Description

Thesis:

I recommend the purchase of shares of New England Realty (NEN), a Boston apartment landlord which I believe has a 200% upside.   I think that it is an exceptional opportunity to invest in a very attractive and tax advantaged asset class.  The stock is selling at a 55%+ discount to replacement cost, 67% discount to NAV, 7x rent roll and at a 10-11% free cash flow yield.  The business is well managed, conservatively financed and should have significant tailwinds to grow rents and cash flows for many years to come, allowing our investment to compound at 15%+ per year for many years.  [Since this is a somewhat illiquid small cap security with $198 million market cap, I do not intend to count it against my membership requirements.]

Description of the business

The company owns apartment buildings in the Boston and the greater Boston area, in towns such as Allston, Andover, Brockton, Brookline, Burlington, Cambridge, Danvers, Framingham, Lexington, Lowell, Newton, Norwood, Watertown, Woburn and Worcester.

These apartment buildings are Class B properties.  New England Realty owns 19 residential buildings, 4 mixed use residential, retail and office buildings, 3 commercial buildings and 7 condominium units at two condominiums that it has been selling.  These properties total 2,711 apartment units, 7 condominium units, and 108,043 square feet of commercial space.  In addition, the company also owns 40-50% interest in 8 residential and mixed use properties consisting of 695 apartment units, 12,500 square feet of commercial space and a 50 car parking lot that will be developed in the next real estate cycle.  So in total, the company owns 3017 apartments including our proportional interest in joint ventures, and the 7 condominium units.

Long term prospects

Based on my conversations with the company and participants in the Boston real estate market, I am very optimistic regarding prospects for rent growth in the Class B apartment buildings in the Greater Boston area for the next couple of decades.  This optimism is based on two factors: continued increase in demand from renters for Class B apartments and virtually zero construction for non-Class A properties.  I do not believe that the situation will change in the future, since based on my conversations with market participants, rents for Class B properties would have to rise by 30% while all costs would have to be unchanged before it would make economic sense to actually build class B apartments.  Moreover, even if rents rose by 30%, while all costs remained unchanged, it would still be very difficult to build due to lack of land, difficulty in obtaining permits and tremendous taxpayer and municipal opposition to building apartments in the suburbs.

This article from the WSJ illustrates the projected supply demand imbalance in the greater Boston area for apartments over the next couple of decades.

https://www.wsj.com/articles/boston-doesnt-have-enough-housing-can-it-get-the-suburbs-to-help-1544284800?mod=hp_major_pos6

Family/management

a)      Treatment of limited partners

This is a limited partnership.  Moreover, there is an external management company owned by the Brown family.  So the question is, how do they treat the limited partners?

The Brown family, which is very well known in the Boston real estate circles, owns 46.4% interest in the company (100% of the GP interest that owns 20% of the company and 33% of the LP interest that owns the remaining 80% of the company.)  Over the past fifteen years of observing them, I found them shrewd, shareholder oriented, and more than fair to the limited partners. 

Here is one example where the family bent over backwards, sacrificing its financial interests for the benefit of the limited partners.  In September of 2009, the company and the Brown family formed a 40/60 joint venture to buy Dexter Park, a 409 unit apartment building in Brookline MA.  The purchase price was $129.5MM.  New England Realty did not have the entire $15.925MM for its share of the down payment, so it borrowed $7.168MM at 6% from the general partner.  This property today is supposedly worth $250MM, should generate around $11MM in EBITDA in 2019, and just got refinanced on June 1^st 2018 with a 10 year $125MM 3.99% interest only mortgage.  When I called up the tax assessor of Brookline immediately after the announcement in 2009 and asked what she thought, she told me that they “stole the building; I cannot buy a one-bedroom here for less than $500K and they paid less than $300K for per unit for a mixture of one and two bedroom units.” We all know that fall of 2009 was a good time to buy assets, and the fact that the general partner lent money at 6% to the company for its share of the down payment rather than buy the entire asset himself speaks volumes about how the family treats the limited partners. 

b)     Quality of management

Having observed them act over the past fifteen years, talked to them almost every quarter since 2004, met with them a few times, and having read the 10-Ks for the past 23 years, I have two observations: 1) they generally do not do stupid things; b) they are very conservatively financed; c) they tend to buy low rather than high and buy back stock at the bottom rather than sell it.

Financials

Debt, less cash at wholly owned properties = $245MM (projected on 12/31/2018.)

Our share of debt at joint ventures = $71MM (projected on 12/31/2018)

Total debt, including our share of debt at joint ventures = $316MM (projected on 12/31/2018)

Shares outstanding on 12/31/2018 = 3,731,602, market cap at $53 per share = $197.77MM.

I project EBITDA (NOI) at wholly owned properties to = $32.25MM in 2019, and our proportionate interest in joint ventures EBITDA to = $6.75MM in 2019, for a total of $39MM EBITDA attributable to our interest.  In addition, according to my research which I confirmed with the company, a number of their apartment leases are under market, and they will bring them up to market over the next couple of years.  That should add another $2MM to annual EBITDA.  So pro-forma EBITDA would be $41MM per annum.

I estimate maintenance cap ex to be around $3MM per annum, and annual interest bill = $16MM, including our pro-rata share of interest expense at the joint ventures. 

So free cash flow, attributable to equity holders = $20MM per annum, or roughly $5.36 per share in 2019.  Assuming that the company re-prices under market leases to market, that should boost free cash flow to $22MM per annum and per share free cash flow to $5.90.

Debt, including our share of joint venture indebtedness, to total 2019 EBITDA = $316/39 = 8.1x (7.7x pro-forma) or less than 40% LTV.  Quite low for apartment buildings.

Valuation

Sam Zell states that you should buy real estate at a discount to replacement cost, not based on cash flows.  At a stock price of $53 per share, enterprise value is: $316MM of debt + $198MM equity market cap = $514MM EV.

Ignoring for the moment the value of commercial space, parking lot, and 7 condominium units, we have 3017 apartments in Boston and the greater Boston area, hence we are creating them at roughly $170,368 per unit.   Based on my conversations with a number of Boston real estate players, replacement cost is around $400k per Class B unit on average.  ($300K is hard construction costs, $100K is for land and permits.  This of course varies depending on the size of the apartment, and location.) 

So we are creating the assets at roughly 42.7% of replacement cost, or a 57.3% discount to replacement cost, ignoring the value of the commercial properties and 7 condominium units.

As mentioned in the financials section, I expect $39MM of EBITDA in 2019 from the company including our pro-rata share of joint ventures, hence cap rate (EBITDA/EV) = 7.6% based on my 2019 forecast.  If one gives the company credit for additional $2MM of EBITDA that it will gain from repricing under market leases, then cap rate rise to 8% (41MM/514MM).  It is my understanding that Class B apartment buildings are being bought at 4.5% cap rates in the greater Boston area, although Dexter Park (the company’s 409 unit building owned by a 40% owned joint venture is probably a 4% cap rate asset.)

Thus, at a 4.5% cap rate, the real estate assets are worth $41MM / 0.045 = $911MM, less $316MM of debt, leaves $595MM to the equity or $159 per share value.  If one wanted to be more conservative, and use $39MM EBITDA and a 5% cap rate, then the value = $39MM / 0.05 less $316MM of debt = $124 per share.

For those who prefer to look at free cash flow, levered free cash flow (post interest payments and maintenance capital expenditures) should be = $20MM in 2019 or $5.36 per share, for a 10% leveraged free cash flow yield assuming a stock price of $53.0.  If one gives the company credit for the EBITDA increase associated with repricing under market leases to market, then free cash flow = $22MM or $5.90 per share, an 11% free cash flow yield.  I expect this figure to grow at around 8% per annum assuming that rents and expenses grow at 4% per annum on a same store basis.  This assumes no value creating acquisitions or share buy-backs, which have created enormous increases in NAV in the past.

So you are paying 7.1x rent roll, 12.5x EBITDA, or 9 times leveraged free cash flow yield to the equity.

Capital allocation

Historically, the company’s preference has been to acquire buildings and grow the portfolio, however the company is not averse to buying back stock.  For instance, from August 2007 through December 31^st 2018, the company has repurchased 1,365,306 shares or roughly 26.8% of shares outstanding, and 30% of shares outstanding since 1995.  Most of the share repurchases happened in 2008 and 2009, although the company paid as much as $62 per share in the first half of 2017.   

The company was a very active buyer of assets in the 2008/2009 downturn.

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Tax treatment

This is a partnership, so tax treatment is a pass through.  Distributions are considered a return of capital, and any taxable income is taxed at the partner level.  Recent tax reform should help, excluding 20% of taxable income from taxation.

Conclusion

We have a unique opportunity to make an investment into a well-managed firm with an aligned management team, in an attractive asset class, with favorable tailwinds and tax characteristics, at a 57% discount to replacement cost, 67% discount to NAV, and one that should be able to compound NAV at double digit rate for a number of years.

Catalyst

Share buy-back.  The stock has not always traded at a such wide discount to NAV, and historically the company took advantage of very wide discounts to buy the stock back.  For instance, the stock was at $32 (on a split adjusted basis) in early 2005, and was at $75 in December of 2017.  I expect that the company will re-start its share buy-back program.  The management recognizes that the stock is tremendously undervalued, and that probably the best use of capital is buying back their own shares.  The company had to pay off the line of credit, before buying back stock, and now that it is paid off, I expect the share buy-back program to recommence. 

Catalyst

Share buy-back.  The stock has not always traded at a such wide discount to NAV, and historically the company took advantage of very wide discounts to buy the stock back.  For instance, the stock was at $32 (on a split adjusted basis) in early 2005, and was at $75 in December of 2017.  I expect that the company will re-start its share buy-back program.  The management recognizes that the stock is tremendously undervalued, and that probably the best use of capital is buying back their own shares.  The company had to pay off the line of credit, before buying back stock, and now that it is paid off, I expect the share buy-back program to recommence.