New England Reality Associates: 50% Appreciation Potential To Fair Value
|August 2, 2013||Posted by Nat Stewart under Cash Flow Stocks, Compounding Machines||
As Stated in New England Reality Associates (NEN) 2012 annual report,
“New England Realty Associates Limited Partnership (“NERA” or the “Partnership”) is engaged in the business of acquiring, developing, holding for investment, operating and selling residential and commercial real estate in the New England region.”
As of the last quarterly report, the company and its subsidiaries own 16 residential apartment buildings, 4 mixed use residential, retail, and office buildings, 3 commercial buildings, and individual condominium units at one condominium complex.” The properties total 2251 apartment units, 19 condominium units, and 110,949 square feet of commercial space. In addition, the partnership owns a 40-50% interest in nine residential and mixed use properties which are consolidated using the equity method on the company’s financial statements.
New England Reality Associates (NEN) is undervalued – Yet there is much more to the story
At a current price of around $42.5 per depositary unit, I believe that New England Reality is trading at a 35% discount to the fair market value of its underlying net assets. As such, a price move to fair value would leave current investors with a +50% gain from recent price levels.
Yet to think of New England Reality as simply a “value” or “net asset” story is to completely miss what a unique and valuable company New England Reality Associates really is. New England Reality Associates has successfully compounded investor wealth at an above-average rate over time and through multiple real estate cycles.
This winning track record did not come about by accident. I believe it is the natural outcome of a great strategy, local market expertise in a solid market, and disciplined operational performance. Fortunately for investors, I believe this favorable situation is just as strong today as it ever has been. Consequently, New England Reality Associates deserves to trade at a premium above net asset value, not at a discount to net asset value.
Opportunity obscured by faulty data
Why do great investments stay hidden? The truth is, it is different in every case. Yet with New England Reality Associates, I think faulty data is partly to blame. For example, Yahoo Finance (Which gets its data from one of the largest institutional data providers) has the market cap for this company at around 5.5 million dollars (See image below). A 5.5 million dollar market capitalization is so small that upon seeing it, the vast majority of investors will simply lose interest. This error occurs because the financial data vendors are counting units outstanding, not depository receipts outstanding, which are what actually trade on the NYSE. (One unit is equal to 30 depository receipts). In reality, New England Reality’s current market cap is about $165 million dollars. Google Finance, which gets its data from another source, actually lists the company as having a negative 10 Trillion dollar market cap – I have no idea how they come to that figure!
New England Reality was formed in 1977, when legendary Boston real estate investor Harold Brown and his business partner (and brother) Ronald Brown successfully bid on the controlling interest in a failed limited partnership that had been in bankruptcy court since 1974. The Browns immediately went to work “righting the ship,” and since that time have been extremely successful in creating value for depository receipt holders.
A winning formula:
How has New England Reality been able to achieve such outstanding results? It comes down to three things: A winning strategy, a good market, and diligent execution.
Strategy – New England Reality Associates:
- Maintains conservative levels of leverage relative to assets and a healthy cash cushion. This helps the company to manage risk through the real estate cycle and has given it the ability to seize opportunities when other operators are stretched thin
- Focuses on properties with steady incomes that can increase over time
- Focuses on “bread and butter” middle income properties, not speculative plays or those with small natural markets (Such as high-end properties)
- Charges just below market rents. This reduces tenant turnover and keeps vacancy levels low relative to the competition. I believe it also generates substantial goodwill with its tenant base
- Capitalizes on local market expertise – New England Reality benefits from a deep bench of managerial and operational talent at Hamilton Reality, the firm that manages its assets.
- Benefits from local network effects – New England Reality Associates has the ability to source potential investments just as they are coming on the market
- Agility – A streamlined decision making process plus the reputation for rapidly closing on deals gives the company a uniquely advantaged framework for investing in Boston area real estate.
A strong market:
The Boston market is unique in many ways. The greater Boston area is one of the nation’s premier intellectual capital hubs where large numbers of medical, technology, and government workers find stable employment. This substantial population of students and middle to upper income professionals live within a relatively constrained space. This dynamic plus strict zoning regulation makes for a tight (and expensive) real estate market. New England Reality’s niche is to provide “bread and butter” affordable, quality housing to the middle income segment of the population.
Running a tight ship
The fruits of New England Reality’s operational efficiency can clearly be seen on the expense side of the income statement.
New England Reality benefits from the economies of scale created by its manager, Hamilton Reality. As can be seen in the above table, since 2009 revenue is up 10%, while controllable operating expenses were up about 1%. (I removed depreciation because it does not reflect an accurate operating expense, taxes and insurance because they are mandatory and not influenced by managerial efficiency, and the management fee of 4% because it is a fee that was contractually set by the original bankruptcy court at 4% of revenue. Today, this 4% fee is a below-market rate).
Locking in low interest rates for the longer term
The partnership has recently been able to refinance a number of its mortgages at very favorable long term interest rates. Let me provide just one example. On March 11, 2013, New England Reality refinanced the mortgage on its School Street property (a 184 unit building) for 10 years at an interest rate of 3.7%. The interest rate on the maturing mortgage was 5.47%, which means that the new mortgage has created a very substantial 177 basis point reduction in interest expense. The partnership plans to finance an additional 47 million in mortgage debt in 2013 – If they are able to do this on terms that are close to what they achieved with the School Street property, this refinancing should prove to be extremely advantageous.
Let’s review two of New England Reality’s recent investments to better understand how this unique firm is able to capitalize on its competitive advantages.
In 2009, New England Reality co-invested (40% ownership) with Harold Brown’s holding company to purchase Dexter Park, a 409 unit apartment complex in Brookline, Massachusetts for $129,500,000. New England Reality invested $15,925,000, $8,757,000 of which was equity. Brookline, Massachusetts, it is one of the greater Boston area’s premier neighborhoods, and Dexter Park’s location within Brookline is considered to be extremely desirable. At the time of the purchase the building was 93% occupied and offering multi-month concessions to tenants. By the time the 2009 annual report was released, the building was 97% occupied and had created a leveraged return in excess of 7%. In today’s market, I believe an extremely desirable building in a nearly unbeatable location such as Dexter Park would be trading at a near 4% cap rate. This would put the Dexter Park properties market value at something close to $200,000,000. This substantially increased value (Do to its 40% economic interest in Dexter Park) is in no way reflected in New England Reality Associates financial statements. In fact, in spite of the substantial cash flow and market price appreciation created by this property, the impact on the income statement is to add to the loss from non-consolidated investments, which in turn reduces book value equity. This is a clear demonstration of how accounting convention can at times be at odds with economic reality. In all, the Dexter Park Investment has proven to be a major coupe for Hamilton and New England reality Associates – It
s bid was chosen over such substantial competition as Equity Residential, the 20B market cap REIT.
Windsor Green Apartments
Windsor Green Apartments is a 193 unit apartment complex located in Andover, Massachusetts and is New England Reality’s most recent acquisition (I learned of it in an 8-K filing that occurred on 6/20/2013). I spoke with Management about this property to better understand how this purchase fit in with the company’s long-standing investment strategy. The key points were (paraphrasing and based upon my notes):
- The partnership was referred to the property through Hamilton’s (the management company’s) extensive broker network
- The property is in an extremely desirable location in a high income area (Wikipedia states that the median family income for Andover, Mass is $138,000)
- A “40B” property – A program that eases zoning requirements if certain affordable housing conditions are met
- Under-rented – On touring and analyzing the property, his team immediately saw ways to increase the property’s income and create value
I think the above illustrates the advantage of investing in real estate through New England Reality Associates. They are not simply buying buildings because real estate is a “hot asset class” or because they have just sold a great number of shares to the public (Which is what occurs at larger, well known REITs). Rather, they are in essence value investors, looking for strong properties where their insights and operating model can create a unique advantage.
I used Google maps to locate the Windsor Green property and to survey the area. I noted that it is just a few miles south of the intersection of Interstate 93 and Route 495, which makes it an extremely convenient location for commuters. I also noted that it is right across the street from a major federal government office complex, and across an intersection from a massive office complex that houses a major federal government contractor. Though my observations are just a cursory view of the area, it does seem to confirm that the Windsor Green apartment complex is in a highly desirable location.
Properties of similar quality to New England Reality’s portfolio are currently trading at a cap rate of around 5%. As such, I believe that by using a .055% cap rate my valuation will contain a margin of safety. I will also be using net operating income from 2012, even though I believe 2013 net operating income (NOI) will be slightly higher. Please study the following table:
As can be seen above, my estimate of net asset value per depository receipt is $65, over 50% above the recent trading price. The “non-consolidated joint-ventures” line requires an explanation. While the existence of New England’s Reality’s joint ventures are clearly stated in the financial statements, their actual value is a bit more difficult to ascertain. As the results are consolidated using the equity method, the joint ventures only appear on a line for “(Loss) from investment in unconsolidated joint ventures” on the income statement (which shows a value of -$1,487,484) and as a book value of $13,986,173 on the Balance sheet.
Below is a valuation of the non-consolidated joint ventures that I believe better reflects New England Reality’s economic interest in these properties. I have attempted to maintain a solid margin of safety in these calculations.
I believe the above demonstrates once again that there is often a significant gap between accounting values and real economic values. The value that has accrued to New England Reality Associates through it’s joint-venture investments is largely invisible to those who only see accounting values.
Between August 20, 2007 and December 31, 2012, New England reality repurchased 1,219,927 depository receipts, which reduced the share count by 24%. These repurchases were made at a highly accretive average price and have had a substantial impact on intrinsic value. The following table demonstrates (all else equal) how these buybacks have added value for continuing shareholders.
- New England Reality is subject to the regular real estate cycles that effect all real estate businesses
- Related party transactions – New England Reality is managed by Hamilton reality, a management firm owned by Harold Brown. The firm also manages Harold’s other (directly or indirectly controlled) properties. The partnership at times also co-invests with Harold’s other partnerships. Related party transactions can at times create conflicts of interest that investors must be aware of
- From an investor perspective, the stock is thinly traded. Investors who (after doing their own due diligence) want to buy should use limit orders and expect for it to take some time to accumulate the desired position
- Taxes are owed in Massachusetts if the investor’s income from New England Reality Associates exceeds a threshold level. Consult Massachusetts law or a tax professional for clarification
I believe that the second risk is the one that requires the most study. After reviewing the company’s financial statements and deal history, I have come to the conclusion that the related party transactions have created substantial benefits for the New England Reality Partnership. On the cost side, the company is able to benefit from the economies of scale of the larger Hamilton organization. On the deal side, the company has been able to co-invest in deals that have proven extremely advantageous (Such as the Dexter park property). The joint investments have substantially expanded New England Reality Associates buying power and expanded its scope of opportunity.
In terms of alignment of interests, the most recent quarterly report states that Harold Brown, his brother Ronald Brown and Carl Valeri, collectively own approximately 40% of the Depositary Receipts representing the Partnership Class A Units (including Depositary Receipts held by trusts
for the benefit of such persons’ family members). This entire investment stake is a result of actual investment – the company has never issued shares as compensation.
While it is easy to view New England Reality Associates through the lens of real estate legend Harold brown’s nearly 60 year real estate career, the truth is that New England reality has a deep bench of talent that will continue to move the company forward far into the future. One example is Carl Valeri, the president and Chief operating officer at Hamilton (the management company) who is responsible for day-to-day operations. Valeri currently oversees acquisitions, development and dispositions as well as major corporate financings. In fact, Valeri proved Instrumental in the Dexter Park purchase, which as outlined above has created a tremendously favorable result for the New England Reality Associates do to its 40% economic interest. Mr. Valeri’s substantial personal stake in Class A units means that he has a substantial interest in the company’s long term performance and that his interests are well aligned with investors.
Over the extended time period that I have followed and studied New England Reality Associates, the more I have learned, the more I have felt it is a unique opportunity. While many investors (upon seeing the discount to net asset value) would suggest that a sale to a larger company (Such as a REIT) would be a quick way to realize shareholder value, I personally hope that this never happens. The truth is, the short term gain from a sale would not make up for the lost benefit that can accrue to investors through the long-term compounding of fundamental values.
My current strategy is to add to my New England Reality position on dips, with a current fair value reference point of $65 per share. If you liked this article and would like to be updated when my next one comes out, sign up for the email list.
* I own shares in New England Reality Associates.
- Information and SEC filings located at New England Reality’s investor site
- Interview with Harold and Ronald Brown at The Wall Street Transcript
- Harold Brown: Octogenarion Comeback Kid – Real Estate BizNow
- Once Burned, twice (not so) shy – The Wall Street Journal
- Boston Landlord Harold Brown Gets Lifetime Achievement Award – Boston Business Journal
- Hamilton Lands Dexter Park Deal for 129.5 Million – The Hamilton Company