Description

InterRent REIT (IIP.UN on TSX) is a residential-focused micro-cap Canadian REIT whose strategy is to consolidate apartments buildings in Ontario’s secondary markets (essentially consolidate markets outside of the Greater Toronto Area).  Its portfolio consists of over 4,000 units located in Ontario.  Ottawa and London are its two largest markets.

Investment Case

InterRent has a Net Asset Value (NAV) of approximately $5.10 using a 7.3% cap rate.  It currently trades in the market at $4.10 implying a 7.8% cap rate.  It thus trades at 20% discount to its NAV.  The support for the cap rate essentially comes from the fact that today they did a non-brokered private placement for $5.09 million priced at $5.09 per share.  This private placement represents almost 8% of the current equity market capitalization.  This financing was structured as one unit and one warrant to purchase a unit at $5.09 for 2 years.

Based on 2008 Adjusted Funds from Operations ($0.35), InterRent trades at 11.7x AFFO, whereas other small cap Canadian REITS (e.g. Killam) trade at around 14x..

Brief Description

InterRent has over 4,000 apartment units with a gross book value of over $260 million in Ontario’s secondary markets.  Management would like to grow the company to at least 10,000 units.  This is very achievable as it would represent only 3% of the Ontario market outside the Greater Toronto Area.

Management owns approximately 9.4% of the total units outstanding.

InterRent concentrates on buying apartment buildings with at least 50 units in order to justify the cost of a resident superintendent.  InterRent buildings have an average of 47 units.  The buildings are roughly 40 – 50 years of age.  Most of the buildings would be considered Class B or C.  Though the buildings may be older, InterRent goes in and starts to upgrade the buildings with better entranceways, hallways and unit improvements such as kitchen and bathroom upgrades.  This helps to drive lower vacancy rates and higher rents.  The vacancy rate in Q2 was 3.8%.

Investment Negatives

1)      The province of Ontario has rent controls which limit the potential for large rent increases as is happening in Western Canada.

2)      The province of Ontario is having slower economic growth due to softness in the manufacturing sector as a result of the high Canadian dollar.

3)      InterRent’s leverage is in the mid-60% range (debt to market value of assets) which is on the high side, especially if the Ontario economy slows substantially.

4)      Cost of debt has increased due to the recent credit turmoil, but not substantially according to management.

5)      Cost of equity – due to its current low share price, it appears that InterRent may not be able to execute its growth strategy – the fact that they were able to raise financing at NAV mitigates this risk somewhat.

6)      The REIT has an AFFO payout ratio greater than 100%.  This is mainly due to the timing of acquisitions.  By year-end 2007, with acquisitions, this should be around 100%.

7)      Size – InterRent has a market capitalization of roughly $65 million and trades around 20,000 shares per day, implying a liquidity constraint for those managing larger portfolios.

8)      The focus on secondary markets may be considered an issue as smaller local economies tend to be less diversified.  This is mitigated by the fact that the company is expanding all across Ontario so it is exposed to many different local economies.

Now that the negatives are out of the way (and if you are still reading):

Some Positives

1)      At the current price, InterRent offers a yield of almost 9.3%.  For Canadian investors, most of the distribution (over 90%) is tax deferred (for US investors, please consult your advisor).

2)      Continuing growth – the ownership of apartments outside the Greater Toronto Area is very fragmented allowing an acquirer a substantial opportunity to gain scale.  As InterRent increases its size, it can spread its General and Administrative Costs over a larger base of units.  As they have continued to acquire apartments in the third quarter, this should reduce the payout ratio.

3)      If InterRent does not trade at NAV and hence can’t execute its acquisition strategy, it will itself become an acquisition target resulting in investors receiving NAV in a takeover.

Catalyst