Canadian Apartment REIT: 3.5% dividend yield with residential real estate (TSX:CAR.UN:CA)

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Blackbook

Introduction

About 13 months ago I argued that it was time to sell Canadian Apartment Properties REIT (OTC:CDPYF) (CAR.UN:CA) as it was an easy decision to make. Today, just over 13 months later, the share price of Canadian Apartment REIT fell from over C$61/share to just over C$40/share, a drop of over 33%. This rekindled my interest, not least because the dividend yield rose again to a more acceptable level of 3.5%.

Chart
Data by YCharts

The US listing of Canadian Apartment REIT has an average daily volume of just over 1,000 shares. The Canadian listing, where Canadian Apartment REIT trades with CAR.UN as its ticker symbol on the Toronto Stock Exchange, is much more liquid with an average daily volume of over 450,000 shares per day. The Canadian listing is clearly the best option here as the liquidity is superior.

FFO and AFFO results remain strong

One of the most important measures of an REIT is obviously the FFO and AFFO. Canadian Apartment REIT publishes FFO and NFFO, Standard Operating Fund, which is similar to AFFO as we know it.

And when we look at CAR.UN’s financial results, we see that the REIT has virtually come to a standstill, because although total FFO has increased, the increase in the number of shares also means that the performance per share does not hasn’t really improved much. Last year. As you can see below, CAR.UN reported a total FFO of around C$100 million in the second quarter of this year and while that’s a pretty nice 2.5% increase compared to the second quarter of 2021, FFO per unit increased by only 1% to C$0.569. Given the performance of the S1:

FFO calculation

CAR Investor Relations

Fortunately, NFFO performance seems better. As you can see below, the REIT generated nearly C$103 million of NFFO during the second quarter, which was approximately C$0.585 per unit, an increase of approximately 1%. (which is slightly higher than the increase in FFO per share).

Calculation of NFFO

CAR Investor Relations

The total payout ratio based on the NFFO was slightly lower at 62%, as CAR.UN pays a dividend of C$1.45/share on an annual basis (divided into twelve equal monthly installments). The image above also shows the “effective payout ratio NFFO”. This ratio is lower than the 61.9% of the second quarter, as it takes into account the stock dividend. Some of the shareholders choose to receive their monthly dividends in new shares, which obviously reduces the net cash outflow.

Asset Allocation

CAR Investor Relations

A look at the balance sheet: Expect manageable headwinds

Issuing shares through the dividend program also helps the balance sheet as it allows Canadian Apartment REIT to keep a substantial portion of its NFFO on the balance sheet. As shown in the image above, CAR was able to keep over C$113.3 million in cash on its balance sheet. Although it declared over C$127 million in distributions, only C$87.2 million was paid out in cash and the remaining C$40 million was covered by issuing new shares.

This is positive for the balance sheet as it allows CAR to conserve cash, but as the share price has started to decline, CAR has also started to buy back shares and the net number of shares has actually decreased at the first semester.

Evolution of the number of shares

CAR Investor Relations

A buyback program makes sense if it creates value and if a company can afford it. Canadian Apartment can certainly afford it, as its balance sheet shows approximately C$6.6 billion in net debt based on a total of over C$17 billion in properties and other long-term investments. This means that the debt ratio is less than 40%.

Debt evolution

CAR Investor Relations

The main question now is obviously also how reliable the book value of the properties is, because this value is important for two reasons: is buying back one’s own shares indeed a good idea, and to what extent is the ratio Is LTV below 40% reliable?

First, let’s look at the official NAV/share, which has gone from nearly C$60/share at the end of last year to just over C$56.6 at the end of June.

Net Asset Value Calculation

CAR Investor Relations

Why is that? Car CAR had to register a valuation reduction of C$466 million on its investment properties during the second quarter. As interest rates rise again, the capitalization rate of real estate assets also rises and as rental increases occur at a slower pace and with some delay, an increase in capitalization rates causes an immediate decline in value .

As you can see below, “fee simple interest,” which makes up the vast majority of assets, saw its cap rate drop from 3.57% to 3.75%. And this increase of 18 basis points resulted in a loss of several hundred million on the fair value of these assets.

Evolution of the capitalization rate

CAR Investor Relations

And the situation could actually get worse. CAP REIT provided sensitivity analysis. As you can see below, a 0.50% increase in the cap rate (which is still quite low, as it would for example allow assets to be valued at a cap rate of only 4.25%) will reduce the asset value of approximately C$2 billion. . Raising the rent will help because a simultaneous 2% increase will reduce the loss in fair value to “only” C$1.67 billion.

Sensitivity analysis

CAR Investor Relations

Personally, I think cap rates will go up a lot more than 0.5% and I think we’re heading towards a 5% cap rate for residential real estate, but I also think the net operating income of the RCA will also increase by more than 2%% because it can gradually increase the rent.

If I assume a 125 basis point increase in the cap rate and a corresponding 10% increase in the NOI, I expect about C$3.3 billion in book value to “evaporate”. This will not happen overnight and the process could be halted by a stabilization of interest rates in the financial markets, but I think it is fair to expect further reductions in book value.

This would not necessarily put Canadian Apartment REIT in a difficult situation. While the book value would drop by around C$20/share, the “new” book value of around C$35-37/share is only 10% lower than the current stock price, so the market already appears to be taking further blows to net asset value. into account.

I also don’t think the LTV ratio will become a major issue. In the scenario described above, the LTV ratio would increase to around 48%. And keep in mind that the REIT keeps more than C$200 million in cash a year on its balance sheet by maintaining a conservative payout ratio and offering a stock dividend.

Debt Level History

CAR Investor Relations

Investment thesis

I am not interested in CAR due to its discount to its NAV, as I believe the NAV will continue to decline over the next six quarters. I think the current share price of around C$40 is fair enough for a REIT to adjust to the new interest rate normal. I think the dividend is safe and the balance sheet is also safe, but the net asset value/share of nearly C$57/share will almost certainly drop.

Author rating history

Looking for Alpha

Looking back, my entry point and exit point were well timed, and while I think CAR.UN isn’t out of the woods yet, I’m slowly getting slightly bullish again. That’s not to say I’m going to run out and buy the stock right away, but I’m considering canceling the silver put options. The P35 from March 2023, for example, can be sold for C$1.20 while a P40 from December 2022 can be sold for C$1.80.

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