BRE PROPERTIES INC BRE S
May 24, 2011 - 6:52pm EST by
agape1095
2011 2012
Price: 48.64 EPS $0.32 $0.00
Shares Out. (in M): 75 P/E 152.0x 0.0x
Market Cap (in $M): 3,669 P/FCF na 0.0x
Net Debt (in $M): 2,013 EBIT 35 0
TEV ($): 5,682 TEV/EBIT 164.5x 0.0x
Borrow Cost: NA

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Description

BRE Properties Inc is a publicly traded REIT that owns, develops, and manages apartment buildings in the western part of the US.  As of FY 2010 year end, it owns 21,318 apartment units, and an 806 units development pipeline.  SF, LA, OC, San Diego and Seattle represent 88% of 2010 revenue.

 

I am recommending a short position in BRE as

1)      Even the "best case" scenario cannot justify the current price of $48.64

2)      The "limited new supply" theme is no longer true

 

Background : What happened in the last 2 years?

The apartment REIT sector has had a stellar rebound from the latest recession.  The Bloomberg US Apartment REIT index has returned more than 125% since March 2009.  The rebound is due to the following factors that are the direct results of the recent credit crisis:

  • Close to zero interest rate has forced investors to chase yield and compressed cap rates (earnings yield of commercial real estate).  Therefore, net asset value (NAV) of all REITs is up.
  • Higher demand - the marginal borrowers that could have qualified for mortgage loans before the crisis but now cannot and the owners who had their houses being foreclosed upon become renters
  • Limited new supply - new developments were halted as the word "construction" became toxic in the commercial real estate world in 2009. 
  • For a brief period in 2009 credit was extremely expensive for real estate companies.  The apartment sector was the exception as the GSEs continue to provide inexpensive financing throughout the crisis in their effort to support the residential real estate market.

 

Earnings model

The business model of BRE is very simple and hence earnings visibility is quite high.  Apartment units are rented for 9 - 12 month terms.  Revenue is determined by occupancy and rent per unit.  Major expenditures are property expense, maintenance capex, corporate G&A and interest expense.

 

In general, BRE's portfolio is of high quality, upper-scale apartment units located in supply-constrained area.  This can be confirmed through Google Map and its operating data.

 

Avg Occupancy

FY 2004

FY 2005

FY 2006

 FY 2007

FY 2008

FY 2009

FY 2010

San Diego

95.0%

95.0%

95.0%

94.0%

94.0%

97.0%

95.4%

San Francisco

94.0%

93.0%

95.0%

95.0%

95.0%

95.0%

92.0%

LA/OC

95.0%

95.0%

94.0%





OC




94.0%

94.0%

95.0%

95.9%

Inland Empire




91.0%

94.0%

95.0%

95.9%

Seattle

94.0%

93.0%

94.0%

94.0%

93.0%

92.0%

93.8%

LA




95.0%

93.0%

96.0%

95.3%

Sacramento

94.0%

95.0%

94.0%

94.0%

91.0%

96.0%

96.4%

Phoenix

95.0%

95.0%

95.0%

93.0%

93.0%

92.0%

95.8%

Salt Lake City

95.0%







Denver

93.0%

92.0%

 

 

 

 


average

94.0%

94.0%

94.0%

94.0%

94.0%

95.0%

94.6%

Source: Form 10K

 

Avg rent/unit

FY 2004

FY 2005

FY 2006

 FY 2007

FY 2008

FY 2009

FY 2010

CAGR

average

1,133

1,191

1,363

1,424

1,528

1,475

1,417

3.80%

yoy growth%


5.12%

14.44%

4.48%

7.30%

-3.47%

-3.93%


Source: Form 10K

 

During that time period, BRE has exited Denver and Salt Lake City, sold assets in Inland Empire, Phoenix and Sacramental.

 

As indicated above, BRE was able to maintain 94% plus occupancy and achieve rent/unit CAGR of 3.8% throughout FY 2004 - 10 through actively managing the portfolio.  These are impressive numbers as the downturn of 08 - 09 is included.

 

Earnings power in best case scenario

Revenue, in a best case scenario, is defined as 100% occupancy.  Assuming $1,500 rent/unit/month (up from $1,417 in FY 2010), 22,124 units (21,318 + 806, assume pipeline is finished and 100% leased), revenue would be $398.2mm.

 

NOI Margin %

FY 2004

FY 2005

FY 2006

FY 2007

FY 2008

FY 2009

FY 2010

avg


67.4%

67.9%

67.9%

69.1%

69.4%

67.3%

66.2%

67.9%

 

capex/unit

FY 2004

FY 2005

FY 2006

 FY 2007

FY 2008

FY 2009

FY 2010

Average


1,602

1,496

2,160

2,126

1,900

1,317

1,368

1,709.96

Source: Form 10K, company supplemental

 

Interest rate%

FY 2004

FY 2005

FY 2006

FY 2007

FY 2008

FY 2009

FY 2010

avg


5.77%

6.15%

6.05%

6.47%

6.09%

5.38%

5.42%

5.93%

Source: Form 10K.  Defined as (preferred dividends + interest expense + capitalized interest) / average (consolidated debt + preferred equity liquidation value)

 

Now, assuming normalized NOI margin of 68%, normalized capex/unit of $1,710, BRE's operating FCF would be $212mm.  ($398.2mm * 68% - $1,710 * 22,124 units - $20m corporate G&A)

 

As of 1Q2011, BRE has $2.02B of interest bearing debt, assuming interest rate stays at the current level of 5.4% indefinitely (which is VERY unlikely) instead of the normalized 5.9%, FCF would be $212mm - $2.02B * 5.4% = $102.5mm, or about $1.36/share (75.44mm common shares/op units outstanding).

 

Valuation

First and foremost, real estate is a cyclical business and over the long term should track inflation.  Prime real estate in supply-constrained areas should be able to grow earnings at 1 or 2% above inflation.  For margin of safety, let's assume BRE can grow FCF/share indefinitely at 5%/year.  I believe a debt-free business with 5% earnings growth is fairly valued at 20x multiple. 

*Unconsolidated JV earns less than $0.1/share so it's immaterial.

 

BRE is highly indebted.  Its debt/best case operating FCF is $2,020/212 = 9.5x.  At $48.6, BRE is trading at 35.7x best case earnings.  Said differently, Mr Market is offering two AAA-rated companies - JNJ & MSFT - at 1/3rd of the multiple of BRE.  I believe BRE is over-valued even at $27.2/share.

 

Catalyst

BRE has traded and stayed above $27 since Nov 2009.  Apartment rental rates and occupancy have been driven up in FY 2009 & 2010 due to higher demand and limited supply.  As the economy improves and house prices goes down, homeownership should go up that would lead to lower rental demand.  However, this is at least several years away.  So one can reasonably ask - why short now? 

 

The answer is the limited supply story has broken.  Please see below:

 

"Our fourth quarter results also showed another period of significant investment activity. We completed almost $500 million in development. We started construction on five new communities with a total capital cost of about $300 million...."

 

"our business plan calls for a significant increase in investment activity with overall investment levels up around 25% from 2010. We expect to start around 850 million in new development this year. Combined with 650 million in starts last year we'll have around 1.4 billion under construction by the end of this year, a level consistent with that experienced in 2005 and 2006 or during the middle of the last cycle."

AVB 4Q2010 earnings call

 

"With rents now increasing, we are pursuing development deals in several West Coast markets underwritten based on today's rents, development cap rates range from 5.5% to 6.25% or six and three-quarters, 7.5% upon stabilization..."

 

"Mike, one of your comments, I'm not sure I'm going to paraphrase it correctly, but you made it seem like you expect the development to come back fairly quickly like you did in last cycle, and that you were tracking  new development projects as a result, is that right?"

 

<A - Michael J. Schall>: That's exactly right. I mean, one of -- I thought there was commentary or question from one of the analysts in some of the other calls had talked about ...

ESS 1Q2011 earnings call

 

"we are commencing the development of a new community in Austin, Texas. Doing so, we are taking advantage of low construction pricing to put existing land into production at the leading edge of a new apartment cycle. Development will be our primary capital investment activity this year."

 

"There is development activity here and there, but it hasn't ramped up significantly. And bankers will take - they're interested in lending more than they were, but it's still relatively slow.  Now, my expectation is that development is going to ramp up as the fundamental picture continues to get better."

PPS 4Q2010 earnings call

 

Conclusion

Once the market realizes the supply of apartments are accelerating, BRE's multiple would contract.  

Catalyst

 The accelerating supply
    sort by   Expand   New

    Description

    BRE Properties Inc is a publicly traded REIT that owns, develops, and manages apartment buildings in the western part of the US.  As of FY 2010 year end, it owns 21,318 apartment units, and an 806 units development pipeline.  SF, LA, OC, San Diego and Seattle represent 88% of 2010 revenue.

     

    I am recommending a short position in BRE as

    1)      Even the "best case" scenario cannot justify the current price of $48.64

    2)      The "limited new supply" theme is no longer true

     

    Background : What happened in the last 2 years?

    The apartment REIT sector has had a stellar rebound from the latest recession.  The Bloomberg US Apartment REIT index has returned more than 125% since March 2009.  The rebound is due to the following factors that are the direct results of the recent credit crisis:

    • Close to zero interest rate has forced investors to chase yield and compressed cap rates (earnings yield of commercial real estate).  Therefore, net asset value (NAV) of all REITs is up.
    • Higher demand - the marginal borrowers that could have qualified for mortgage loans before the crisis but now cannot and the owners who had their houses being foreclosed upon become renters
    • Limited new supply - new developments were halted as the word "construction" became toxic in the commercial real estate world in 2009. 
    • For a brief period in 2009 credit was extremely expensive for real estate companies.  The apartment sector was the exception as the GSEs continue to provide inexpensive financing throughout the crisis in their effort to support the residential real estate market.

     

    Earnings model

    The business model of BRE is very simple and hence earnings visibility is quite high.  Apartment units are rented for 9 - 12 month terms.  Revenue is determined by occupancy and rent per unit.  Major expenditures are property expense, maintenance capex, corporate G&A and interest expense.

     

    In general, BRE's portfolio is of high quality, upper-scale apartment units located in supply-constrained area.  This can be confirmed through Google Map and its operating data.

     

    Avg Occupancy

    FY 2004

    FY 2005

    FY 2006

     FY 2007

    FY 2008

    FY 2009

    FY 2010

    San Diego

    95.0%

    95.0%

    95.0%

    94.0%

    94.0%

    97.0%

    95.4%

    San Francisco

    94.0%

    93.0%

    95.0%

    95.0%

    95.0%

    95.0%

    92.0%

    LA/OC

    95.0%

    95.0%

    94.0%





    OC




    94.0%

    94.0%

    95.0%

    95.9%

    Inland Empire




    91.0%

    94.0%

    95.0%

    95.9%

    Seattle

    94.0%

    93.0%

    94.0%

    94.0%

    93.0%

    92.0%

    93.8%

    LA




    95.0%

    93.0%

    96.0%

    95.3%

    Sacramento

    94.0%

    95.0%

    94.0%

    94.0%

    91.0%

    96.0%

    96.4%

    Phoenix

    95.0%

    95.0%

    95.0%

    93.0%

    93.0%

    92.0%

    95.8%

    Salt Lake City

    95.0%







    Denver

    93.0%

    92.0%

     

     

     

     


    average

    94.0%

    94.0%

    94.0%

    94.0%

    94.0%

    95.0%

    94.6%

    Source: Form 10K

     

    Avg rent/unit

    FY 2004

    FY 2005

    FY 2006

     FY 2007

    FY 2008

    FY 2009

    FY 2010

    CAGR

    average

    1,133

    1,191

    1,363

    1,424

    1,528

    1,475

    1,417

    3.80%

    yoy growth%


    5.12%

    14.44%

    4.48%

    7.30%

    -3.47%

    -3.93%


    Source: Form 10K

     

    During that time period, BRE has exited Denver and Salt Lake City, sold assets in Inland Empire, Phoenix and Sacramental.

     

    As indicated above, BRE was able to maintain 94% plus occupancy and achieve rent/unit CAGR of 3.8% throughout FY 2004 - 10 through actively managing the portfolio.  These are impressive numbers as the downturn of 08 - 09 is included.

     

    Earnings power in best case scenario

    Revenue, in a best case scenario, is defined as 100% occupancy.  Assuming $1,500 rent/unit/month (up from $1,417 in FY 2010), 22,124 units (21,318 + 806, assume pipeline is finished and 100% leased), revenue would be $398.2mm.

     

    NOI Margin %

    FY 2004

    FY 2005

    FY 2006

    FY 2007

    FY 2008

    FY 2009

    FY 2010

    avg


    67.4%

    67.9%

    67.9%

    69.1%

    69.4%

    67.3%

    66.2%

    67.9%

     

    capex/unit

    FY 2004

    FY 2005

    FY 2006

     FY 2007

    FY 2008

    FY 2009

    FY 2010

    Average


    1,602

    1,496

    2,160

    2,126

    1,900

    1,317

    1,368

    1,709.96

    Source: Form 10K, company supplemental

     

    Interest rate%

    FY 2004

    FY 2005

    FY 2006

    FY 2007

    FY 2008

    FY 2009

    FY 2010

    avg


    5.77%

    6.15%

    6.05%

    6.47%

    6.09%

    5.38%

    5.42%

    5.93%

    Source: Form 10K.  Defined as (preferred dividends + interest expense + capitalized interest) / average (consolidated debt + preferred equity liquidation value)

     

    Now, assuming normalized NOI margin of 68%, normalized capex/unit of $1,710, BRE's operating FCF would be $212mm.  ($398.2mm * 68% - $1,710 * 22,124 units - $20m corporate G&A)

     

    As of 1Q2011, BRE has $2.02B of interest bearing debt, assuming interest rate stays at the current level of 5.4% indefinitely (which is VERY unlikely) instead of the normalized 5.9%, FCF would be $212mm - $2.02B * 5.4% = $102.5mm, or about $1.36/share (75.44mm common shares/op units outstanding).

     

    Valuation

    First and foremost, real estate is a cyclical business and over the long term should track inflation.  Prime real estate in supply-constrained areas should be able to grow earnings at 1 or 2% above inflation.  For margin of safety, let's assume BRE can grow FCF/share indefinitely at 5%/year.  I believe a debt-free business with 5% earnings growth is fairly valued at 20x multiple. 

    *Unconsolidated JV earns less than $0.1/share so it's immaterial.

     

    BRE is highly indebted.  Its debt/best case operating FCF is $2,020/212 = 9.5x.  At $48.6, BRE is trading at 35.7x best case earnings.  Said differently, Mr Market is offering two AAA-rated companies - JNJ & MSFT - at 1/3rd of the multiple of BRE.  I believe BRE is over-valued even at $27.2/share.

     

    Catalyst

    BRE has traded and stayed above $27 since Nov 2009.  Apartment rental rates and occupancy have been driven up in FY 2009 & 2010 due to higher demand and limited supply.  As the economy improves and house prices goes down, homeownership should go up that would lead to lower rental demand.  However, this is at least several years away.  So one can reasonably ask - why short now? 

     

    The answer is the limited supply story has broken.  Please see below:

     

    "Our fourth quarter results also showed another period of significant investment activity. We completed almost $500 million in development. We started construction on five new communities with a total capital cost of about $300 million...."

     

    "our business plan calls for a significant increase in investment activity with overall investment levels up around 25% from 2010. We expect to start around 850 million in new development this year. Combined with 650 million in starts last year we'll have around 1.4 billion under construction by the end of this year, a level consistent with that experienced in 2005 and 2006 or during the middle of the last cycle."

    AVB 4Q2010 earnings call

     

    "With rents now increasing, we are pursuing development deals in several West Coast markets underwritten based on today's rents, development cap rates range from 5.5% to 6.25% or six and three-quarters, 7.5% upon stabilization..."

     

    "Mike, one of your comments, I'm not sure I'm going to paraphrase it correctly, but you made it seem like you expect the development to come back fairly quickly like you did in last cycle, and that you were tracking  new development projects as a result, is that right?"

     

    <A - Michael J. Schall>: That's exactly right. I mean, one of -- I thought there was commentary or question from one of the analysts in some of the other calls had talked about ...

    ESS 1Q2011 earnings call

     

    "we are commencing the development of a new community in Austin, Texas. Doing so, we are taking advantage of low construction pricing to put existing land into production at the leading edge of a new apartment cycle. Development will be our primary capital investment activity this year."

     

    "There is development activity here and there, but it hasn't ramped up significantly. And bankers will take - they're interested in lending more than they were, but it's still relatively slow.  Now, my expectation is that development is going to ramp up as the fundamental picture continues to get better."

    PPS 4Q2010 earnings call

     

    Conclusion

    Once the market realizes the supply of apartments are accelerating, BRE's multiple would contract.  

    Catalyst

     The accelerating supply

    Messages


    SubjectPipeline and NOI
    Entry05/24/2011 11:19 PM
    Memberthrive25
    Thanks for the writeup.  A couple questions:
     
    1) Do the 806 units that you included in your fully ramped NOI with included 806 units of pipeline represent the 1.4 billion that management commented as being in development?
     
    2) What is the effective blended cap rate implied by the EV?  Am I doing the math correctly in that you are estimating NOI to be ~$270 / 5680 = 4.5% forward cap rate?  Just for clarification....
     
    3) While I definitely agree on the increasing supply story, there is no denying there is also a strong increasing demand story that might become structural, no?  Yes, home affordability is increasing month after month; but it seems we are living through an unprecedented phenomenon in which home-ownership is shunned due to a long list of reasons, not least the fact that we are all still psychologically hurt by the credit crisis.  In reality the buy / rent relationship is actually just reverting to its long term trend of the last 30 - 40 years (the housing bubble being the aberration) There have been a number of stories in the media recently on the so-called "rental economy" we are in.  
     
    So, while I agree that supply coming online might keep rental rates in check, there is reason to believe these developments actually do ramp up in a healthy manner in terms of occupancy and make them good investments.
     
    4) I agree that the valuation is not warranted regardless of their success in new developments.  But I don't see the specific catalyst that would dissapoint investors and make the multiple come down.  What is embedded in investors expectations that would dissapoint in, say, the next year or two?  Is the stock pricing in a dramatic rise in rental rates that won't occur?
     
    It does seem like a good short idea; just would like to see a harder catalyst....

    SubjectRE: Pipeline and NOI
    Entry05/25/2011 09:50 AM
    Memberagape1095
    1) The 806 units represents Lawrence Station and Wilshire La Brea.  The other ones (Walnut Creek, Park Viridian II etc) are still in early stage.
     
    2) I would include the capex in the cap rate calculation.  So it is ($270.3 - 37.8)/ 5680 = 4.1%.
     
    3) I agree with you.  The demand side of the equation is at least several years away for the shorts and over the LT these developments are good.  However, since REITs cannot retain earnings, they have to fund the pipelines by new capital (debt or equity or both).  So part of the incremental FCF from developments will be diluted away.
     
    4) Per Bloomberg, the sell-side concensus is 30% and 10% FFO/share growth in FY 2011E and 2012E. I believe any buyer at this multiple is expecting earnings growth of 8% at least.  All it takes for the multiple to contract is when investors realize that every publicly traded apartment REIT is accelerating its pipeline (private RE companies are doing the same btw) and the expected earnings growth (especially the 2012 numbers) just woudn't be there.

    SubjectBloomberg article
    Entry05/31/2011 03:42 PM
    Memberagape1095
    http://www.bloomberg.com/news/2011-05-30/rising-rents-risk-higher-u-s-inflation-as-fed-s-rate-restraint-questioned.html

    The boon for landlords is a burden for residents like Alexander Shevlyagin, a 25-year-old Seattle computer-software manager, who said he was shocked to learn his rent is rising to $1,305 a month from $935 and his free parking space will cost $100.

    "My building manager told me, 'Hey, we're almost at full occupancy,'" Shevlyagin said. "He said he signed the same place I have on a different floor for the new rates, so someone thinks that this is reasonable. Knowing what I'm paying right now, I don't consider it reasonable."

    The quote from the article sums up the current situation.  Rents, occupancy and NOI are going through the roof right now.  Stock prices imply this would go on forever.  I believe this kind of rent growth won't be sustainable, not when everyone is developing.


    SubjectRE: Bloomberg article
    Entry05/31/2011 07:36 PM
    Membercreditguy
    I think you underestimate how hard it is to develop in infill coastal markets.  You have got all of the fundamentals working against you.   I think valuation shorts absent a catalyst are very dangerous.  They generally never end well.   Look at Green Mountain as an example.

    SubjectRE: RE: Bloomberg article
    Entry06/01/2011 09:49 AM
    Memberagape1095
    I agree with you that development is hard (define as costly) but defintely do-able.  If you look at the compare the 1Q10 vs 1Q11 pipeline of the coastal REITs (AVB and ESS), you can see they are definitely ramping it up.  
     
    On the other hand, I don't think that rent rates need to decline or stay flat for BRE's multiple to break.  My sanity check is, when that $1305/month lease expire in 2012, how much will it cost to renew?  While I don't have a crystal ball, given what I know today, I don't think it will go up another 40%.  I believe the renewal rate would be closer to $1400 rather than $1800.  BRE has been in these coastal market for some time, CAGR of rents is 1 or 2% above inflation at best.
     
     

    SubjectRE: RE: RE: Bloomberg article
    Entry06/01/2011 11:08 AM
    Membercreditguy
    Your statement that BRE is heavily leveraged is patently absurd.  In fact is it conservatively levarged.  A debt yield of close to 10% is actually very high.  Clearly debt investors disagree with you -- their unsecured bonds yielding about 4.5% or 175 bsp over treasuries.

    SubjectRE: RE: RE: RE: Bloomberg article
    Entry06/01/2011 04:08 PM
    Memberagape1095
    You are looking at leverage from a bondholder's perspective.  Can you explain, how BRE is "conservatively leveraged" from an equity holder perspective?
     
    Here is why I think BRE is highly leverage.
     
    After retiring the series C preferred, BRE has $1.9B of debt outstanding.  So that's about 9x best case operating income of $212mm.  Now, unlike most companies, not all of that earnings can be used to pay down debt because BRE is a REIT, so it has to paid out most of its earnings as dividends.  Therefore, to repay its debt without issuing new equity would actually take A LOT longer than 9 years.
     
    In summary, BRE is debt/operating income = 9x and it has limited abililty to retain earnings.  I guess you can say it's relatively low leverage if you compare it to the banks...
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