were student housing operating expense, maintenance capex, corporate G&A and interest expense.

Define as total rental revenue (including discontinued operations) divided by average # of beds.  This excludes expense reimbursements and 3^rd party development/management service.

As of 3Q11, EDR has 21,482 available beds and 2,208 in development.  The 3^rd party business brings about $8mm/yr.  CAGR from 2005 – 10 has been at 1%.  Let’s be aggressive and assume 5% growth, revenue would be $394*1.05 * 12 * (21,482 + 2,208)+ 8 = $125.6mm

Operating margins before capex has averaged 45%.  Let’s assume 48% margin.  So before capex and interest expense EDR is earning about $125.6 * 0.48 = $60.3mm.

To finish the development pipeline EDR needs at least $95.8m.  (total cost – sunk cost – cash – restricted cash).

As of 3Q11, interest bearing debt is $335.9mm.  Current weighted average interest rate is 5.55%.  Assuming EDR can lower that to 5.3%, interest cost would be $(335.9 + 95.8) *0.053 = $22.9m.

If you take a leap of faith and use the “recurring capex” number, capex would be 23,690 beds * $145.55 = $3.45mm.  FCF/share would be $(60.3 – 22.9 – 3.45) / 91.82 = $0.37/share in FY2012.

Using a realistic assumption of 2% revenue growth, 45% margin and using the full capex:  23,690 * 434.57 = $10.3mm.  FCF/share will be $0.24/share.  EDR is trading at 44.7x normal FCF.  EDR is worth $3.36/share at 14x FCF.