Description

Brookfield Real Estate Services Fund (which I will refer to as the "Fund") is a Canadian income trust that trades for 8.8x LTM fully taxed free cash flow, and that has a current annualized distribution yield of 11.4%.

Income trusts distribute cash to investors on a corporate-tax-free basis, similar to MLPs and REITs. Canadian income trusts will lose their tax-advantaged status in 2011, which in many cases will precipitate a change in corporate structure.

I will argue 3 points. First, the Fund's business is attractive and has good long-term growth prospects. Second, as a result of the tax on Canadian income trusts that will become effective on January 1, 2011, the Fund is likely to undergo a corporate restructuring, which could unlock value. Third, the Fund's units (shares) are significantly undervalued at today's price of $12.25.

BUSINESS DESCRIPTION
The Fund is the franchisor of three leading residential real estate brokerage brands in Canada: Royal LePage, Johnston & Daniel, and La Capitale. Royal LePage is by far the most significant, representing 90% of the nearly 15,000 agents in the Fund's network. Franchisees are predominantly small brokerages that pay fees for the right to operate under the Royal LePage brand and to receive marketing and technology support.

Residential real estate brokerage is a good business for firms with well-respected brands and high market shares. Because buying or selling a home is one of the most important transactions people undertake in their lifetimes, it is highly advantageous to be perceived as trustworthy and authoritative when competing for the role as the broker of such transactions. Respected, well-known brokerage brands are afforded a competitive advantage in attracting high-quality agents, who in turn have an edge in attracting customers. There are also advantages to scale, because large brokerage firms can spread office rent, advertising costs, and technology investments over a greater number of agents and transactions. As a result, in both the US and Canada, there is a limited number of enduring, national residential real estate brands (such as RE/MAX, Century 21, Coldwell Banker, etc.), which over time have taken market share from the thousands of regional and local competitors.

Royal LePage is nearly 100 years old and is one of the most venerable residential real estate brands in Canada. Over the past decade, Royal LePage has steadily taken market share and now possesses over 20% of the market, measured by transaction dollar volume. The only other national competitor in Canada is RE/MAX, which has a slightly higher market share.

A key indicator of a brand's strength is the productivity of its agents. Royal LePage agents have enjoyed above-average productivity (measured by transaction dollar volume) since the early 1990s. The gap has widened over time, and most recently Royal LePage agents were 69% more productive than the industry average. Johnston & Daniel (a sub-brand of Royal LePage) has a niche brokering high-end transactions in affluent Toronto neighborhoods. La Capitale, which the Fund acquired in 2009, is a leading Francophone brand and has had industry-leading transactions per agent for the past 5 years.

CONSERVATIVE ECONOMIC STRUCTURE
The Fund's revenue consists of royalties collected from its franchisees. The royalty structure is designed to mitigate the volatility of the residential real estate market. The majority (currently, 69%) of the Fund's royalties are derived from flat per-agent fees. Such fees are referred to as "fixed" because they vary with the number of agents, rather than with their commissions, which are affected by the number of transactions and by home prices. Excluding the benefits from acquisitions, the Fund's royalties declined by only 2.5% in 2008. By contrast, overall industry commissions were down 17% that year.

The Fund incurs administrative costs, most of which are management fees paid to an entity called Brookfield Real Estate Services Limited (the "Manager"), which manages the operating business that generates the royalties collected by the Fund. The Manager is a wholly owned subsidiary of the large investment firm Brookfield Asset Management and is discussed later.

The Fund's EBITDA margins are about 80%. Intangibles amortization does not represent an economic cost, and because the Fund employs no tangible capital, there is no depreciation or capex. Therefore, EBITDA is a proxy for pretax cash flow.

The Fund's cost structure is almost entirely variable, because management fees are defined as a percentage of royalties (20% of royalties for Royal LePage and 30% for La Capitale). The table below is an abbreviated income statement for the last twelve months (LTM):

($CAD millions)
Royalties                      33.6
Administrative costs       0.8
Management fees         6.2
EBITDA                        26.6
Interest expense          3.2

The Fund has debt, but the stability of its royalties and the variability of its cost structure render the associated risk minimal, in my view. In addition to a $14 million term facility, the Fund has $38 million of 5.882% fixed-rate debt due in February 2010, with certain covenants.  From the recessionary base of the last twelve months, royalties would have to decline by 15% to approach the maximum debt / EBITDA covenant of 2.25x, and would have to decline by over 35% to approach the minimum EBITDA / interest expense covenant of 5.00x. This far exceeds the relatively minor declines experienced during the difficult conditions of the past 2 years.

It is also important to understand that the Canadian housing market is much healthier than the US housing market, primarily as a result of the former's responsible financing practices. A large majority of Canadian mortgage loans are made by major banks and are held on their balance sheets. In Canada (unlike the US), in the event of default lenders have the ability to pursue personal assets and to garnish wages if there is a deficiency after the sale of the property. Mortgage interest payments are not tax-deductible in Canada, removing the incentive that exists in the US for homeowners to delay repayment of principal or to over-leverage. All of these factors promote responsible lending, borrowing, and repayment behavior. There is virtually no subprime mortgage market in Canada. Mortgage delinquency rates have been much lower in Canada than in the US, both historically and recently. The peak mortgage delinquency rate in Canada occurred during the early-1990s downturn and was 0.64%.  In 2009, Canadian delinquency rates remain below 0.50%, compared to over 8% in the US.

GROWTH
The Fund's business has good long-term growth prospects. The agent count, and therefore revenue, should continue to increase organically at a mid-single-digit annual rate. This growth should be driven both by overall market expansion, and by market share gains, which have persisted for more than a decade. The Fund invests no capital to achieve organic growth, so free cash flow should increase at a pace similar to that of revenue.

The Fund also has an acquisition program, which is explained below. From the 2003 IPO through 2007, the Fund made monthly distributions equal to 70-80% of free cash flow to unit holders and used the balance for acquisitions.

RELATIONSHIP WITH THE MANAGER
The Fund has no employees. The operating business that generates the royalties collected by the Fund is managed by an entity called Brookfield Real Estate Services Limited (which I will refer to as the "Manager"). The Manager does not participate in the royalties (100% of the royalties flow to the Fund), but instead is compensated for its services to the Fund by management fees, as mentioned before.

A large portion of the Manager's mandate is to find additional franchise contracts for acquisition by the Fund. In most cases, the Manager itself enters into the contract, and then presents it to the Fund's Board of Trustees (which represents the interests of the unit holders) for evaluation. If the Fund chooses to acquire a contract from the Manager, the purchase price is determined by a formula.

The formula begins with the annual free cash flow the franchise is expected to generate for the Fund (equal to royalties less management fees paid to the Manager), modestly discounts that figure, and capitalizes it as no-growth perpetuity. The capitalization rate is determined by the Fund's average distribution yield over the year preceding the date of acquisition. For example, assume a Royal LePage franchise is expected to generate $1 million of free cash flow annually for the Fund, and that the average distribution yield on the Fund's units was 10% over the past year. The acquisition price would be: $1 million, discounted by 7.5% = $925,000, divided by 10% = $9.25 million.

There is an underlying logic to this arrangement, but it is clearly not ideal. The Manager benefits from the increase in management fees that results from the Fund's acquisitions. However, the Manager also benefits from a high unit trading price, because a higher unit price implies a lower distribution yield, which produces a higher acquisition price for franchise contracts sold to the Fund by the Manager. This dynamic serves as an incentive for the Manager to manage the Fund for the benefit of unit holders.

On the other hand, the arrangement is convoluted and somewhat opaque. The corporate divide between the Fund and the Manager necessitates the two-step acquisition process, which in theory could be collapsed. The associated purchase price formula is, in part, irrational, because a key input is the units' distribution yield, which itself is not necessarily rational (more about this later). Nor is the units' distribution yield necessarily related to the economic value of the franchises being priced by the formula. Moreover, neither the profitability nor the financial health of the Manager is disclosed.

CORPORATE RESTRUCTURING
As mentioned before, the Manager is a wholly owned subsidiary of Brookfield Asset Management (BAM). BAM is a respected, value-oriented investment firm with $80 billion in assets under management. Royal LePage had been wholly owned by BAM prior to the Fund's IPO. In 2003, BAM sold 75% of the Fund to the public and held onto the balance, which it still owns. At the time, the income trust structure-and in particular the royalty income trust with an external manager-was very popular. However, the structure ceased to be practical in late 2006, when a 29.5% tax on income trusts was announced, effective January 1, 2011.

There are at least 3 reasons it would be advantageous for the Manager to restructure the fund:

• The income trust structure makes various legal, investor relations, and capital raising functions more difficult than for corporations, but will provide no advantage once the tax is imposed.
• Numerous benefits would ensue from the Fund and the Manger being collapsed into one entity. There would be no need for a two-step acquisition process. The extra administrative hassle and the need for an irrational purchase price formula would be eliminated, as would real or perceived misalignments of incentives. Operationally, the Manager could introduce lower margin fee-generating services that do not make sense under the current arrangement, in which the Manager is paid a fixed percentage of royalties.
• I believe the Manager has been disadvantaged by the acquisition price formula because of the historical and present cheapness of the Fund's units. Since the IPO, the Fund's distribution yield generally has been greater than 8% and, for much of the time, has been in the double digits. The units' free cash flow yields have been even higher-in the low-to-mid-teens-because free cash flow has exceed distributions by 1/3 on average. In conversation, management is open about having initially expected higher unit prices and the attendant lower yields. One consequence of the unexpectedly high yields is that the acquisition price formula has produced lower-than-expected results, which have created bargains for the Fund. For instance, based on today's distribution yield of 11.4%, the Fund can purchase a Royal LePage franchise contract from the Manager for 8x free cash flow. Although the Manager is required by its agreement with the Fund to present suitable franchise contracts for acquisition, from an economic perspective the Manager would be better off retaining the contracts for itself, in my view, given today's unit price. If this is true, then it is another incentive for the Manager to restructure its relationship with the Fund.

The CEO, Philip Soper, has publicly hinted at a combination with other BAM companies that are in related businesses. Here is his answer to a question on the 3Q09 earnings conference call about the plans for the Fund after 2011:

In broad terms we could continue as a trust as is. Obviously, there are additional costs both to the public company and in the administration of a business, without obvious benefits. Certainly I don't think there will be too many people in general businesses setting up this kind of trust structure if they had to pay the same tax as a corporation.

...The fact remains though that we're in an industry with very long-term contracts, with a long history of providing services and stable growth. So the underlying business hasn't changed, and I think we'll find a capital structure that's a good fit for the business that way.

I should add, and we have talked about this previously, the Manager is engaged in other activities surrounding the residential real estate transaction. It's certainly widely known-it's not part of the Fund today, I stress that-we have the second largest relocation company in the world that provides mobility services to corporations and governments around the world. And we're Canada's largest provider of residential real estate settlement services, predominantly appraisal services. So we have a very strong offering in that space. Not part of the Fund but they're very closely related businesses, and it's worth noting that.

The two companies he is referring to are Brookfield Global Relocation Services (BGRS) and Centract. Both are wholly owned by BAM, operate out of the same office building as the Manager in Toronto, share a CFO with the Manager, and are considered within BAM as "sister companies" of the Manager. (It is interesting that Soper referred to the Manager as being in these other businesses. This was actually a misstatement, because the sister companies are currently distinct corporate entities. But it does appear to indicate the closeness the three companies are perceived to have by insiders.)

In my view, there are three likely outcomes for the Fund. Either:

• it will be privatized by BAM;
• it will be combined with the other sister companies in a publicly traded entity;
• it will be converted to a corporation and remain an independent, publicly traded entity.

I think the most significant risk in this investment is the possibility of a bad deal for unit holders, but there are a few mitigating factors. BAM's business model revolves around collaboration with its co-investors. The company has built an excellent reputation, and I believe it would be unlikely to risk that reputation by bilking the Fund's unit holders. Moreover, BAM itself owns 25% of the Fund. Any transaction would require the approval of the Board of Trustees, which represents the interests of the unit holders. There are 5 Trustees, of whom 4 are independent of BAM, though none has significant unit ownership. A final factor that mitigates the possibility of a bad deal for unit holders is the cheapness of the units at today's price.

VALUATION
The Fund's units trade for 8.8x LTM P/FCF, calculated on a fully taxed basis.

(CAD $000)
Unit price                                                         $12.25
Units outstanding                                             12,812
Market cap                                                       $156,941
Less: Cash                                                       $3,902
Less: 2010 tax shield                                       $4,200
Less: Tax shield from intangibles amortization     $8,500
Plus: Debt                                                        $52,864
Enterprise value                                                                $193,203
Adjusted market cap (mkt cap - tax shields)           $144,241

FCF to equity, LTM fully taxed                             $16,500
FCF to enterprise, LTM fully taxed                                $18,700

P / FCF                                                                               8.8x
EV / FCF                                                                            10.3x
Current annualized distribution yield                        11.4%

The tax shields are worth clarifying. The above multiples are based on fully taxed free cash flow, despite the fact that the Fund will not be required to pay taxes until 2011. "2010 tax shield" represents the present value of the estimated taxes the Fund will not pay in 2010, assuming no EBIT growth and a 10% discount rate. "Tax shield from intangibles amortization" represents $79 million of deductible amortization, which will shield future taxes. These deductions do not expire, but only 7% of the balance can used each year. I estimate the present value to be about $8.5 million, using a 10% discount rate.

The following table shows the unit prices implied by various P/FCF multiples. I believe a mid-teens multiple of fully taxed FCF is appropriate, given the Fund's attractive business characteristics and long-term prospects for free cash flow growth.

                        12x                        14x                          16x                 
Unit price         $16.50             $19.00             $21.75                        
% upside          35%                 55%                 78%                

The Fund is covered by only one sell-side analyst. The units are illiquid, trading only a few thousand shares per day. Despite the Fund's stable performance during 2008, it suffers from the stigma attached to real-estate related investments. Finally, income trusts are out-of-favor among institutional investors because of the forthcoming tax and the resulting uncertainty about the level of distributions.

Catalyst

Restructuring of the Fund; potential acquisition by BAM