New England Realty (NEN) is a publicly traded limited partnership that owns apartment buildings in metropolitan Boston. Mal 228 recommended NEN to VIC in late 2001 at $29.50 and again in late 2002 at $40, so it clearly has already been a terrific stock. Digression for an old joke: Stockbroker calls a customer and says, “Remember that ABC you bought 2 years ago? It’s doubled but it’s an even better buy now than it was then.” Customer: “Darn! I should have waited.” Taking away nothing from Mal, whose work got me interested in NEN in the first place, those who want to read a very thoughtful analysis of the company should go to the comments of Jim 77 in the thread from mid-2004.
While NEN is not as cheap as it was two or three years ago, I believe it is still a very attractive purchase candidate. On LTM NOI, making adjustments for joint ventures and sundry income which I discuss below, NEN trades at an implicit cap rate of 7.7%. Currently, quality apartments the country are trading at cap rates of 6% or less--in certain markets at times even lower than 5%. Many recent transactions support this, including the purchase in the last year of Summit Properties (buyer Camden, cap rate in mid-5’s), Gables Residential (buyer ING, underbidder GE, cap rate in mid 5’s), and, most recently, AMLI (buyer Morgan Stanley fund, 6% cap rate). In addition, there are many sales of single buildings and complexes. Note, for instance, the recent sales of non-strategic properties by BRE. Boston is a constrained market. Land is hard to find for development and zoning issues in most towns are onerous. At a 6% cap rate, which I think is pretty conservative, NEN has an NAV around $113, or a 40% premium to the current price. Jim 77 got to a value of $128/share in the summer of 2004. I don’t think his value is crazy at all but I wanted to be conservative. Note that NEN is not inordinately levered. Excluding it’s 50% owned joint ventures, the debt/market value is under 40%. Furthermore, all of the debt is mortgages at the individual property level and there is no cross-collateralization.
NEN is controlled by Harold Brown, a near-legendary 80 year-old Boston real estate investor. Brown continues to buy NEN shares in the open market: 12,000 in 2004 and 15,900 so far this year, paying up to $74/share. In fact, Brown has entered into successive 10b-5-1 Trading Plans enabling him to purchase additional shares. I’ve seen hundreds of 10b-5-1 plans enabling company executives to sell holdings over time, but I’ve never seen this kind of formal agreement to add to a position. Brown owns a lot of real estate away from NEN and also owns outright The Hamilton Company, which manages NEN properties. Furthermore, there have been a series of joint ventures between Brown and NEN and also some purchases and sales of properties. I don’t think there is any way to become totally comfortable from the outside with these transactions but I would note the following: Continued insider buying (if he was taking advantage of NEN wouldn’t selling be much more likely), NEN’s operating margins are in line with industry norms and, lastly, in certain cases Brown has personally guaranteed debt assumed by NEN or its JVs.
Beginning in late 2004, NEN has partnered 50/50 with Brown in buying 5 apartment complexes, in total 718 units (359 net to NEN) at a total price of $135 million. On a base of roughly 2400 units, this is a significant series of deals for the company. More leverage was employed here than the corporate norm--NEN’s share of the total equity is about $20 million. In three of the five complexes, the JV’s have begun to sell some of the units off as condos, with a goal of using the proceeds to pay down debt and thus owning the remaining apartments at a very attractive price with limited leverage or, potentially, no leverage. (Of course, it would not preclude NEN from refinancing the residual units and redeploying the capital.) Management notes that condo sales remain an option at the other two properties.
A closer look at one of these deals is instructive: In March, 2005 the JV bought a 176 unit building in Quincy (a middle-income South Shore town) for $23.75 million ($4.6MM total equity) or $135K/unit. Thus far, 59 units have been sold at an average profit of $60,000 each; 20 more are under contract. The ultimate goal is to sell about 130 units and retain the rest as rentals. Assuming the $60K profit remains constant going forward, the JV will recoup the entire purchase price and own 46 units free and clear, with a value of between $4-5 million net to NEN, or almost #3/share. Less detail is available about the other JVs and they may not be the home run that this Quincy building is, but I think it highly unlikely that they are down on a mark-to-market basis. In the valuation model below, however, I only give NEN credit for the actual contributed capital in each of the JVs.
NOI peaked in 2002 for NEN, declining 8% over the next two years. Through the first three quarters of 2005, NOI is flat on a same-store basis and up a little less than 2% in aggregate. Importantly, occupancy is higher (the vacancy rate was 3.9% in 11/04 and has declined to 1.4% in 11/05. While concessions have diminished, rents are only just now starting to increase. As mortgage rates continue to rise (especially for ARMs) and the pool of echo boomers coming into the rental market continues to increase, I think the outlook for modest NOI growth is pretty good.
As a partnership as opposed to a REIT, NEN does not have to distribute the majority of its net income, although I would expect modest increases in the dividend, now $2.80/share going forward. Accordingly, through retained income and continual refinancing of low mortgage properties, to say nothing of using slightly more leverage or through continued use of the JV structure, NEN has the ability to continue to purchase properties opportunistically as it has done for a long time. Cap rates could easily turn around and more higher in years ahead, but I would argue that that would most likely happen in an environment of pretty solid same-store NOI growth which up to a point should cushion the impact on the intrinsic value of NEN.
LTM NOI: $16.6MM* @ 6% cap rate=$277MM
Equity in JVs: 20
Sundry Income (10X $350K)** 3
Net Debt (104)
Per share value (1.7325 MM)*** : $113
* Adjusted by adding back one-half of corporate expenses assumed to be public company costs.
**The vast majority of this is laundry income; while it is highly stable I have a hard time with a much higher multiple.
***Note that because it is an MLP there is no share creep whatsoever; the number of units has been unchanged for many years
Risk Factors/Other Issues:
1. Cap rates do a U-turn and move up sharply.
2. Conflict of interest issues. Discussed above but real.
3. Illiquidity. There are days that NEN does not trade.
4. Massachusetts taxes. Out of state residents with more than $8000 of Mass income need to file. Distributions do lower your basis.
Many have speculated over the years that Harold Brown will sell one day; I don't think so. A large discount to what has been and should be a growing intrinsic value over time with a known wealth builder is catalyst enough for me.