Revenue Properties Company Lim RPC CN
May 17, 2007 - 4:32pm EST by
lindsay790
2007 2008
Price: 17.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 192 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

How often do you find real estate companies trading at 8x 2007 funds from operations (FFO) and 10x 2007 adjusted funds from operations (AFFO)? We have found one for you, Revenue Properties Company Limited (RPC).

RPC invests in Canadian and US retail, residential and office properties. The Company is 68% owned by Morguard Corporation, which manages over $7 billion of real estate, and the management teams of the two companies overlap. Because RPC trades on the Toronto exchange, does not do conference calls, and has no Wall Street research coverage, it has been overlooked by investors. RPC trades at a significant discount to its peers – a 9.2% cap rate for 2007 net operating income (NOI) (vs. peers under 6.6%) and 7.9x 2007 FFO (vs. peers over 15.3x). We value the Company at over $37 per share, more than a 100% premium to the current price, based upon an average of the high end of 2007 peer cap rates and the low end of FFO and AFFO multiples. As RPC realizes the benefits of its recent acquisition of Sizeler Property Investors, we see potential for an even higher valuation.

(Please note: All numbers are in Canadian $ unless otherwise noted.)

Sizeler Acquisition
RPC operated primarily in Canada until the acquisition of Sizeler Property Investors in November 2006. Sizeler now makes up the majority of the Company’s assets and revenues. The acquisition of Sizeler by RPC was objected to by some of Sizeler’s major shareholders for not adequately compensating them. However, RPC made the best offer for a poorly managed company that needed a change of management. With many opportunities to improve Sizeler’s results, RPC was able to purchase Sizeler for a great price (an 8.5% cap rate on June 30, 2006 LQA NOI while almost all US REITs trade with less than a 7% cap rate).

Property Portfolio
Following the Sizeler acquisition, RPC’s property portfolio breaks down as follows:
Property Type
No. of Properties


GLA
Sq. Ft. (mm) / Apartments
US / Canada Properties
Book Value
($mm)
Q1 2007
NOI(1)
($mm)

Commercial








Community Enclosed Malls
5


2.1
2/3
140.8
6.9

Retail Shopping Centers
16


1.5
13/3
145.2
5.4

Office/Mixed-Use
6


0.9
1/5
82.7
1.8

Total Commercial
27


4.5

368.7
14.1










Apartment
15


3,414
15/0
216.2
4.2

Land for Development
--




17.5
--

Total
42




602.5
18.2



















(1) Reported NOI. Not adjusted for $1.5 million of amortization of below market rents.

The historical Sizeler portfolio, which is all US malls, shopping centers and apartments, is as follows:
· 2 malls, 5 shopping centers, and 7 apartment complexes in Louisiana
· 8 shopping centers and 4 apartment complexes in Florida; and
· 4 apartment complexes in Alabama
Many of these properties are on higher ground and are benefiting from people relocating after Hurricane Katrina. Rents at these properties have been rising quickly as shown by the $30+ million of below market leases accounted for in RPC’s acquisition of Sizeler. In addition, RPC can take advantage of accelerated depreciation for tax purposes (another consequence of Katrina) on most capital expenditures at these properties making development activities more attractive. Given these dynamics, one could argue that the historical Sizeler portfolio should trade with a lower cap rate than its peers, which makes RPC’s deal look like even more of a steal. Morguard may use RPC as a platform to acquire or develop more properties in the US in the future.

The remaining US commercial property, a warehouse in Danville, Virginia leased to a textile company beginning in 2006 as part of a sale-leaseback transaction, has an attractive double-digit free cash flow yield. The lease has a 10-year term. The income from this property is recorded as other income on the income statement, and the asset is listed as an investment in a direct financing lease on the balance sheet. This property was owned by RPC prior to the Sizeler acquisition.

The Canadian commercial properties, RPC’s historical portfolio, consist of 3 office properties (2 in Ontario, 1 in New Brunswick) leased to single credit-worthy tenants, a mixed-use (retail, office and residential) property in a prime area of Toronto (Bloor Street), 3 malls (2 in Toronto, 1 in Alberta), and 3 shopping centers (all in the Toronto Area). RPC’s historical portfolio has organically grown revenues and net operating income at a steady rate over the past 3 years (5.1% and 5.9% annual growth rates, respectively). This level of organic growth places RPC squarely in the range of other Canadian property companies. The Company’s largest tenant accounts for only 8% of its 2006 revenue and its top 3 tenants account for only 13% of 2006 revenue. This solid performance from a diversified tenant base makes RPC’s historical portfolio deserving of a cap rate or FFO multiple similar to its peers.

RPC also owns 108 acres of developable land, including 56 acres from the Sizeler transaction in Florida, Alabama and Louisiana that are all adjacent to rental properties. The land in Canada (primarily in Guelph, Ontario) is likely to be sold off as lots for houses or condos while the land in the US is likely to be used for new projects or additions to current properties. We use the book value of these properties in our enterprise value calculation.

Current Enterprise Value (EV)
Shares Out 10,827
Share Price $ 17.75
Equity Value 192,179



Debt

Mortgages 401,835

Loans Payable 199,956

Construction Financing -

Converts -

Bank Debt 15,923



Total Debt 617,714



Cash $ 2,098
Mortgage and Loan Receivables 12,929
Land for Development and Sale 17,511
Investment in Direct Financing Lease 8,194



Enterprise Value 769,161

Projections
As RPC is able to raise rents on the Sizeler portfolio, NOI, FFO, and AFFO should grow significantly during 2007. Our numbers are summarized below. We would expect RPC’s reported revenues, NOI, FFO, and AFFO will be significantly higher as we exclude amortization of below market rents (a non-cash item representing $1.5 million of non-cash revenue in Q1) from revenues. We think our methodology is more conservative, but appropriate for valuation purposes.


Pro Forma Q1 2007
Q2 2007E
Q3 2007E
Q4 2007E
FY 2007E
Assumptions














Revenues












Income from Properties - Canada 14,934
15,046
15,159
15,273
60,411
3.0% Annual Revenue Growth (1)

Income from Properties - US 15,934
16,450
17,228
17,786
67,399
13.0% Annual Rev Growth (2)(3)(4)
Total Revenues 30,868
31,496
32,387
33,059
127,810
















Property Operating Expenses












Property Operating - Canada (7,357)
(7,403)
(7,449)
(7,496)
(29,705)
2.5% Annual Growth (5)

Property Operating - US (6,755)
(6,806)
(6,753)
(6,803)
(27,116)
3.0% Annual Growth (3)(6)
Total Property Operating Expenses (14,112)
(14,209)
(14,202)
(14,299)
(56,822)
















Net Operating Income












Net Operating Income - Canada 7,577
7,643
7,710
7,777
30,706



Net Operating Income - US 9,179
9,645
10,476
10,983
40,282


Total Net Operating Income 16,756
17,288
18,185
18,760
70,989
















G&A Expenses












G&A - Canada (566)
(570)
(573)
(577)
(2,285)
2.5% Annual Growth (5)

G&A - US (1,059)
(1,067)
(1,075)
(1,083)
(4,284)
3.0% Annual Growth (6)(7)
Total G&A Expenses (1,625)
(1,636)
(1,648)
(1,660)
(6,569)
















EBITDA












Property EBITDA - Canada 7,011
7,073
7,137
7,200
28,421



Property EBITDA - US 8,120
8,578
9,401
9,900
35,999


Total EBITDA 15,131
15,651
16,537
17,100
64,420


D&A












D&A - Canada (2,020)
(2,020)
(2,020)
(2,020)
(8,080)
Flat















D&A - US (11,366)
(11,366)
(11,366)
(8,183)
(42,281)
Flat Through Q3; Apartment Intangibles Will Be Fully Amortized in Nov 2007 (8)
Total D&A (13,386)
(13,386)
(13,386)
(10,203)
(50,361)

EBIT 1,745
2,265
3,151
6,898
14,059


Interest (9,718)
(9,275)
(8,850)
(8,850)
(36,694)
Flat Less Savings from Refinancings (9)
EBT and Other (7,973)
(7,010)
(5,699)
(1,953)
(22,635)


Other












Dividend Income and Other 467
467
467
467
1,868
Flat (10)

Other -          
-          
-          
-           
-           
Excludes Early Extinguishment of Debt
Total Other 467
467
467
467
1,868


EBT (7,506)
(6,543)
(5,232)
(1,486)
(20,767)


Current Taxes (1,287)
(1,303)
(1,319)
(1,336)
(5,245)
Flat % of Canadian EBIT
Future Taxes -          
-          
-          
-          
-           
Assume No Tax Benefit Recognized
Net Income (8,793)
(7,846)
(6,552)
(2,822)
(26,013)
















Maintenance CapEx 1,130
1,138
1,146
1,154
4,567
2.9% Annual Growth (11)
Straight-Line Rents 286
292
298
304
1,180
8.3% Annual Growth (12)














EV/EBITDA







11.9x
















Implied Cap Rate







9.23%
















FFO 4,593
5,540
6,834
7,381
24,348
(13)
FFO/Share







$ 2.25


FFO Multiple







7.9x
















AFFO 3,177
4,110
5,391
5,923
18,601


AFFO/Share







$ 1.72


AFFO Multiple







10.3x



Notes:
  1. Q1 2007 Income from Properties – Canada is a reported number. 3.0% annual growth is divided into 0.75% per quarter sequential growth from Q2 2007 to Q4 2007. 3.0% annual revenue growth consistent with growth from 2005 to 2006.
  2. Income from Properties – US excludes amortization of below market leases.
  3. RPC is completing the redevelopment of a Kmart property in Florida in the second quarter. The cost of the project was $7 million. Assuming an 8% yield, the property should do $0.2 million of revenue and $0.1 million of NOI per quarter beginning in Q3 2007.
  4. Q1 2007 Income from Properties – US is a reported number less amortization of below market leases. 13.0% annual revenue growth derived from 3.3% sequential revenue growth from Q4 2006 to Q1 2007 annualized. We assume this sequential growth continues from Q2 2007 to Q4 2007. Further evidence of the potential for strong 2007 revenue growth comes from the $26.3 million of net below market leases (below market leases less above market leases) as accounted for in RPC’s acquisition of Sizeler. From a discussion with management, 25% of below market leases are from apartments and 75% are from retail. The average apartment lease is 1 year while the average retail lease is 5 to 7 years, and the below market leases are to be marked to market over this period. If all leases were marked to market as amortized, revenues would grow over $1 million per quarter each of the next 3 quarters, more than double the $ growth rate we have assumed.
  5. Expense growth consistent with rate of Canadian inflation.
  6. Expense growth consistent with rate of US inflation.
  7. G&A – US excludes $1.1 million of mortgage origination costs in Q1 2007.
  8. D&A – US is high because of the amortization of in-place leases costs that were over $100 million at the time of the Sizeler acquisition. Apartment in-place lease costs will be fully amortized at the beginning of November 2007 leading to reduction in Q4 2007 amortization.
  9. Interest Expense excludes amortization of loan origination ($0.6 million in Q1 2007). The Company priced US$150 million of new mortgages at 5.6% in January 2007. This debt took out debt with rates from 7.13% to 8.25%, saving $2.8 million in interest expense annually. The Company expects to place additional mortgages in May 2007 to take out the rest of the 7.13% acquisition financing. We assume a 5.75% average rate for these mortgages, saving RPC $2.5 million annually.
  10. Income from the Danville, Virginia property is accounted for as Dividend and Other Income. Dividend and Other Income excludes a reserve for mortgages receivable of $0.6 million in Q1 2007. It includes $0.1 million of interest quarterly on these receivables that will be included going forward according to management.
  11. Estimates of maintenance capital expenditures. Q1 2007 capital expenditures are based on 0.8% of assets, the midpoint of the range to which management has guided. Capital expenditure growth is based on a weighted average of US and Canadian expense growth. Q1 2007 total capital expenditures were higher owing to redevelopment of the Kmart property in Florida.
  12. Blended rate of US and Canadian revenue growth.
  13. Pro Forma Q1 2007 FFO reconciliation to reported FFO:
Reported FFO
2.9
Below Market Lease Amortization - 1.5
Mortgage Transaction Costs + 1.1
Amortization of Loan Origination Costs + 0.6
Accounting Reserve for Mortgages Receivable + 0.6
Interest on Mortgages Receivable + 0.1
Debt Defeasance Costs + 0.8
Pro Forma FFO
4.6

Valuation
We believe the best way to value RPC is using comparable company analysis. We include Canadian diversified REITs, US apartment REITs, and US shopping center REITs as comparable companies. Using the average of the minimum multiple of each group, we arrive at a price of $37.34 using 2007 numbers. We think this is conservative as we are using minimum multiples given RPC’s relatively small size and float.







FFO Multiple
2007
AFFO Multiple
2007
Cap Rate
2007





RPC Multiples 7.9x 10.3x 9.23%





Canadian Diversified


Averages
15.0x 18.1x 6.40%
Min
14.0x 16.9x 6.80%
Max
17.2x 18.8x 5.80%





US Apartment


Averages
16.9x 20.7x 6.32%
Min
15.9x 18.6x 6.71%
Max
18.1x 21.8x 5.97%





US Shopping Center


Averages
17.9x 20.8x 5.62%
Min
16.1x 18.4x 6.17%
Max
19.6x 24.6x 5.19%





Average of Peer Min 15.3x 18.0x 6.56%





Revenue Properties Data $ 2.25 $ 1.72 70,989





Implied Prices $34.48 $30.87 $46.66










Average Valuation - 2007 $ 37.34

Sources: Merrill Lynch and RBC

Even if you think that RPC’s current trailing (i.e. LQA) multiples are somehow warranted, our projected operational improvement from Q1 2007 to Q4 2007 would imply a price target of $26 to $33 a year from now.

Issues
  • Taxes. RPC is not a REIT; it pays corporate level taxes. As a result, making comparisons with REITs is complicated. We realize that accounting for taxes should mean that our valuation be discounted. Any discount would have to make assumptions concerning when (or if) taxes would be paid (e.g. RPC does not expect to pay US taxes in 2007 because of high levels of interest expense and amortization) and the tax considerations of the investor.
  • Liquidity. RPC’s shares trade rather infrequently. We think the discount to fair value on the shares more than makes up for this.
  • Morguard Corporation Ownership. As a 68% owner, Morguard could push actions detrimental to minority shareholders. In addition, the overlap of management between the two companies creates a conflict of interest as to where they spend their time and allocate capital.
  • Weather. The Sizeler portfolio is located on the Gulf Coast, which is susceptible to hurricanes. While most of the properties are on high ground, further hurricane damage in the region may cause more people to leave the area and may raise insurance rates further.
Bottom Line
The market does not know that this company exists based upon its massively discounted valuation as compared to peers. RPC has produced solid results in the past, and there is no reason to believe they will not continue to do so in the future. They take a disciplined approach to acquisitions and dispositions to their portfolio. We recommend potential investors visit www.morguard.com to see the extensive market-by-market and sector-by-sector forecasts and overviews put out by the management team. More importantly, the Company completed the Sizeler acquisition at a very good price, and has many opportunities to add value there. We believe this value will become apparent in 2007 results.

Catalyst

- Reporting solid results in line with our 2007 expectations
- Increased Wall Street attention
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