Note: All $ references are to Canadian dollars

Recommendation

This idea involves a microcap and a highly levered one at that.  The risk of a complete loss is high. 

While each has very different risk/reward characteristics, I would recommend buying all of the securities in the LRT capital structure.  The 9.5% debentures trade at par but the yield is satisfactory given that asset coverage offered by the Company’s real estate portfolio. The common stock units are a classic levered equity situation that offer significant upside if the Company is successful in its deleveraging efforts and can turnaround its Fort McMurray property portfolio.  I believe the units can double or triple in price over the next two years.  Therefore, as one would expect, the warrants (which are currently in the money) are very interesting speculative bets (think ~200-800%) on the successful rerating of the units over the next 9-18 months.

Situation Overview

Lanesborough Real Estate Investment Trust is a closed-end real estate investment trust created to invest primarily in a portfolio of retail, residential, industrial and office properties located across Canada.  LRT’s portfolio consists of 18 multi-family residential projects, one commercial property, one mixed-use commercial/residential property and two senior housing complexes. Thirteen of the 18 multi-family residential projects, representing over 1,000 units, are located in Fort McMurray, Alberta. 

Like many real estate ventures prior to the financial crisis, the Company went on an acquisition spree – funded, of course, with plenty of leverage – and found itself on the verge of insolvency as occupancy rates collapsed as a result of the North American economy tanking during the 2008-2011 period.  The Company was able to survive thanks to some creative refinancings, covenant waivers from creditors, and plenty of asset sales. 

Today, LRT has eliminated all debt covenant breaches with the exception of one swap mortgage loan, which is in breach of NOI achievement requirements.  Since 2009, the Company has sold 23 properties and 17 condominium units for $261.3mm which has netted the Company $97.4mm in proceeds.  Accordingly, debt has been paid down considerably and interest rates have also been reduced substantially.

While not completely out of the woods just yet as management has more blocking and tackling to do with the capital structure in 2014 and 2015, LRT looks to be stabilized today.  The continuation of strong activity in the oil sands industry and higher stabilized occupancy levels for the Fort McMurray property portfolio should provide earnings growth for the remainder of 2014 and a solid foundation for future growth.  Cash flow will increase making it possible for the Company to start paying dividends again, perhaps as early as 2015 after additional properties are sold and expensive debt is paid off.  At some point, the market will recognize these positive developments and the units will trade closer to LRT's NAV.  Management also seems to think that better days are ahead as the Company is currently in the market looking to buyback 10% of its outstanding bonds and warrants.

Real Estate Portfolio

The property portfolio consists of 20 investment properties and 2 senior housing complexes that are slated to be divested.  The entire portfolio of 22 properties has a total purchase price of $396.1mm and encompasses 2,125 suites and 123,126 square feet of leasable commercial area.  The properties consist of:

• 1 commercial property located in Airdrie, Alberta
• 1 mixed-use residential and commercial property located in Winnipeg, Manitoba (Colony Square)
• 13 multi-family residential properties in Fort McMurray, Alberta
• 1 multi-family property in Yellowknife, Northwest Territories
• 4 multi-family residential properties located in Thompson, Manitoba, Brandon, Manitoba, Edson, Alberta and Peace River, Alberta
• 2 senior housing complexes are located in Moose Jaw, Saskatchewan and Port Elgin, Ontario

Parsons Landing, one of LRT’s key properties in Fort McMurray, was damaged due to a fire in 2012 and has been going through a reconstruction process.  The property consists of 160 suites and as of late 2013 all units were fully reconstructed and available for rent.  The lease-up of these units will be one of the drivers of higher NOI for the Company in 2014 and beyond.

Fort McMurray / Alberta

Fort McMurray is considered the heart of one of Alberta's (and Canada's) hubs of oil production, located near the Athabasca Oil Sands. Besides the oil sands, the economy also relies on natural gas and oil pipelines, forestry and tourism.  Some facts about Alberta’s economy (from Cushman & Wakefield):

• Unemployment rate stands at 4.8%; there are fears that 2014 will see a labor shortage in various industries; expect more in-migration
• In 2013 Alberta’s robust employment growth lead the country; one third of all new jobs in Canada were generated in Alberta
• Alberta’s population increased by 3.5% in 2013 (the fastest growth since 1982) and surpassed the 4 million mark
• Alberta’s real GDP growth is projected to be an encouraging 3.9% in 2014, up from 3.3% in 2013 and 3.8% in 2012
• Number of oil sands projects: 36 announced ($17B); 46 applications ($27B); 41 approved ($21B); 10 under construction ($4B); 30 operating ($14B)
• Over the next 25 years, Alberta’s oil sands, serviced primarily through Edmonton, will generate over $2.1 trillion in economic activity in Canada
• With 170 billion barrels, the oil sands represent 97% of Canada’s total reserves which are the world’s third largest after Saudi Arabia & Venezuela

Capital Structure

LRT has $333.8mm in total debt of which $304.5mm is mortgage related and $29.3mm is at the parent level.  Pro forma cash totals $22.6mm resulting in net debt of $311.2mm.  There are approximately 41.5mm units currently outstanding on a fully diluted basis putting the market cap at $48.7mm and total enterprise value at $359.9mm.  The warrants with an exercise price of $1.00 expire on March 9, 2015 and the warrants with an exercise price of $0.75 expire on December 24, 2015.  With the equity representing ~14% of the enterprise value, even small improvements in the value of the real estate can result in a meaningful re-rating of the units – for example, a $1.0mm improvement in NOI can in theory increase the intrinsic value of the units by ~20-25%.

Stabilized Net Operating Income

LRT generated NOI of $22.4mm and $24.2mm for the FY12 and FY13, respectively (these figures do not include any contribution from Parson Landing as it was undergoing renovation from the fire damage).  Going forward, management estimates that the entire real estate portfolio, including Parsons Landing, is capable of generating $28.0mm of NOI on a normalized basis.  While this seems a bit aggressive to me, I can get to $25.7mm as a reasonable estimate for run-rate stabilized NOI without making any heroic assumptions.  The key assumptions in the model below are 93% occupancy rates for the properties and ~4% growth in the monthly rents and the inclusion of Parsons Landing.  Given the strong economy projected for Alberta, I don’t see any reason why LRT couldn’t achieve these metrics. 

It is important to note that Q1 2014 was unusually challenging for LRT.  It generated NOI that was $1.2mm lower in comparison to the previous year.  Occupancy at its Fort McMurray properties were negatively impacted by a more competitive rental market due to an increase in the available rental units and increased competition from temporary housing units.  If this is not a temporary situation, then my stabilized NOI estimate will prove to be aggressive as will be my estimate of the Company valuation.  I’m comforted by the disclosure that occupancy levels have improved significantly since Q1 and the Company now expects its Fort McMurray portfolio occupancy to reach 91% by June 1, 2014. 

Net Asset Value

The Company values its real estate at $421mm based on a normalized NOI assumption of $28mm and a weighted average cap rate assumption of 6.76%.  This falls within my valuation range of $331–$463mm which I derive based on a cap rate range of 6.0–7.0% and an NOI range of $23.2–$27.8mm.  I don’t profess to be a Canadian real estate expert but these assumptions don’t seem unreasonable based on the research materials put together by the big CRE houses on the Alberta real estate market. 

Assuming the units trade to NAV, the following are potential returns for the units and the warrants.  The upside in the units is very compelling but the warrants become homeruns should the market re-rate the units within the next 9-18 months. 

Free Cash Flow / Potential Dividends

While there is no excess cash flow today to pay a dividend, it is conceivable that LRT could do so in the future should it execute on its strategy to improve NOI and delever.  The two potential sources of cash that could be available for debt paydown are proceeds from the sale of the two senior housing properties and cash from the warrants exercise. 

Assuming that the Company can sell the senior housing properties for $17–$30mm, there would be $4–$16mm in net cash available for debt reduction.  Add to this the $17mm that the Company could potentially generate should all the warrants get exercised and there would now be $4–$33mm available to retire debt.  If this were to happen, the Company would save up to $3mm in interest expense and could generate as much as $6.7mm in cash flow that could theoretically be available for dividend payments. 

Investment Risks

• The Company is externally managed which is not ideal.  Shelter Canadian Properties is under contract through 2024 to provide asset management and property management services to LRT.  Arni Thorsteinson, the CEO of LRT is also the President of Shelter. In 2013, Shelter received service fees of $1.4mm and property management fees of $1.7mm.  Obviously, these fees are way too high for a company of LRT’s size.  There is also risk of related party transactions with Shelter’s other portfolio companies.
• The Company has $175mm in debt maturities in 2014 and 2015.  While nearly all of this is non-recourse mortgage related and will most likely be refinanced given sub 80% loan-to-value ratios, it would be a major blow to the thesis if properties were foreclosed upon by the lenders.   Additionally, there are no cross-default covenants between the mortgage loans, mortgage bonds or the debentures.
• An investment in Fort McMurray/Alberta real estate is really a bet on the growth of oil sands industry.  While strong growth is forecasted, there could be any number of factors that could derail the industry.  Environment and health and safety related restrictions are likely the key concerns.  But commodity prices and the availability of key resources could also have an impact of the profitability and growth of the industry.
• Many believe that the Canadian housing market is in a bubble and that at some point prices and volumes will collapse.  While I have no insight into when and if this happens, it would obviously not be a positive for the Canadian economy and multi-family property values.  If cap rates widen and the financing markets close, LRT equity is a zero and even the bonds may be impaired.
• Along the same lines, Canada is levered to China and any slowdown in the Chinese economic activity will have ripple effects on the Canadian economy.  Again, I have no insight into when and if this happens but this risk has to be recognized whenever you’re investing in Canadian securities.