Description

Shinoken Group (8909:JP) is a real estate developer and management company that is a pioneer and market leader in a rapidly growing niche: development, sales, and management of rental properties for individuals who qualify for preferential mortgage terms based on employment status, income and credit history.  The shares are significantly mispriced at less than 6x trailing P/E, which should eventually correct to a market valuation or higher as the company continues to generate returns on invested capital well in excess of industry and market averages.

Before we delve into the details of the business model, let’s start with why you should care:

Shinoken has maintained an average pre-tax ROIC of 41.5% over the past seven years, driving a tenfold increase in operating profit.  A comparison to industry and market averages strongly suggests that this outstanding performance is not due to broader economic forces, but rather an outlier in a low-return environment:

(Data Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html )

Shinoken has generated these exceptional returns with a differentiated business model that creates additional value beyond a typical rental property transaction for all stakeholders: landlords, tenants, and lenders.  As the Company retains long-term management contracts for properties sold, there is a constantly growing base of asset-light recurring revenue from management fees and additional services.  Furthermore, the Company has significantly reduced its reliance on relatively asset-intensive and less predictable condominium development over the past decade in favor of apartment development, in which inventory can be turned over much quicker with practically no development or balance sheet risk.

Shinoken develops both condominiums (also called “mansions” in Japan) and apartments.  In Japan, condominiums are high-rise residential buildings, and apartments are low-rise buildings, generally two stories tall with six to eight units.  Condominium units make up 10.6% of the country’s housing stock (5.5m), privately owned apartments 27.9% (14.5m), and single detached housing 50.5%.  Condominiums and apartments are more concentrated in city cores, for example in Tokyo, about 70% of housing units within 30km of Central Tokyo are condominiums and apartments.  Condominium units tend to be larger and more expensive than apartment units, all else being equal.  Condominiums have higher construction costs due to more expensive strong fireproof construction material such as steel reinforced concrete and higher management fees due to having elevators and building managers.  Apartments have lower fire and building strength standards, so they are generally constructed with wood or light gauge steel; lower construction material costs and lower management fees makes for lower rent.

Condominiums take two to three years to build, and developers must complete construction before carrying out sales activities.  Apartments only require six to eight months to complete, and developers are able to enter into binding sales agreements with buyers before ground is broken or a mortgage is approved.  While condominium development offers higher gross margins, apartment development removes market speculation and balance sheet risk from the equation for the developer.  Margins are lower but asset turnover is higher and short-term financing can be used, so returns can be very attractive.  However, from the perspective of a buyer, the risks are reversed, so to attract enough buying interest to make this model work, the developer needs to have a track record of delivering on time at a satisfactory quality and cost.  Shinoken has taken this a step further by building a track record of managing their properties to very occupancy rates and providing additional related services to keep lenders, landlords, and tenants happy.

From to 2011 to 2016, Shinoken reported apartment sales and condominium sales separately (they have been combined again for 2017).  From this data, we can see a clear focus on growing apartment sales:

Although we do not have exact sales information, we can surmise from the number of apartment and condo units managed that apartment sales continued to grow as a proportion of record-high real estate sales in 2017.  Shinoken is supplying about 1% of new rental housing starts annually in Japan.

In a typical apartment transaction for Shinoken, the Company is first approached by a buyer.  As the Company does not employ cold calling sales tactics, prospective buyers are either existing customers, referred by existing customers, or learn about Shinoken through their long-running TV commercial campaign.  About 40% of sales are to repeat customers or referrals from existing customers.  Shinoken targets salaried office workers who are likely to be approved for a high-LTV mortgage later in the process, so the Company will sometimes turn away applicants that do need meet certain financial criteria.  In 90% of cases, Shinoken will enter into a sales contract with the buyer before buying land; otherwise they hold the land for about one month before entering a sales contract.  Once a contract is signed, there is a 20% penalty for backing out, so the cancellation rate has been consistently low, even through the financial crisis.  As the apartment is basically presold, Shinoken finances development with short-term debt from a consortium of 39 banks, primarily backed by inventory under development.  Shinoken keeps design and contracting functions in-house, enabling efficient construction of an apartment building in six to eight months, then records the sales when the units are handed over to the buyer.  Prior to the handover, the buyer applies for a mortgage from a partner bank.  Following a handover, Shinoken retains a long-term management contract for the unit, starting with five years and renewing every subsequent two years.  Historically, the retention rate has been 98%; this is in part due to clause stipulating that if Shinoken is able to maintain a certain occupancy level for an apartment unit, the landlord must pay one full month of rent to exit the contract.  Shinoken’s management fee is 5% of gross rent collected.

A snapshot of the balance sheet shows that the Company relies on debt to finance development; however, we can see that the balance sheet is becoming much stronger over time:

The Company targets a 30% capital adequacy ratio (equity/total assets) and an ROE consistently above 20% “under any circumstances.”  ROE came down as management steered the business toward its desired capital adequacy ratio, but it appears that the business could still generate an ROE over 30% while maintaining its target capital adequacy ratio.

Inventory, held at development cost, matches up roughly with total debt, 55% of which is backed by the inventory.  Long-term debt is used to finance condominium construction.  Considering the profit margins of the condominium segment, market prices would have to fall 30% before any impairment to the balance sheet occurs.  The apartment segment would be profitable through any environment as the sales price is determined at the same time as the land is purchased and development costs are determined.  Shinoken is reducing their relative exposure to condominium development to be more resilient through downturns, but they continue to maintain some level of condominium development to respond to the demands of their customers.

In 2014, Shinoken acquired a general contracting business to lower construction costs.  The purchase price was JPY2.6 billion, which was only about 5x EBIT at the time.  In retrospect, the purchase was an absolute bargain at 1.8x 2016 and 2017 EBIT.  The increase in sales and EBIT was due to increased internal sales; 30% of sales for this segment are now internal, which covers roughly 60% of the Company’s general contracting needs.  The Company plans to scale this business up a further 60% to JPY30 billion in revenue.

Aside from the development and contracting segments, there are a number of recurring businesses, including apartment and condominium management, energy and LPG supply, long-term care, rent guarantee and insurance services.  As the Company sometimes changes the way they report these smaller segments, but they all follow a similar thread of logic in that they are recurring businesses that grow as more units are developed, I have added up results from these segments into one “Recurring” segment:

Shinoken strives to maintain a high occupancy rate across its managed units.  The rate currently stands at about 98%, exceptionally high compared with a national average of 81%.  The most important factor in maintaining a high occupancy is location.  Shinoken only selects sites within 10 minutes’ walk to a train station in one of five major cities with growing singles populations: Tokyo, Fukuoka, Nagoya, Osaka, and Sendai.  This particular demographic trend will work in Shinoken’s favor over the next two decades, despite an overall population decline.  Another factor is price: Shinoken rents their apartments out at a 5% discount to comparable apartments in a given neighborhood.  They can do this by keeping development costs lower than average, given more efficient construction techniques and economies of scale.  The third factor is quality and design: rental housing ages faster and quite a lot of the existing housing stock in Japan will need to be replaced in the coming decades due to quality issues with cheaper construction materials.  The average age of a demolished unit in Japan is only thirty years.  The final factor is the convenience and efficiency of dealing with a professional management company compared to an individual landlord.  Shinoken offers various insurance products to renters to give them peace of mind (such as stalker insurance!).  To sum that up, as a tenant, you are getting a conveniently located, higher quality, professionally managed property at a discounted rate; it’s a no-brainer if you are lucky enough to find a vacancy.

From the buyer’s perspective, Shinoken is offering an additional cash flow stream and asking for little in return.  In most cases the buyer is making little or no down payment, so the transaction makes financial sense (high double-digit IRR) if there is a reasonable spread between rental yields and mortgage rates.  There is practically no time commitment for the buyer to manage the property, and Shinoken offers additional services to guarantee the collection of rent, insure against a death in the property, and so on.  Gross rental yields are currently between 5-6%, and 35-year fixed mortgages are close to 1%. Rental yields and interest rates can obviously fluctuate through cycles, but rental rates and occupancy were flat for small-size apartments in Japanese urban areas through the last financial crisis.  As the buyers are typically buying to hold for the extra income, and they have locked in a positive cash flow spread, as long as the rent gets paid, the fluctuations of rental yield and interest rates have little impact on them.  Shinoken offers a rent guarantee service to landlords for up to six months for a fee; and but even without the service the delinquency rate is less than 1% vs. a national average of 5%.  According to the Company, the deal is so attractive for buyers in the current environment that there is more interest than Shinoken can fully supply.

See the green lines below to see stability of rental rates for small apartments through the crisis:

As for the lenders, their primary objective is to make loans that can be repaid, to match that with deposits or debt, and to profit from the interest rate spread.  They must do this regardless of where interest rates sit or which way they are going.  Shinoken’s track record of maintaining a high level of occupancy over the lifetime of a property (even their 25-year-old units are running at 98% occupancy) and offering services like rent guarantees gives them the confidence to offer higher LTV loans.  These special mortgages require the landlord to enter into a management contract with Shinoken.  While the mortgage payments are well covered by rental income, the banks are still maintaining strict personal income requirements.  Regarding the development financing that Shinoken uses to build apartments, this is also low-risk lending for banks as the collateral is already contracted to be sold.  Given this lower risk profile, Shinoken’s partner banks have committed to continue lending to them (according to Shinoken, there are contractual obligations in force) in the event of another large shock to the Japanese or global financial system.  Incidentally, Shinoken was heavily reliant on Lehman Brothers for financing preceding the financial crisis; this experience has led them to spread the risk around to several dozen lenders and to make sure they will not pull the rug out from under them next time around.

Shinoken is about twice the size of its nearest direct competitor in terms of units managed. Investor Cloud (1435:JP) had 18,699 units under management at the end of 2017.  Their model is not an apples to apples comparison; their property management business includes many units that they did not have a hand in designing or developing; only 14% of the added units under management in 2017 were designed in-house.  Investor Cloud does not select land sites or develop them; they offer land information matching services, design services, and management services, but any development is kept off their balance sheet and the buyer takes on development risk.  Because of this difference, their growth potential is not constrained by their balance sheet, Investor Cloud is seen by the market as an online platform rather than a real estate developer, and its stock has been awarded with a 45x P/E multiple.  I do think Investor Cloud has bright growth prospects long-term, as the growth drivers are essentially the same, but the underlying industry risks are essentially the same as well.  Shinoken’s view is that their experienced land purchasing team is a core asset and an advantage over competitors, and that choosing the right locations is essential to achieving an acceptable yield and occupancy over the life of an apartment.

There is one major cloud currently hanging over the rental housing industry.  In January 2015, Abe’s inheritance tax reform lowered the threshold over which the tax must be paid, which increased the number of people required to pay inheritance tax by 80%.  This led to a surge in interest from private individuals in developing rental properties, as land is appraised at a lower value for inheritance tax purposes when the land has a residential building on it than when the land is vacant.  The discount is based on rules that made sense during the 1980’s real estate bubble, when land prices rose so much that people had to sell their parents’ homes to pay their taxes.  Land prices have since fallen by two-thirds, but the laws are still on the books and the discount can be as high as 75%.  This loophole is one main cause of high vacancy rates nationally, as rental properties end up being built on farmland in out of the way places.  Some developers, such as Daito Trust Construction (1878), focus their business entirely on approaching wealthy landowners with proposals for residential development with a long-term (30 years) leasing and subleasing contract.

New rental housing starts jumped 10.5% in the year following the inheritance tax reform, and in early 2017 the government warned of a possible bubble forming in the residential real estate construction market.  Developers and lenders have been eager to cash in on the new source of demand from landowners looking to reduce their tax bills, while actual demand from potential tenants appears to be a secondary consideration.  Rather than closing the loophole, the government response has been for regulatory bodies such as the Financial Services Agency to tighten oversight of mortgage lenders, examining the mortgage approval process to ensure that banks are thoroughly going over the risk of vacancy and changes in rent.  There is market speculation that regulatory pressure will lead to a retraction of lending to developers with this kind of business model.

http://oakescapital.com/latest_news/land-loophole-looks-ever-juicier-as-japan-bumps-inheritance-tax/

https://www.japantimes.co.jp/community/2016/07/02/how-tos/rise-vacancies-wont-mean-drops-rent/#.WpbUuahuaUk

https://www.japantimes.co.jp/news/2017/05/23/business/inheritance-tax-avoidance-cheap-mortgages-driving-rental-housing-bubble/#.WpWGsqhuaUk

https://resources.realestate.co.jp/news/japanese-govt-warns-possible-bubble-residential-rental-market/

Shinoken may be included in this market speculation, simply because they are in the business of developing rental properties and hold debt.  However, the business model does not facilitate inheritance tax avoidance and appears to be entirely unaffected by changes in the inheritance tax law.  The Company focuses on high-demand locations near train stations, and the Company is buying and selling land then managing the properties, rather than developing a property for a landowner in exchange for a long-term lease.  Furthermore, the business model raises tax revenue through real estate acquisition taxes and income tax on rental income.  The founder and CEO recently addressed this issue in an interview, in which he also discusses how the business was started and how they have dealt with crisis in the past:

http://www.shinoken.co.jp/press/media/view/294

Valuation comparison

Considering that 55% of Shinoken’s debt is secured by presold apartments, I would make the case that net debt should be adjusted to zero, in which case the stock would trade at 3.7x EV/EBIT.  I included Daito Trust Construction in this table as an example of a developer with direct exposure to the inheritance tax issues that still trades at a reasonable valuation multiple, likely due to its larger size.  Whichever way you look at it, Shinoken is clearly undervalued and would have to double or triple just to get to a market average.  In addition to that, the business is compounding at a very attractive rate.  Management recently gave the following updated guidance for the next three years:

Management has a history of setting the bar way too low.  2017 actual operating income exceeded their original guidance by 17.4%.  If we go back three years, we can see that 2017 actual operating income exceeded the original target set in 2015 by 101%!

If the current three-year plan turns out to be accurate, then the balance sheet will strengthen significantly and would move to net cash, even if we give the company no credit for using their debt to finance presold inventory.  By 2020 the current stock price would imply a 4x P/E multiple with a net cash balance sheet.  On the other hand, if the Company can continue to find opportunities to grow and compound earnings at a 30% rate as it has in the past, earnings will more than double from here and the stock is trading at 2.5x 2020 P/E.

For now, the Company has its sights set on further growth.  As for their core business, they are continually receiving more inbound interest than they can currently supply, but there will be other sources of growth as well.  Just today, they announced the launch of their first real estate investment fund for institutional investors as well as a second fund in the works.  There are several new initiatives in the works that will enhance or extend their management business, including biomass power generation with guaranteed returns from feed-in tariffs, a new digital currency that will facilitate easier and cheaper transactions for tenants and landlords, and new insurance products.  There is also a small construction and development business in Indonesia which they have been incubating for more than ten years and could be rolled out on a larger scale soon.

Once the business matures to a point where they are no longer to compound book at such a high rate, I expect returns of capital to shareholders to increase, based on past behavior.  The dividend payout ratio increased from 5% to 10% in 2016, and annual dividends per share have grown 13x in 5 years.  The Company has repurchased shares in the past and is currently holding about 7% of their outstanding shares as treasury shares.  With a similar policy of maintaining an ROE over 20%, they may take a cue from Daito Trust Construction, which targets a total return of at least 80% of earnings to shareholders and has repurchased and retired about half of their shares outstanding since 1996:

http://www.kentaku.co.jp/corporate/ir/kabushikisuii.html

Another outstanding U.S. homebuilder I came across while doing due diligence for Shinoken is NVR, which has posted incredible returns in the past two decades (25% annualized), in large part thanks to a massive reduction in shares outstanding and a conservative balance sheet going into the financial crisis.

Conclusion

Take the long-term view here.  There may be no immediate catalyst on the horizon to spark a normalization of the P/E ratio, but the business is solid and can compound at very attractive rates of return.  Through some combination of growth in the core business, opportunistic acquisitions, synergy through new businesses, and perhaps share repurchases, earnings could grow at a 20% to 25% CAGR over the next decade.  If they deliver on that, the valuation should at least triple over time, and your IRR from today will be about 35%.   This being Japan, the shares could also rerate very quickly with no specific catalyst.

Buy and hold, forget you own it and let Shinoken do all the work for you… sound familiar?

Catalyst

Compounding earnings, low valuation, strengthening balance sheet, clarification of business model