Disclosure: We own small positions in this company.
Mainstreet Equity is a bit of a different company. Unlike your typical public real estate company, they do not pay a dividend. They do not buy a few large income producing towers and sit on them. Mainstreet is a bit more fun. They: 1) buy underperforming or distressed mid-market apartment buildings in Western Canada, typically only a few floors high, 2) upgrade their insides, improve energy efficiency and curb appeal, 3) increase rents and refinance them using larger low rate mortgages, taking out most of their initial equity, 4) profit. The Company’s argument is that these properties are selling significantly below their replacement value (the cost to build a new building), particularly after they have been renovated.
Bob Dhillon is the CEO and founder. This is his baby and owns approximately 43% of the Company. This strategy has been stated and executed consistently by him and his team since its founding. They also have a history of disciplined buying, which we like. For example around 2006, Calgary property prices were not meeting their required returns, and instead they focused on Saskatoon, southern B.C. and Edmonton where there was less competition (Mainstreet started buying in Calgary again in 2010). Mainstreet also acquired properties in Ontario but prudently decided to exit the market in 2012 due to valuation/return concerns and high competition compared to its other markets.
The Company has grown quite remarkably from 1,370 units in 2000 to 9,936 at the end of Q1 2017. This has also been done by only reinvesting cash flow and new mortgages since the mid-2000s with no new equity (with the exception of options issued in the early 2000s). Mainstreet has actually been buying back a significant number of shares over the past few years (see below) as the Company views itself as being undervalued. Apartment units per million shares (a fun metric we have made up) has grown 148 in 2000, to 513 in 2009 to 1,119 at Q1/17.
Mainstreet seems to renovate very efficiently where they actually have an office in China to buy materials in bulk. The strategy also incorporates technology and methods like clustering of properties to reduce costs (e.g. share maintenance teams and managers across multiple buildings). They seem to be managing operating and G&A costs per unit effectively, but not amazingly, which is just fine.
As with most real estate companies, debt is heavily used but maturities are managed well. There has been a string of recent refinancings continuing the trend of reducing the Company’s average interest rates. “During Q1 2017, the Corporation refinanced $50.1 million of pre-maturity mortgages and incurred pay-out penalties in an aggregate amount of $1.9 million. The refinancing reduced the average interest rate from 5.24% to 2.44% resulting in annualized interest savings of $1.5 million and raised additional low cost capital of $49.5 million after pay-out penalty for further growth of the Corporation.”
Valuation – What is it worth?
We believe that this Company is potentially undervalued because: 1) general concern over western Canada (if it's cheap enough we don’t mind), 2) they do not pay a dividend (we don’t mind if they are investing profitably), and 3) reasonably low liquidity and float (which we don’t mind).
When we are looking at this Company to see if it's undervalued, we have focused on two things: Cash flow per share and NAV per share. The Company is trading at approximately 57% of Q1 2017 net asset value. One could argue that NAV could be overstated but on a cap rate and per unit basis it seems reasonable and also buying below 60% seems to provide decent enough cushion for price decreases / overvaluation issues. Secondly is cash flow. Assuming 2015 cash flow and the current share count, the Company is trading at approximately 10x normalized cash flow (not bad at all). The thought process is that they can get to $3.50 a share through stabilization of existing properties, rents stabilizing in their key Alberta markets, continued asset growth, and other efforts like refinancing debt at lower rates. We are not projecting what cash flow will be next year; we are more focused on the general direction. These things all move cash flow in the right direction.
Of course, do your own due diligence. A few of the things to look out for:
- Lot’s of debt but used consistently over its history with increasing focus on long-term CMHC insured debt.
- Shares frequently “undervalued”.
- Very frequent acquirer/seller making it very difficult to calculate normalized profit/cash flow and creates noise about gains and losses. For example, in 2008 stabilized properties had FFO of $5.84M while non-stabilized properties had a loss of $2.1M.
- Assets now valued at “fair value” since the adoption of IFRS. The cap rate has decreased over time (not exclusive to MEQ) but stabilized and actually increased in 2016 (as it should in a down market).
- Maintenance capex. We have not gotten to the bottom of this.