Dream Office Or Office Nightmare

Dream Office or Office Nightmare

I don't own dream office directly but for a while there have been a few entities that I do which have stakes in it. This has led me to follow it as a de-facto position. I've compiled a few thoughts on valuation and strategy.

Stated NAV 'must' be pointless

I say this with a little sarcasm and a little seriousness but NAVs in this market must be pointless. Normally, I'd suggest that NAV is a guidepost for something like a REIT as they can always trade units/shares for assets or assets for shares in the gap is too wide... that's assuming the NAV is accurate and there is liquidity to transact on both sides. Recently however, either due to liquidity, volatility or credibility, NAVs seem to be in a prolonged period where the market completely disbelieves them.

Most public REITs seem to trade at some sort of discount to their net asset values. It seems like the public market has marked real estate to a significantly higher cap rate than the private market. I'm not sure how that resolves... if public valuations increase, private decreases or both? It does seem like the public offers a better risk reward in the meantime. That said, a discount to NAV should probably be measured relative to other discounts in NAV... and ideally, NAV should be judged further than what the company says. I could add a few sentences about discounting the discounts vs other discounts... but that was confusing me as I was writing it... sufficed to say NAV & discounts can be a messy measure. I may refer to it and use it but in isolation it's usefulness is limited.

I suggest that NAV must be a pointless measure because if the buildings were sellable at what NAV's supposed to be, the answer to making a ton of money would be impossibly simple. Sell a fraction of the assets and buy back a majority of the shares. Similar to the DIR transaction... and the last asset sale, except more. With +30% of the float already in insider hands & the price at least than 0.3x book, they'd only need to sell 20% of their assets to own the whole thing. (And no, it's not riskier to own more office in this way because they could then sell additional assets to further reduce risk)

Now, my math isn't great, but 100% of 80% is a lot more than 30% of 100%.  So there's obviously no easy way to advance in this direction... which in turn means stated NAV probably isn't helpful to investors. 

One area however, where it'd be helpful to have as high an appraised NAV as possible is when measuring the LTV for asset leverage. It's also unclear how much less the assets may be priced at if a sale was pushed today. 1%? 50%? I don't know. Maybe they would be stressed seller discount makes that strategy not work. It's possible the values are fair but there's no liquidity at the moment. I could make a case based on past sales and private market data that this could be the case but I mentally can't make it fit with the rest of the picture that I'm going through today.

One thing I will say about NAV is it catches something that cashflow metrics miss. If you have an empty Office or piece of land in a good location, it'll show up as a drain on cashflow and provide no income. That land can still be worth a lot of money. You might even be able to develop the land by pulling equity from it or JV it into something.

Overall, I think a better approach is to use a fresh set of assumptions.

The problem then becomes what do you want to use... or how do you want to weight the various components. I want to look at "What you'd be buying" in Dream Office.

Breakdown

Units Outstanding 38M

Market Cap (@$10) $380M

Enterprise Value $1.69B

Industrial

13.5  Million Units @

$12= $162

$13= $175.5

$14= $189

$15= $202.5

$16= $216

$17 (NAV)= $229.5

That's $4.25 to $6 per unit

Residential

Using what was suggested on a recent conference call, 

2200 Eglinton should be worth $200M at Dream's share as condos.

74 Victoria is also zoned residential. I don't know the size for residential development but maybe $50M+

$5.25-$6.50 per unit 

Potential Residential 

30 Adelaide could be worth $300M if it can be rezoned residential

(Almost $8/unit)

Office

That essentially leaves the remaining 18 downtown Toronto office properties 

Plus 7 offices in other markets

All this 

2.5 million square feet of downtown Toronto office plus 1.5M square feet elsewhere...

That are combined worth a negative 300M... or Negative $8/unit

If Toronto core office is worth +$400/sq ft and other is worth +$200 it would more than cover the debt. As of Q2, the average selling price for Toronto offices was $600/sq foot.

From another perspective, you'd need $480/sq ft & 240/Sq ft to cover the entire enterprise value today and get the residential and industrial for free.

A third perspective would be take $450M Industrial + Residential, then office would be valued at roughly $380 & $190. 

Note, don't take much from my 2:1 ratio I'm just using it as an example as I think Toronto core likely deserves a premium for quality and stability. I'm less sure what that should be.

Debt

The problem with this situation and most discounts, is debt. Obviously the real estate is worth something... even if it's only something speculative. With debt however, the risk can always be is the something less than the debt. Further, if something is 50% levered, if the value drops by 25%, the equity value drops by 50%. So there is a multiplied effect of value declines.

As long as the debt is in mortgages, the value can't really go negative. The building may be lost if it can't service the debt alone and doesn't have any equity left... but it won't drag down the other assets.

If the debt is at the company level it could... depending on the terms and collateral.

In this case, it looks like the portfolio is given negative value... as in not even enough to cover the companies' liabilities.

The drawback currently with what I've mentioned above in the residential NAV is I guess that the market is saying that those values aren't the REIT's equity in those projects so much as gross value.

How to realize value

The simplest way to "do something about it" would be to buyback more units... but with so much of the cashflow directed towards distributions, that's easier said than done.

I was half thinking that the SIB tender might be a way for DREAM Unlimited to move towards taking the thing private. Own 100% of a smaller portfolio. Sell assets and buy shares until they owned all of what was left. Instead, they sold into the SIB to bolster their own liquidity. They still own a large stake but it wasn't a great sign.

What some have suggested is to do something with the DIR units and de-lever the portfolio a bit (because office is at risk). I couldn't disagree more... if your worry is office at least. I'm not opposed to deleveraging but think it would make more sense to de-lever with office assets wherever possible if that's the worry. That said, if navs are close to accurate, it makes far more sense to allocate to buybacks than deleveraging. 

What I'd do is try to structure the leverage within the company on the asset level. Make it so that the offices have to pay for themselves or go bust INDIVIDUALLY. Avoid the domino potential of one really bad office outcome dragging down a perfectly fine asset. If they can't earn their cost of capital they're probably not that big of a loss. This is how a portion of the liabilities are structured today but I'd want to try to further separate fall back value and risk value.  

This way you can let the stuff that doesn't have an existential threat be around as a fallback incase office completely dies. If it does being 10% less levered probably won't help much anyway.

From there work on balancing resources between leverage and buybacks. The problem with asset sales is that some of the value must be used to de-lever, it's not simply a $100M sale means buyback 1/4 of the units. Couple that with a forced sale likely being at a (Multiplied) discount and it's tricky to 'just do'... what seems 'obvious.' It would also be unfair to act like they haven't done anything. They sold an asset for actually above what it's NAV was at the time & did the giant substantial issuer bid buying back 1/4 of their shares. That would have seemed very bullish to me if it was accompanied by insiders increasing their stakes.

Confidence 

The problem with the situation is that nobody seems to have any confidence in any values. Ideally, this is when you'd want to see insiders putting their own money into shares. Or at least some action being taken to benefit from the discount. In this case DRM and Cooper have stated that they're not sure what the future of office holds. Further still, Dream office is limited with their liquidity at this point. So is Dream Unlimited who also arguably has better options for places to put capital as other vehicles also trade at large discounts and have less questionable futures. Also... are we done with rate hikes yet? Market isn't sure.

The thing that really stops me from thinking, "maybe NAV is accurate and they can arbitrage that for massive value creation," is the fact that so much was sold at half NAV (into the SIB). That to me makes the whole transaction much more bizarre. If you're so concerned about office that you're selling at half 'NAV,' why are you essentially levering up on office (making a greater concentration of assets be office buildings.)

I mean at $13-$14/unit, the asset value of the industrial units would be in the range of $338M-$364M vs now $175M -$189M. Maybe I'm the odd one here because a few people seem to like the idea of selling the rest. To me, that's something you do if you're very bullish office. If not, or if you're unsure, I'd want diversification or some type of value backstop incase office goes exceptionally wrong.

I have nothing but the utmost respect for Mr. Cooper and his candidness about his view of the office situation. It has certainly looked correct so far in public markets. I do wonder at what point price or redevelopment potential might support the idea that the possibility of narrative overshooting reality. His stance did have me confused about the SIB situation. It could easily have been step one to a take private via asset sales and share buyback on discounted units that (if NAV was accessible) would have been immensely accretive. Clearly it's believed that values are at least at-risk.

More asset sales (at ~NAV+) and buybacks would probably work towards proving out and simultaneously adding to fair value per unit. For the time being, most of the office space is trading like a big levered uncertainty that nobody knows what to do with.

Distribution at Risk?

I always find it weird when an executive says that the dividend isn't at risk... everything is a risk... in some scenarios. I guess that would sound bad in an interview. I'm referring of course to a peer with a similar yield stating their distribution was safe. The problem is you can never know. What's not at risk today might be excessively risky if interest rates double. 5% interest rates were a very low risk scenario 5 years ago.

In Dream Office's case I think they should be able to keep it... or at least that was their belief a few months ago. I don't know if that's still the case if rates go to 6% (or long end goes up to high 5s) or if vacancy drops further or rents decline. A delay of redevelopment also hurts.

In other words, should be more workable as of last quarter and if things play out well with rates. But if a small number of things go poorly it's at significant risk (at least until they improve). That said, I have no idea if trying to keep it as long as possible is the best idea. I'm not sure what management is thinking on the subject or what suits shareholders. I think there's value potential here but I'm not sure the best way to access it is to try to extract every last cent in cashflow from distributions.

REITs have different rules. They need to distribute a large portion of their tax liability. 99% of the time that means paying income to unitholders... but it doesn't necessarily mean they need to give them cash. A REIT can keep the cash to use for different purposes (debt paydown or buyback) and just distribute the tax liability. Most hate this so they almost never do it. I don't think it will happen in this case but I mention it because it was done by an American office peer quite effectively when the stock got too cheap.

Rents

Oddly, rents have remained solid in the face of increased vacancy. If that persists, the offices more so be able to hold their own value better than what the market is pricing. I suppose that means the market suggests they won't.

My Office View

I'm not sure I share Mr. Cooper's view on offices. Of course that means I'm probably wrong... Sure there's a change and some will be sticky but I also have seen a fair amount that makes me feel that work from home can often be BS. Lots of people are immensely unproductive and frequently more disruptable. Not to mention I'm not convinced it's healthy long term.

Plus, if you think about utilization rates, offices used to be packed with people 9-5 Monday to Friday. Compare that to other types of real estate, a restaurant for instance which is still economically viable with much less operating/busy hours. I think the utilization rate can decline and still have similar net square footage demand.

Additionally, I think between 2.5% population growth and housing demand, it wouldn't surprise me to see supply shrink after current (past) construction cycle completes. (Side note: That should also open up labor for housing construction. I think in Canada in general labor will loosen which will work against the idea of workers being able to dictate that they can work from anywhere) I don't think it'll be tremendously quick but if we're ever going to need more offices, replacement cost will matter again. If we don't, then presumably the need to keep stuff zoned office or have replacement for teardowns would also diminish. Central downtown land with residential zoning sounds like hundreds of millions, if not billions in potential value.

Conclusion

My personal view on Offices from a few years ago was wrong for multiple reasons. 1: I thought return to office was going to be fuller and swifter. It was pretty apparent to me and most I spoke to working at home that productivity was a disaster... if people were working at all.

2: Getting rugged by interest rates.

I'm still in the "I don't know" camp. But I think we're definitely at the point where an entity with the right debt structure can make a lot of sense. The problem is that everything is discounted and uncertain. We live in a world of 'what its.' In the most confusing sentence I will write today I ask... What if, What if office goes to 0 turns into what if it doesn't? 

Disclosure: I don't own any units in Dream Office directly but I have stakes in two public entities that do.

Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

Canadian Market Outlook

Canadian Stocks

Maybe you've heard... Canada isn't in a great place. Interest rates have started biting the Canadian economy & without a change in course, that will get worse by the month as mortgages reset for the next 2-3 years. Further still, the Bank of Canada is still deciding if they want to make it worse or not.

Productivity is bad & inflation has been staying higher than wanted. We should probably be in a pretty bad recession already... which should in turn cause worse damage and rate cuts, further damaging the currency... causing more stagflation etc etc etc....

But we're not... and honestly the same reason we're not is why we might not. Population growth.

People want to blame population growth for stress on the housing market and rental affordability. The reality is they're bailing out a financially sinking (because of increased rates) property owner. The fact is... and many people need to hear this... despite the averages "Top 10% salary can't afford the average house!!! (*with no trade up equity and average heavily weighted by most expensive markets... but let's avoid talking about that*)" and what you hear about Canada, Toronto and Vancouver. You can still buy a brand new 3 bedroom, 2.5 bathroom house for 450k (USD$330k) near Calgary, Edmonton, Regina, Saskatoon, Atlantic Canada etc. That's because despite the "immigration making housing unaffordable," when builders can build, prices follow the cost of production. As a reminder, this is EVEN AFTER a decade where "low interest rates made housing unaffordable." In my opinion, at 2.5% interest, $1800/month as a mortgage payment on such a home is affordable. Immigration is obviously not the problem... but it does amplify what the actual problem is. The actual problem being the time, cost and difficulty of building. Also, it's crazy how many people will complain about affordability but when given 5 affordable options, look down on those locations in some form. The averages are warped by people's perceptions about frankly what's not Ontario & B.C. Another issue the MASSIVE take governments reap from inflated land transfer taxes and other such costs. The problem is almost entirely artificial and self induced. Population growth is bailing out our economy from home made stupidity. It's 'easy' to point the finger but it's not the problem. Same with "low interest rates."

Recession or Not

I don't know if we enter a recession. GDP growth has sucked for 6 months & could easily slip negative. On the other hand with adding 25k jobs per month (probably hurting productivity) we've already added 0.5% to our unemployment rate. By year end, that could easily be 1% off the lows without a recession. If we had 0 job growth, unemployment would rise 0.2% per month which would be a similar pace to the GFC. If you believed that inflation was caused by tightness in the labor market... this sounds deflationary... even adding 25k jobs per month sounds deflationary. Also, if we're going to look at wage growth with immense fear "omg still 5.2%" well, I believe we are about to witness some favorable base effects in that regard. 

In the last 8 months January to August, wages went from 33.01 to 33.47. In the last few months of last year, wages went from 31.67 to that 33.01 in January. That's a 1.34 increase that gets lapped vs a 0.46 increase over the majority of this year.

In any case, recessions are transitory. Plus, most of the time by the time everyone agrees it has arrived, the market is looking past it.

We're already in a non-recession... recession.

Believe it or not, I started this not really wanting to discuss macro factors. I wanted to talk about some stocks. I did however want to make an important point. That is, in the discussion about Recession... economic collapse... bubble bursting etc. It's important to realize that the pain & stress is already being felt. We are adding growth potential... companies are adding long term value... the economy is stagnating for now but adding potential. We're not growing but in suffering this (higher rates and higher unemployment) without collapse... we gain the potential value of; 

What if yields normalize at inflation +50bps... 

What if more people find jobs... eventually 

That could mean higher growth, higher cashflows, higher valuations.

I don't like the near term Canadian economy... and think there are real risks there but also think... to use a horrible cliché... what doesn't kill us, makes us stronger... now the key of course is... not dying. (Or suffering permanent damage). I think we need to look South... and West... if the Fed can be done and investment in Oil can bail out our currency we could be surprisingly ok. If the Fed presses onward and our currency gets caught between a rock and a hard place it could push a bad situation towards a very bad situation.

Banks

Ok so... housing bubble... inverted yield curve... possible recession... economic stress etc... who in their right mind would go out and want to buy bank stocks? That's a valid question that many are probably asking. I don't have a good answer... or I should say wouldn't have a good answer if we were talking small 1/10000 banks at full price with marginal equity cushions.

In Canada we have maybe 10 worth a look... 6 that every Canadian has hear of... all heavily regulated and capitalized like a GSIB ( Global Systemically Important Bank) most of these have been adding to their PCL (Provisions for Credit Losses) aka reduced earnings and is at a P/B multiple comparable to COVID or mid GFC. So yes... we may see the implosion of the Canadian economy through gross incompetence... but a normalization of bank performance over the next 5 years could generate something like a 25% IRR... from owning the big banks. That would mainly require enough population growth to avoid a Recession. 

The Canadian banks have been around for many years:

Bank of Montreal 206 

Bank of Nova Scotia 191 

Royal Bank of Canada 159

Toronto Dominion 68 [merger of Bank of Toronto (would be 168) and The Dominion Bank (would be 154)]

Canadian Imperial Bank of Commerce 62 [merger of Canadian Bank of Commerce 156 & Imperial bank of Canada 150]

National Bank of Canada 164 (or 43)

Not to mention Laurentian Bank which has achieved much less in their 177 year history. 

The point being that these banks survived the great depression and the GFC along with 20% interest rates and many difficult environments. That's not to say that they're invulnerable... but they are pretty resilient.

Canada doesn't have the same MBS problem that the US had in 2008. We also regularly have 1/5th to 1/10th the mortgage delinquency rate of the US. Further, a large percentage of mortgages are insured or have a large equity cushions. Then remember we've already seen some decline in construction as prices don't satisfy return thresholds for new supply. 

What I think happens is somewhere in the middle. A few years of reduced earnings before gradual improvement. I don't think dividend cuts are likely so when I run through some possibilities it's an area that looks interesting from a DCA, collecting a few shares perspective. Particularly because my portfolio is light on the yield. I don't like buying things exclusively for their yield but I think that in a few years those dividends will return to growth in that environment I think there's relevant capital appreciation potential.

Oil

There's a lot to like about Canadian oil. (...but)

Maybe OPEC extends cuts or is near their production limits... maybe the Permian has peaked... maybe the Canadian dollar falls apart. I honestly have no idea... but with a bunch of these companies continuously saying they can make money at $45 oil... I continuously wonder why they aren't putting even more capital to work at $70+

In Q2 we had 10.4B of capex... that was the third most of any quarter since the big oil collapse of Nealy a decade ago. Plus, now their balance sheets are much stronger. Capex is still at roughly half of last cycle. Frankly as a Canadian & someone with significant investments in Alberta, I hope the capital keeps going in. The alternative is basically worse on all fronts.

The problem from a stock perspective is that the volatility of earnings and the depletion type of business isn't necessarily a good long term idea. Now they can grow assets and long term value quickly but that won't always be the case. Investments currently pay back quicker and leave income streams beyond that so it makes sense to invest... and leave the company with more residual value when it no longer makes sense to. This won't remain the case forever because it's a cyclical industry. That's why for energy companies I think one metric that you can't lose sight of is book value. If an oil company trades at 2x book (it's more so asset value than book but...) it might be possible to put a fresh $1B to work and have it be worth $2B. Eventually someone will do that. Whether that's capex from an existing company or a pool of investors putting their dividends to work or a management team with their buyout proceeds... it doesn't matter someone will eventually do it and make a ton of money. Doing it sooner will allow you/your company to make more of the excess profits... doing it later is more likely to miss some excess profits...that's the only difference. Maybe the company can quadruple it's long term value first... maybe more or less is lost to taxes, maybe it takes 1 year, maybe 10... maybe price goes high enough to reduce demand... maybe price is flat... I have no idea but eventually the investment gets made... and at a company level it makes much more sense to do it early.

The stocks are probably a decent hedge for more pain in Canada but too much pain here or globally can backfire in many ways. I like the sector and think there's a lot of profit left to be had in Canadian Oil. I don't think it's as cheap as some nor am I a believer in sustained $100+ oil. But I think the sector is well positioned especially for as long as Saudi wants to give up market share.

Rails

One area of interest for "permanent capital" in Canada might be an investment in one (or both) of our two railroads. Ideally an entry point with a mid teens multiple starts getting quite interesting from a long term perspective. Both rails have been around nearly 100 years and stand a shot of being around for another hundred.

Grocery Stores

Grocery stores are another Canadian oligopoly that's been moreso in the news recently. On one hand I believe they're very stable business and probably have some upside with population and GDP growth longer term. That said, I've continued to be skeptical that the recent pace of growth is realistic. These are very low margin business. That means they do and must pass on price increases quickly. So any nominal price increase that's not their fault results in earnings growth. The hilarious irony of our current government blaming grocery stores for higher food prices is that their very carbon tax has pushed the cost of food higher... and... higher nominal prices mean more profit (although a similar minimal margin). Then the government threatens 'take prices down' (they can't) "or we tax them more." Which could arguably push prices even higher. Before I turn this into a political commentary I'll move on.

The good news is that 'whatever' the factors that pushed food prices this high, globally, food inflation is fading HARD... at least... good news for us, perhaps less for food stores. Supply has responded to higher prices. Part of this feeds in to why I suggest inflation is likely less of a concern than some suggest. Food inflation at 7.8% YoY is roughly 1.2 of the 3.3% add in 0.8 from mortgage interest cost... both of which should quickly roll off should more than offset some rebound in some other components. In fact most other components that went up as quickly as food eventually saw negative YoY numbers. Then figure that if inflation was deemed to be under control, and rates were reduced, that +0.8 could flip to negative too... then new development makes sense and rents don't need to increase anymore... more inflation gone.

Reflexivity. If we believe inflation is gone it will be (with some time). If we keep creating our own inflation it'll stick around. (Higher rates = inflation + need for higher prices = inflation= taxes = higher prices = inflation= rate hikes = inflation.

I got slightly off topic in my attempt to say that food price inflation disappearing will likely mean slower growth for supermarkets. But with reasonable valuations I think the outlook is fine.

Utilities

The utilities and pipelines are another interesting sector. They have been double hot by the rise in interest rates. The highly levered utilities now face a wall of more expensive capital upon maturity. They also face the fact that with higher rates and the availability of yield on GICs, there's less value/demand for high dividend stocks. This is a similar challenge for real estate. Both may now be in a position to reset with a new baseline of assumptions which they can perform against... in other words, if rates peaked and decline, you get the revaluation higher & improved cashflow fundamentals from lower refinancing cost. I think we're somewhere in the repricing. I don't think all of them have fully priced in higher rates persisting but I think most are in the process of slowly assuming that maybe rates will remain a bit higher for a bit longer. I don't think they should fully price in higher rates (that view comes from my personal opinion on rates). The more that they do price in, the more asymmetric the investment. The companies are mostly fine but the appeal of the price of years ago wasn't what investors hoped. There will probably be a stretch of less growth while debt is managed. It's a place where there's probably some time but may be worth picking up some long term holdings over a few years.

REITs

Real estate is in a weird spot. From a price to book/NAV perspective, it's extremely cheap. (There's a rather significant discrepancy between public and private prices.) From a 'I can get a 6% GIC' perspective... less so. 

The two things that matter most are interest rates and NOIs. If rents/incomes keep rising then existing debts can incrementally be retired and long term values can be fine. If occupancy or rent falls then we have a more complicated situation... especially if funding becomes more expensive.

We haven't seen yields like this out of REITs in many years. It is possible that they stay here... or are cut. It's complicated and can't be answered with blanket statements. I suspect with catch up rents and incremental deleveraging, the new set of expectations is probably pretty low. The discount to NAV simply means they are much cheaper then their private/I traded alternatives. They may or may not be extremely cheap... it depends where interest rates settle.

Miners

At the risk of repeating myself, mining is a difficult business. While not apparent in the same way as for REITs and Utilities, miners are similarly worth less in this kind of environment. Inflation = cost inflation too. And interest rates make the capital more expensive.

On the other hand, and this is something I've been mentioning for a while but goes directly against traditional economic thinking... in commodity -like capital heavy industries, capital is your most. It's not a great moat and it will be overcome eventually but it is some moat. This is because you need (Risk free rate +) for the investment to be worth it. The more capital costs, the bigger that number needs to be. Higher rates need higher prices to get the same returns... and higher rates mean even higher still prices are needed to justify taking the same risk.

I want to be clear, I'm not saying higher rates are purely Inflationary... they remove capital availability too (that's deflationary) what they do is make people poorer and life less affordable.

Gold, I don't have a strong view 

Silver is roughly fair value

Copper, I'm bullish on demand longer term but think price is higher now than bulls give it credit for & has two way risk short term. My history has taught me that you really only need to buy these when the metal has been flushed.

Lithium there's very little on the TSX but I'll say. Lithium price was ridiculously too high, it's now decently high. It's demand longer term is pretty obvious but I'm less sure how much that translates into price from here. Most companies can make their projects work with prices at half of current levels, so the odds are pretty good that eventually prices fall by more than 50%. Maybe the stocks make 1000% first, that I don't know.

Exporters

One area that I think has more potential is export companies. In the Oil segment, I mentioned in passing that maybe the CAD falls apart. A weakening currency would be a tailwind to companies that cost in CAD and sell in USD. It's funny actually, the other day, prior to a discussion that got to this point, I saw someone tweet a weird boast. They said they converted a bunch of CAD to USD at 0.65 back in the day but that's good because now they have USD investments that give them USD cashflow. I immediately thought... ok... why not just own Canadian businesses that sell into the US (oil qualifies) if you want protection against a falling CAD. It's hard to find many pure-plays of this as most have diversified operations as well as sales. Still, at present it's a more interesting area because A: you don't have to deal with struggling Canadian clients... B: if the currency sucks more, you're hedged as margins should improve.

That said, I don't know if I've ever gotten a currency related trade right... there's always more to it or expectations than what I imagine and I have no idea how to measure prices or what the market is saying. There's economic strength, rates, trade, inflation and so on already built in and evolving, most of the time I just figure, currencies go up, currencies go down... I'll never know why. Even still, there are times when I appreciate a more global sales exposure & other times when being regional is nice.

'Cheap'

On a price to earning basis... as well as a price to book basis in many places... the Canadian market looks cheap. Or at least, cheap relative to recently or relative to the U.S. That is however, not the be all end all of security analysis (despite what some may say). It's the market's message that current earnings or asset values are in danger. Maybe that's transitory earnings capabilities, margin normalization, pending recession-related losses, maybe end of cycle pricing...etc

This pessimism may or may not be misplaced. I would suggest that, commodity companies and tech stocks shouldn't trade at similar multiples. Asset heavy businesses have growth constraints that other companies don't. Being that capital and balance sheet capacity is often the limiting factor, the risk for such business is often tied closely to marginal changes in the economy. I mention this because Canada has a lot of asset/balance sheet heavy businesses. First and perhaps most relevantly when looking at Canadian stocks... the banks... then oil etc.

I think that a lot of Canada is set to perform well at some point but I think things need to point in the right direction first... or at least stop pointing in the wrong direction. This can be especially annoying because some things are moving in the right direction but sentiment is not and has capped them. There's a lot of torque in the Canadian market's earnings. With bad things happening they can easily fall a lot more that the US and that what central banks keep trying to cause. If we could get past that to an actually good economy like the late 90s or mid 00s the entire picture can flip. What is now '20% discount to book because of losses coming' can become '2x a 40% higher book' the difference there may be 2 or 3 x in earnings multiples (more in some cases) but 300% in stock price. We could be at the start of a decade of outperformance or the start of a multi year brutal underperformance. I think the current expectations are skewed to the pessimist side, but I also think at these rates, our economy is in an awful position in the short term.

Bonds

Bonds are tricky too.

I think short rates need to move lower... but I don't know if they will. (Yes you heard that right)

I don't think the long end needs to go lower... but I can't bet on the front end going lower without thinking the same event would push the long end lower.

I also don't know when or how much because the whole thing isn't a bet of what should happen or what makes sense, it's a bet on the choices of parties that seem completely illogical. 

I don't believe low rates are bad. I think there's a massive "back in my day rates were" bla bla bla ... "those were the good ol' days of 11% unemployment and 10% interest rates when we nuked our own economy because of an exogenous oil shock," out there by people in positions of authority. When you get into logic of how rates actually helped anything be better back then, the arguments fall apart... they turn into "well if nobody could afford it and everyone was struggling then things would be better for everyone." The honesty of the matter is most people should just say "I want to make 5% on my money for taking no risk; because I have money."

The problem is, with today's taxes, costs, demographics etc I don't think the country functions at +3.5% interest rates. I think it leads to very bad things, economically, socially, politically etc. I also think that things are comparatively fine at 2% interest. We could have great growth and prosperity without problematic inflation.

Any prediction needs to be a mix of will and should... so if I were going to make one it would be something like: YoY is probably almost 4 before October data... so they may panic and do one more hikes before realizing in ~March that inflation is falling very quickly and by ~April that they're way too restrictive. Then they start cuts around then... probably (as I mentioned above), once they start cutting there's probably a long way to go. Probably +250bps of cuts over many quarters because they'll stay concerned about a rebound. However, this basically assumes they act like headline chasing trained monkeys. If thought goes in to other data, they could easily move the timeline up 3 months... I mean if they really were concerned with data they could move the timeline up 8 months... but evidence suggests that's unlikely.

Wrap Up

When I talk to people, many seem to think we are in a lose lose situation. For lower rates, they believe we need a recession. A recession has historically meant catastrophe earnings felines/losses by sensitive companies. In other words it is believed that companies need to do poorly in order for the pain & unsustainably higher rates to end. I don't know if that's accurate. It does seem to be what the market is looking at in a few places. I think Canada is buffered by the ability to export to the US... and simultaneously at added risk because of Currency on imports. Buffered by population growth and at risk because that masks the true pain some are experiencing. This might mean no recession or a very mild one... or cause the BoC to go massively overboard and do severe damage. I do think that there is a tremendous amount of pent up demand in some of our more rate vulnerable areas. The incremental relief at some point could do wonders.

Everything is to a large degree... interest rates. So far that has been a running shock. In some ways the economy handled it well, in others we've handled them terribly. Led by our debt and mortgage resets I think that rates are already too high for much of the country. I've given up on believing that what should happen will or that there's consideration of factors beyond headline inflation. There was plenty to suggest that we should have stopped before 4%... it seemed insane to resume after the pause at 4.5... they did. So yes, I think we've gone far further than necessary. If food reverted to global averages and we excluded Mortgage Interest Costs we'd have BELOW target inflation... I digress. Other parts of the country/economy are completely survivable and doing fine. The yield curve also matters, what discount rate is used? 5% or 3.5%. The higher a number you can make work, the better the odds of success. 

That said, if you're asking my opinion of what eventually happens. 

Let's look at it this way. The people who currently own the 10 year bond at 3.65% probably think that short end rates are going lower (if not they'd roll short treasuries). When that happens they believe that long rates will go lower and long bonds will become more valuable. In other words, they expect long rates to drop and short rates to drop to an even lower level than that lower long end level. So a 3.65 10 year is probably a suggestion that the short end may go to 1-1.5% and the long end would be 2-2.75% or something. This is basically what bulls of the 10 year are thinking. If that happens, real estate and other supply can react, affordability can improve and the economy can function properly. The one thing preventing us from getting there is patience (inflation). I say patience because, there are no signs of a wage price spiral, the economy is incredibly clearly not overheating... so what we need is time for the volatile/incentive prices to roll off and stability to return to the supply side. You know, it's ironic that central banks claim they want to achieve price stability yet their actions are essentially trying to crash some prices thereby creating volatility.

We're clearly not overheating... we may be stagflating but I think at some unknow point the Bank of Canada will regain sense and stop intentionally hurting the economy. On a lag from that point there are a lot of companies out there that to varying degrees are pricing in the pessimism that I spoke about. I don't know exactly when the point of peak pessimism will be but keep trying to look beyond that at the 'next cycle' and think we're starting to see some interesting longer term prices.

Canada may not be in a great place right now... but you really can't find many people that think it's doing too well... and it shows.

Quarter End Thoughts

Hello Again

I haven't done a market update type of thing in a while. That's mostly because I haven't felt like I had something worth saying. But given that I've got a few suggestions that I should do this type of commentary, I'll see what I can come up with today.

Recently I've noticed a somewhat inexplicable (at least on timing) pivot beneath the market. It's almost as if some economically sensitive parts of the market are doubting that they should be pricing in a recession. It has seemed like the money flows that move the market are shifting from recession to recovery. This has been more so the case in US exposed sectors. It also feels like we're seeing a shift in trajectory of some sectors and economic priorities.

Is it done? Well that's the million if not billion dollar question. I don't know. I believe there are some things with very optimistic prices other things have a long way to go to reach historical average valuations... That's all within what I'd call cyclicals, not even AI related stocks. Cruise lines at these prices are extremely confusing. I'd contemplate a short position there to reduce the 'cyclical' factor of my portfolio but... With the market acting mechanically on narrative of cyclical recovery into a heavily shorted sector... I mean that's how value investors (and people who ignore market mechanics) die. Mostly I like some cyclical areas.

Lumber

Many commodity producers remain below book, including a number who more often than not fare well within their field. I think some are past the cyclical trough in margins and are likely into early stages of what's effectively 'next cycle.' things that went into the cost curve and had supply come out. One that I've spoken about here is lumber for instance. It's particularly interesting because the US homebuilders (a different type of cycle) have been telling the story of a recovery for a while as the market kept talking crash. From here, I believe if their starts volumes increase it should disproportionately help the lumber recovery. I'm not in the 2021 $1000 lumber camp at this point but in 2018 the group had +20% ROEs and traded at 2x book... Vs now 0.7-0.9x book... Whatever the market decides, breakeven is roughly $500 so time above is some decent cashflow, we don't seem to be pricing in a ton. It's interesting (disclosure long). I still think incremental demand should be strong while most of the market is more locked in place with their old mortgages as that doesn't help/matter to those looking for a first time home. Family formation is actually stronger in the 'good times' periods that would coincide with higher rates. Either way there was a lengthy stretch where building was depressed and I believe some higher level/catch up is necessary.

Auto Parts

Auto parts is another cyclical that I remain long and optimistic about. They're historically cheap because economic sensitivity... As best I can tell. If the structural earnings recovery & growth doesn't revalue them higher, I hope they're able to buy shares off the unappreciative shareholders to compound at +20% most years. Less of a clear catalyst there for what would make the market revalue but history suggests it should happen eventually. Stocks with those kinds of track records don't trade that cheaply forever. Yes, I know someone out there is rolling their eyes at the thought of this value moron talking about cheap cyclicals. You might me right... But I'm talking (or trying to talk at least) about the assets from a full cycle earnings power perspective. Sub book vs 1.5-2x book average. It's not flashy but if it works as historically it's probably a double+ on a decent company. One which can hopefully add value to move the target further forward along the way. It's the type of thing that feels like it deserves more than the decent allocation I've given it because the risk reward feels like it makes a lot of sense. While people would rightly point out that autos are interest sensitive, I find it interesting that the last time we had sustained higher rates (the 90s) auto parts companies were absolutely rocking. perhaps it was the strong economy, perhaps the high cost of capital just increased the required returns to make investments acting as an artificial moat. It's not my thesis, just something I found interesting and counter to conventional thinking (or this market's assumptions at least).

The point of most of these is that things have long histories of being less dramatic than people expect. It makes investment interesting when the market basically assumes trouble. When there's upside in continued difficulty it's easier to be patient enough to stick through the potentially not ideal but survivable situation.

Real Estate

Personally, I'm well versed in entering the pain trade. It's probably where I've entered the most asymmetric investments historically. I have benefitted from the fact that I don't have to report my performance to anyone in this way. Being rate-exposed has been painful. Unfortunately, at this point most of my favorite sectors value-wise are places negatively impacted by the same hike-resumption environment.

I think some of the fear in the real estate is misplaced. People frequently discuss cap rates as negatively impacted by rates. What gets lost in that discussion is the rising rents, replacement costs and economic values of prime locations in decent economic environments. The last time we had a rate hikes cycle, real estate values rose substantially... In the 70s too. Further still people seem concerned about interest rates and leverage profiles. On some assets that could be an eventual issue. On the sector from a very broad perspective... The math if actually done on the leverage is closer to a shrug.

40% leverage and 5-6% cap rates while you can fix 6+ year debt at 5.25% or lower for longer term. There's a monumental difference between a 40% levered 10-15 year amortization debt load with laddered maturities and a 20+ year amortization individual mortgage jumping 40% all of a sudden when it comes to interest service. I mean a RE developer spoke about accessing 10 year debt near 4% too.. that's less than most cap rates and we'll below what's available for consumer mortgages. I wouldn't go overboard on pushing all expirees to the same time but if you're concerned about RE that can tap fixed rate capital below 5% for 10 years you basically cover the whole amortization period while gathering the cash you sit on and earnings +5% on shorter term cash... It doesn't sound tremendously concerning. They could essentially flip their balance sheets to be net beneficiaries of higher rates while reducing risk. I've basically come to the point where I've decided that what I think should be done doesn't matter... the central banks are intent on being a danger to everyone so protection from the 'risk' that they could be incompetent morons who are willing to blindly wreck the world must be considered. If rates go down they'd get a valuation bump and have plenty of capital and access to more. If rates go higher you make more on the cash & probably higher NOIs plus gain flexibility to deploy cash at higher rates of return.

That ~4% 10 year debt is probably a blessing for the country of the market priced a flat yield curve more in line with 'higher for longer' we could easily start facing other problems.

This slide from one of Canada's largest REITs basically explains it. For all the expensive living, high rent etc, their yield on cost is under 5%. If bonds or cap rates were pushed above 5% for duration you'd make less money adding supply than sitting in cash or buying existing assets. That would further shut down very much needed rental development. As is, most non-pre-sold development is rapidly slowing. According to central bankers that's the way to cool rent inflation... Incase you were wondering what caused my lack of faith in central bank logic.

Meanwhile... And this is the weird part... A bunch of these things have long term rental contracts often with rents well below market that roll into NOI growth. More economic growth or inflation doesn't hurt them in the long term. So, while I look cautiously at the potential for further cap rate raises, I think that with proper maturity management plenty of REITs are actually looking at some of this market backwards. Leverage is normally a structured bet on improvement or value creation. Here the market jumped straight to the concern that things keep going so well that it would be expensive to repeat the same bet.

As you can see, rising real estate prices have been a lowering rates phenomenon for 40 years... Before that they were a rising rates phenomenon. :)

Oddly, for REITs in the last rate hiking cycle they were compounding in the high 20% total returns.

Whatever the rhyme or reason or market thinking it's another area where I think you're able to pick up discounted assets. It wouldn't surprise me to see tactical deleveraging in response to higher debt service costs and perhaps different investor yield expectations. The fear is really that central banks are completely incompetent and hike into a declining economy. That's why I look at inverting the rate exposure on the balance sheet to any degree that flexibility allows. If they're going to further invert the yield curve...

Also I mean, let's say you're a company with access to long term debt near or sub 5, I may sell assets to de-risk but I'm not paying off the debt. I'm setting up maturities at better terms with my newfound flexibility and making the spread sitting on cash until something changes. If you can develop for a ~5% yield, your floor is somewhat hedged grab increased debt at 4.5, on assets that pay for themselves sit on excess cash at 5.5 or 6 or whatever stupid level they decide. Make the spread, benefit from the rent growth lunatics can cause & once they figure it out and put rates where it makes sense to develop you have cash (when you ironically don't need it). Point being fresh rates are the floor & as long as an eye is kept on debt roll/pay down schedule there's an intrinsic & logical hedge available here. There's always a spread somewhere, in a healthy market the spread rewards usefulness most (developing a new building) in a well supplied market it might be on buying a asset at a higher yield... On a demented market it's being useless/wasteful and accumulating cash... But that's where we are.

I hate suggesting this strategy of grabbing term in debt because I believe it *should* be perfectly wrong. Rates should have peaked and in terms of what's best for growth of humanity and what's best for most people, should come down. Not only that, I think inflation is falling and will normalize without further hikes. What should happen and what will happen don't necessarily have any relationship with each other. Protection and ability to survive stupidity is more important.

Hate For Housing

It's amazing how much hate the Canadian housing market has. Plenty of renters are downright angry or gloating about rate hike putting homeowners underwater. I don't know what they think will happen when housing starts continue to decline due to lack of profitability. I don't think affordability will get better on that trajectory. I don't think rents will get much lower either. We lost 14000 construction workers last month which is a repeat of the April losses. Step one Price down. Step two Supply down. Step Three Price up... but with less people being able to afford it due to less supply. I for one would prefer the price to fall because we get supply for everyone than the price to rise because no one can rationalize building... but what do I know. Months if not years ago I was being vocal about the fact that rate increases make affordability worse... they did... when they moderated and we priced in cuts it started getting a bit better only for hikes to reverse that. That's without getting into supply destruction. Worse is coming on this trajectory.

Oil

I keep hearing that crude is underpriced, lack of investment higher cost, no profit at $70 etc.

I also keep hearing that offshore break-even are $40 and that seems to go with drill baby drill among offshore companies. The Canadian oil companies keep talking about ability to make good profit at lower prices while the Saudis seem content subsidizing the market. $70 is plenty for most of the world to grow but iffy for the marginal producer's full cycle returns. IMO the bear case is that $70 looks like good money in many places and the bull case is we need all the $70 oil we can get later. I don't believe we need sustained $90+ oil. I think in a reasonable environment $80 is more than adequate for all relevant parties... That said, the market is rarely so civil. I'm not a believer in $100+ oil. I mean if you look at the technological advancement since 2007 era... we've grown drilling productivity by something like 20% CAGR. There are resource quality offsets but I don't think we're near a place where sustained higher prices are needed. Looking at the cycle of equity prices leads me to similar conclusions. $75-$80 is my rough idea of right price. $60 to $90 wouldn't make me surprised. I do find in interesting how much the WCS spread has fallen.

Gasoline

Gasoline has remained, largely through elevated crack spread, significantly (unhelpfully) inflated. It would be a breath of fresh air if the futures got this right. Many perceptions of inflation are linked to gasoline plus if you're looking for short term CPI relief that could be where it pops up. The futures suggesting a ~20% decline in gasoline prices would certainly be a useful data point in suggesting that inflation is back at target quicker to avoid further damage.

This has been delayed enough that I really wouldn't count on it to be accurate.

Uranium

It amazes me how long a sector can go without me feeling like I have much new to say. The price is still below where I feel it must eventually go. The investment possibilities remain a different question altogether. Most, obviously don't trade strictly on uranium price or fundamentals. It leaves a huge basket of things that I don't know what to make of. I will say that we have seen a different psychology from what some early bulls hoped for. There was hope that companies would wait for a good price to move forward. What we've seen is companies rush forward with a minimum price. It doesn't change the end S/D math but it does change the irr hopes. There has been some positive demand developments but the big one (China) simply hasn't been progressing at the pace hoped years ago that would be required to make this an explosive bull market. It's been more nuanced than I or many bulls from years ago thought. There are some names within the space I find appealing and many more I have no interest in today given the other opportunities in the market in less risky companies. The uranium I own I sometimes question why... and other times think I should add more.

Data

Inflation has continued to decline but particularly in the US, the economic data has been improving.

In the US, data has probably been the strongest. It looks like the economy may be reaccelerating. GDP revisions are upward and payrolls look very strong. Housing hasn't been getting weaker since last year despite the continued hikes. This despite record profit spread between the 30 year treasury and 30 year mortgage rates further tightening the funding in that market. Builders are stepping in to offer their product with more reasonable funding to great effect. May had very strong starts and new home sales data. If that's a trend, I like the outlook in lumber.

In Canada the only data still looking very strong is the population numbers. Ironically... The weakest of data (in May at least) was housing starts. We're at like 1 housing start per 6 new inhabitants (trailing)... It's almost like as profit margins shrink you get less housing starts or something. The interesting thing is for a decade now people have been indoctrinated with the belief that low rates caused prices to increase yet if you look at 100+ years of history, it doesn't seem to suggest that. Anyway, housing starts are now down by ~33% YoY and back to pre pandemic pace. The most recent number was before the June rate hike (also before some positive US housing data). 

Canada has now seen back to back months of declines in full time employment. A few months ago, out main transports suggested volumes were consistent with a mild recession. These points are wild to me considering we're running at something like a 2.5% population growth. Adding a million people a year and the economy is still losing jobs and volumes declining. I don't know if the recent improvement in the US will drag us out of this slump or not. Either way, the BoC seems absolutely oblivious to this entire paragraph as they just restarted raising rates in June. They want more suffering so we may well get that.

In connection with the railroads saying in may that they're seeing a mild recession amidst 2.5% population growth, wages have now been flat since March posting declines in may and June from their April peak. Unemployment is 5.4% up from a cyclical low of 4.9% (5% two months ago). We are certainly in a per capita recession... not that that means anything. The economists who at the same time 'we need more hikes' & predict 20k jobs per month and call 60K a big beat while 250K population growth per quarter should (at average employment rate) mean 55k jobs per month are truly infuriating. 292k from last Q at a 62.2% employment rate would be 60.5K per month... so the last 3 months average of 28k is... not great.

Counterintuitively the CAD has been strengthening despite the weaker data. Probably the surprise hike. Ideally this helps trade prices and reduces inflation perceptions. We're trailing the US in many things but we are likely to be dragged around by their data on a muted and lagged degree.

I think the Canadian economy is in conflict between the mortgage holders (almost all of which have rates that will reset in 5 years or less at any given time) and the human QE of immigrants supporting the pending suffering. Unfortunately, whichever way you cut it I think we're going to see an increase of homelessness. You have one hand fighting the other and the net policy looks incompetent and disgusting. The interest payments are off the charts because the debt load is so much higher than in the past. The shock of it all is pretty ridiculous because there's not really time to adapt and recognize what's happening to try to stem the bleeding before the next assault. They aren't even giving the time necessary to see that inflation was already falling because they literally keep adding to it. Every month from August to February ~0.1% inflation worth of Mortgage interest cost (CORE) inflation will roll off (except if rates are sent higher first). I think the bigger risk is political response and to living standards of the average Canadian rather than 1% above target inflation being potentially sticky or having a few more tech workers. The market will figure it out... But probably not in the way that some are thinking.

In the meantime, the reset of rates will continue to put the incremental financially marginal Canadian in a position where they lose their house... And the non marginal to ship large payments to rich old GIC holders. The loss of productivity on this capital will likely be a negative to the economy and destructive to some people's lives. This differs from the US where most rates are fixed for 30 years at the time of purchase so rate hikes don't change the conditions of past deals. (Before you ask we just generally don't have the same options available)

Rates

What I think should happen and what I believe is likely are two different questions. Ignoring that I think rates are already higher than they need to be, I think the data has given cover to CBs for more stupidity. By this point I think it should be clear that interest rates don't do what some people thought. Places that didn't hike have seen inflation implode... But no one is talking about that. In Canada 1/4 of our core inflation is Mortgage Interest Cost... Few care about that. Capital and supply is now more expensive... nobody cares. Anything bought with financing is being inflated in CPI. Acceleration interest payments are stimulating the US economy and we're just gonna pretend that's not happening. But let's just keep pretending that raising rates is the only magic in the universe capable of bringing down inflation. The reality is I think inflation is probably running 2s which basically already disproved the 'sticky' fears and shouldn't be a reason to take rates higher. That said, we have 1 more month of helpful base effects here in Canada which should take inflation to 3.0 or 2.9 from 3.4... we then get effectively a season of negative base effects where inflation is likely to rise. (Before you tell me that 3 and rising is too high, I'd highlight that 3 is actually 2 + Mortgage Interest Cost and by rising I mean by 0.5 excluding Mortgage Interest Cost.) I have 0 faith in those at the helm to be any more prescient than the moronic hot takes one might hear on twitter... I really have no idea what they might do with that.

The US Might actually be a beneficiary of higher rates. I was cautious about this theory and don't know how fully sold on it I am... BUT. The US has $32 trillion in debt most of which is short term T bills. as that rolls over it's now $1.5 Trillion of unfunded interest payments being shipped out to the holders of US debt. US debt is an ASSET as well as a liability. The owners of those assets are getting paid more as the US treasury goes further into the red. IE new money being pumped into the economy. That should at least offset some of the theoretical slowing hikes are supposed to cause. I'm pretty surprised that the US is just paying out 2x their military budget in interest or 1/3 of their tax revenues and we're just acting like that's normal. It could be rather terrifying if it turns out to be the case that debt payments are accelerating the economy (if that proves to be inflationary)... but not bearish stocks.

We actually had 3% inflation back in 2018... We didn't freak out about it then and it naturally fell back down... with interest rates at roughly 1.5%-1.75%.

'Missed it by That Much'

It's pretty unfortunate... Being me at least... I've been calling for inflation to come down with or without rate hikes... It mostly has (and looking at how inflation has collapsed the places that didn't increase rates, I think there's more undiscussed validity there). I've been saying Canada should scrape by because of our immense population growth. Population has boomed and Canada has miraculously muddled along despite every rate reason not to. Despite being ok with those points my expression of these ideas have been junk. I failed to consider that the BoC would want to kill us for no reason. We could have had a very soft landing if we stopped rates a long time ago. Maybe we still can, maybe not. Maybe a soft landing is still a miserable outcome because the average Canadian suffers. 

Conclusion

It's difficult to plan your investment when you're having to base decisions on the market's response to irrationality. The market tries to fix problems while forces act to make them worse. There are tremendous risks in both directions... Will they kill the economy? Will the create more inflation? I don't know how much of each we get. What I have noticed is that most of the time people only discuss half the equation... the half that the market believed for a long time. "Interest rate hikes slow the economy and kill inflation," or "When rates do X, this market does Y." Often, when you follow the logic, there is none & the historical reference is based on a time where there was a bunch more going on. The economy & the market work things out. Supply is a big part of the equation. Profit and cost of production matter. Often relying on what 'people say' misses a lot of the other side. In physics you learn every action has an equal and opposite reaction. Economists seem to ignore that. It's becoming evident how dangerous that is. My response is caution. Spread factor exposures, company risk profiles, sectors etc out to avoid being at the mercy of poor policy. 

I'm critical of much of this stuff because I fear the consequences. I believe there is something deeply wrong with the premise of how things are being done. Tons of potential is possible for making it better but immense destruction is possible from making it worse too. I hope we don't go that direction but believe we're concerningly close.

Enough rambling for today, catch you next time.

Disclosure: At the time of this article I own stocks within sectors mentioned.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

A Day Dreaming

The Dream family of companies recently had their AGMs. While I didn't attend, I listened to them and came away with a few thoughts.

September 6th

Early on my ears perked up when Michael Cooper, speaking as Dream Unlimited's CRO (CEO) announced a future educational event (Teach in) where they'd talk about "how we think we're going to continue making money at the rate we've been making over the last 10 years." Now that's pretty interesting when you consider where NAV/book have gone over the last 10 years compared to the current discount to try to figure out an IRR for today. If one were to use NAV growth as a surrogate for expected return, the numbers get pretty interesting, pretty quickly at a decent range of assumptions on what both of those numbers would be.

It was also said that FFO was shown because some would appreciate it but the company has always and will always focus of growing Net Asset Value. My humble opinion is this is the best way to run and think about real estate companies. It is the gravity which the company will orbit long term. Amounts of leverage, distributions, uses and prices of capital will change over time focusing on growing the terminal value of assets makes the most sense when you can do it as well as Dream.

Infinite Money Glitch

Unlimited spoke about their development activities saying they essentially end up building to 6% cap rates in western Canada... And 10 years debt was available near 4% (3.8%). Now that doesn't sound like much of a clip. 

It isn't, strictly speaking but it's also infinite. Making 2% is very little but it's not really making 2% in that scenario... It's an inflate % because you'd keep the 2% on someone else's incremental capital. Similar to asset management fees.

Use assets + credibility to get capital, use capital to create asset, use asset to pay off the capital... Keep asset + credibility.

Sure, it might not make sense to use 100% debt to finance development at a 2% spread but there's a lot of room for good returns between the infinite % of using all debt and the 6% of using all equity capital. Given however the incremental WC unit being a relatively small cost and portion of the companies' NAV, they can effectively use outside capital for the majority of the development. Also, if you have access to asset specific debt that can be locked in for a long time you can use a significant amount. If those assets become gifts that keep giving the returns can be ridiculous... If not, it consumed less capital.

I'm sure they won't take this idea as far as I suggested above and will have some level of equity backing assets. On the other hand, when looking at incremental capital needs & if we assume they own the land unlevered... 

Developing at 6 or in the 6s and having access to term debt closer to 4 also means that the interest on the higher cost construction loan (6s or 7s) are somewhat misleading when it comes to interest cost modeling. As the assets are completed, the cost of debt decreases as the revenue kicks in to pay off the development.

I took the scenic route to saying: $8 of unproductive land on the BS... Weighing down book value CAGR... Or $15-20 of land in NAV yielding nothing can easily blossom into its own company there without requiring the rest of the business to subsidize it. WC dev is a potentially significant business.

We Prefer Apartments

Cooper made an offhand comment that was interesting to me when he said, "We prefer apartments because they keep on giving." It's interesting because... They don't really have many rental apartments. Most of what they do have on the platform are small stakes via funds and JVs not what they developed. Hopefully this means dream will develop and keep some awesome properties that keep adding value for years and decades to come.

Hundred Baggers

Cooper spoke about some of dream's best performing investments. They bought assets that nobody wanted for very cheap... A cast-off ski hill. An old distillery. And turned them into great desirable, niche places. They develop a culture around them and add to the region. Grow the assets with more vision than math. Long into the future you have assets who yield 100s of % of the companies' cost. Assets worth much... Much more.

I quite liked the story about the investor who told them they 'better not buy that middle of nowhere asset in one of their funds.'

With all the respect in the world for Cooper this does make me wonder about the affordability arm of MPCT. What dream has done fantastically was prove out the ability to visualize and materialize a wonderful experience. Think, Distillery District, A-Basin, Forma. What's completely different is dealing with affordable side of the market and those associated challenges.

Office.

Office remains excessively noisy. The most interesting Cooper remark on Office was around zoning. They provided an example, using their head office building as an example... Of how an office building is worth about $240M whereas if it were empty land with residential zoning, it would probably be worth $300M. Meaning: office zoning essentially has negative value. The implicit suggestion here is that there's a more drastic manner of balancing the currently oversupplied office market. If cities would remove need to replace office space, plenty of residential development would be possible.

This would work towards balancing both markets (resi and office) much quicker and provide cities with more vibrancy and tax revenues. The main problem with this scenario which seems ideal for all parties is it hinges on wise political governance... In other words, it's probably dead on arrival.

D-UN focused the bulk of their presentation on the quality of their assets. Core assets, market leading rent and rent growth. Strong renewals and significant spreads over past leases. Highly in demand restaurants. They're certainly holding up better than many... But I'm sure the toxicity of the asset class weighs on all.

It remained unclear what DRM would be doing with their stake. Cooper didn't sound tremendously bullish even on what the rest of the crew were discussing as tremendous properties. The asset collector in me doesn't really want them to sell any. I have various conflicting thoughts on this whole thing so instead of more back and forth, I'll just wait and see.

US Real Estate

I can't remember which call it was in but Cooper mentioned that 3000 buildings in the US were given back due to changed market fundamentals and credit availability in the country. He also suggested that's going higher. It sounds like RE credit markets aren't going well where it comes to availability.

This plugs in to two other points.

1: Their entrance into the US credit markets with the Aviro partnership. Perhaps there's space and opportunities in the US lending market. Given however that my hopes for that business are that it's an OPM asset management business, I guess the challenge would be convincing investors to step in with funding. I'm not sure how tied to a niche their initiative might me at this point vs broad enough to market the equity fear (on lack of credit availability) as an opportunity. 

2:  A Basin

A-Basin

They mentioned that it doesn't really make sense to sell A-Basin. Their cost basis is 0 and tax would eat too much of the value to justify. They also suggested they they don't have other US assets to offset the tax. They can however use pull capital from the asset while keeping the growing, strong asset.

No US assets, US capital available, people having to give back assets... Need I go on? I don't really know what kind of thing they'd have interest in. As much as I prefer the development side of the business particularly in Resi, the fundamentals in Canada seem far stronger than in the US. The distressed assets also aren't necessarily there. A-Basin, if that's also where the bulk of the capital were to come from, isn't tremendously huge either. They could buy an asset... Or two but couldn't acquire a portfolio. That said, they also suggested they wouldn't need to acquire much because of their current long runway of assets. I for one would love to see the legend of the $4M asset acquisition continue to expand in value across other assets in the country.

Canada Fundamentals

One point brought up in the Impact Trust Q&A I wanted to discuss because I emphatically agree with it. Last year Canada had this wonderful plan to help housing affordability... Build twice as many houses each year. No sarcasm here... It's a good idea. The "how" was a bit less though out. The capital needed to execute on the plan was to be a mere 2x GDP. So naturally they assumed it would just happen without much help. One thing that did brilliantly help is interest rates were raised ~tripling the price of that 2xGDP of capital. That one was sarcasm. Anyways housing starts fell because builders don't want to fight the central bank. So now we need to almost triple housing starts... Lovely.

It's slightly better (worse) than that. The reason we weren't building more before was labor constraints. Constraints which likely don't naturally improve as most of that labor force is far closer to retirement than day 1. Constraints which also mean that infrastructure improvements would consume the same productive capacity that would otherwise be building places to live.

Now imagine how screwed up the situation would be if 30% of construction costs were taxes... 

Replacement Cost

The above point about labor flows into the point about apartments being the gift that keeps giving. Something that many people seem to miss but seems impossibly evident when coming from commodities is that cost of production is paramount. You can always have more of something if the price is high enough to cause people to profitably add capacity. Whereas you get no more of somethings if the price is too low to produce it. (There's of course a lag). It's much more expensive to build a building today than it was 50 years ago. It'll probably be much more dollars in 50 years to build than now. If we're talking about an apartment building... it'll house the same number of people... people who'll be earning much higher wages (in $). The economic value of this apartment will likely increase over time. 

As long as you need to keep expanding capacity... ie growing an economy... prices will need to trace production cost. If you want to understand the main reason why Canada is more expensive than Japan... or Toronto is so much more expansive than Edmonton look no further than the continued need to develop in a constrained area. You can wreck the economy short term and disrupt the incentive to build... overcapacity or negative economic growth, population shrinkage etc. There are a few (Land and Tax) costs which are medium term questions and could in theory decline leading to lower prices... although offset on the developer side. When the need to grow supply returns it will cost money... and probably more money. Better or more in demand areas also contribute to how much people are willing to pay to live there. Higher wages, more entertainment...

Rental properties can provide cashflow as that process works in the background... Location Location Location.

Sovereign Wealth Fund... Part 2?

It was hinted that Dream was trying to duplicate what they did with GIC & Summit. I'm of course all for that. A second deal could easily take NAV in that segment into the mid 20s from high teens. Not that anyone cares about such things. It's amazing really, the market apathy around dream's AM business. This is especially true after they landed their first Sovereign wealth fund partnership. Any catch of that size going forward is a step in value of relevant size for the company as a whole.

I compare an ideal Asset Managers' approach to that of fishing. To have the best chance of success, you want to have a bunch of lines cast and waiting for excitement. Having more funds, at least at a size that the market would accept, wants there are more scenarios for growth. A suspicion I had when they bought more of a stake in the distillery district was they may have been setting up a future Retail REIT. 

Ideally someday they have a retail REIT, a Canadian residential REIT, more private Canadian funds, some US public stuff etc... that way there'd be more scenarios that could provide them with funds. The issue of course is that each needs it's own scale and liquidity not to mention their own management team... Associated costs etc.

I'm sure they'd love to have a second asset class with scale. Industrial has been the majority of their asset management success... It now makes up a disproportionately large portion of their fee bearing AUM. It's the only public field I could see able to make bite-sized additions and partnerships that would make significant jumps for DRM's AM growth.

Tax

I am one investor who wasn't the least bit surprised about the mention by DRM's CEO about the tremendous amount of time he spends on tax. I'm not just saying that to try to sound like a know it all jackass. I've been thinking a lot about it myself especially since tax season 2022. 

Most of the excess returns on an asset purchase are front loaded... You see something differently, maybe you get it right or something changes. The value moves to where you expect... Then what. For an asset to get there... Say 5-10x the initial price, it probably needs to prove a lot of value, deleverage, grow, add stability, normalize the bargain price, etc. You then are left with a bigger asset with more average prospects and return profile at the asset level. You can sell it and reinvest the proceeds... After tax, losing a chunk of your gain in the swap. Or you can pull capital from that improved asset value (an asset with an average cashflow yield & average prospects) to invest in an asset with superior prospects.

Further, the mechanics when it comes to writing off interest vs the tax efficiency of certain income streams and nuance of different tax laws make it quite beneficial to put ample consideration of tax ramifications of virtually everything. Depreciation & amortization etc. Were I operating an asset collecting platform on any relevantly sized scale, I'm sure tax would be a huge part of most decisions.

The margin of alpha in many investments is so slim that it's hard to really benefit to an excess degree over time if you have to keep taking hits on tax every time you want to deploy capital. This is especially the case when you have perfectly good assets that should easily more than cover the cost of the capital you'd pull from them. Doubly so if you had an actual business with access reasonably priced fixed debt. Managing small things like D&A properly have a multiplied downstream impact on returns when operating cashflow can support new investments which offer high returns. Assets can have tons more value than what the taxable earnings they spit out might suggest. As I suggested much earlier, NAV or fair value of the assets is key... This isn't always the same thing as book value.

It's a bit of a relief to know that I haven't been the only one obcesing over the tax lens of investing. I feel a bit less crazy. I do find it a bit amusing given part of what's special about DRM, in my opinion vs the many cheap stocks out there and perhaps even slightly cheaper RE peers is that I think dream offers superior long term tax efficiency. I guess we'll see if that's the case.

Conclusion

I started this reflecting on some AGM thoughts. By this point however, I find myself looking at the company's intermediate future in a way I hadn't quite before. A billion dollar asset management business. A billion dollar western Canada homebuilding business. A billion dollar urban development business. A billion dollars worth of REIT unit holdings & other stabilized assets. That's four distinct categories which could all single handedly be worth more than the current market cap in a few years. All of which are both self sufficient and strengthened by their connection to the rest of the business. Dream will continue to work towards solving Canada's housing shortage to the degree they can. Rate hikes will continue to slow the industry and make the problem worse short term. I believe demand will be resilient based on supply and demand fundamentals, likely for years to come. As for me, I'll probably try to collect a few more shares over time if prices remain as discounted as I believe they are.

Disclosure: At the time of this article I own $DRM.TO & $MPCT-UN.TO as well as indirect stakes in other entities mentioned in this article.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.

 

Canadian Housing... Bubble?

Canada Housing... Bubble?

Housing in Canada is perhaps the most discussed topic. In fairness... We don't have much else. You'd think with as much land as we have and as much discussion as the topic received that we'd be able to easily solve any availability issues. You'd think.

The problems with housing starts with an inconvenient point. Despite the vastness of our empty country searching for relevance, most people want to live in half a dozen places. Particularly two that get the most discussion (Toronto & Vancouver). Both of which have water and transportation issues somewhat boxing them in. Anyways everyone agrees they're ridiculously expensive, particularly for the young family.

Mostly answers to such problems there are two simple answers. 

1: Move elsewhere. While sounding simple, people understandably don't want to listen to the "it's not that hard, just leave the place where you were born and raised that has all the jobs" argument. That's fine, so we should go to option 2

2: Build More. Easy right... Right... Here's my biggest problem with some of the complaints. (Let's pretend that people don't fight against development). It's expensive to build.

Building:

You need Land

+

Plan

Plan includes zoning, building permits, engineering work

+

Money

Your capital, debt, backing for the risk (pre-sales)

+

Incentive

Developers need to have a reason to develop, so that's profit - tax paid - interest

If you add up all the costs, you get something like this

You better believe this has increased since 2020.

In other words, if you want more supply, you need prices at that level minimum. Recently I saw someone talking about the ridiculous price of Toronto condos... the same person a few weeks earlier was asking 'now that prices are almost such that developers can't make money, what do they do? will they sell at a loss or wait?' I CAN'T MAKE THIS UP... but this story explains so much... why do developers pre-sell units to investors? Why hasn't supply been more responsive in 'bubble' prices? Why have prices been so high for so long? INCREMENTAL SUPPLY IS VERY EXPENSIVE. A bubble... with costs close to construction costs.

Beyond that you need policy to help (and there's definitely policy available to help) 

If you work that out as a baseline to compare against, the market isn't that bad. 

On the other hand, if you look at what has happened in the market, the obvious levels of shooting ourselves in the foot is killing me.

Mechanically: Raise rates= raising payments 

So we've collapsed the incentive to produce more supply while artificially made housing less affordable 👍👏👍👏.

At least immigration has been lower so the market can catch...

... Nevermind.

Ok but we must be working off a very high production base... After all prices are in "bubble territory" in some people's minds.

That's a matter of perspective

My perspective is: no... but I'm sure some would disagree. Like, it would be high if population growth was at 2005 or 1970 or 1985 levels... but last year we added 2.5x the growth that we had in those periods.

Even within the G7 Canada has low housing stock

Compared to the US population growth & starts 

So here we are... Market so concerned about 2008/9 that we're being cautious with investment.

Ironically, prices had received declined more on a % YoY basis than they did in the GFC.

I've all but given up trying to explain why I'm super bullish on developing real estate in Canada longer term. It hasn't mattered for months. I get it, price is going to hurt with rate hikes or a weaker economy. I also understand that my volume businesses may take a hit because of the margin hit and caution.

Do you see how that makes the problem worse (investment outlook better) afterwards?

What I believe the main constraint should/will be is labor. At this moment I'm sure some genius is about to tell me how rate hikes will help with that because the layoffs from interest rate sensitive sectors (like housing) will provide labor. But my point is there is a realistic concern about the right skilled labor availability to build as many dwellings as we'd need. I think the market will mostly figure it out but I also don't see why we need hundreds of thousands of tech worker immigrants but don't bring immigrants who want to build homes.

Hate on Pre-Con sales

One narrative that really grinds my gears is the hate out there for people 'speculating' on pre-constructed condos. (P.S. I've never done this). Builders need capital to develop $250M buildings. Banks don't want to take price risk, nor do builders. So builders often need to sell units before they build. Given that the entry home buyer uses their home as a place to live, they're less able to dish out large amounts of money years before there's a place to live. Investors step in and fund the development.

Yes, you understood that right, without those speculators that get all the hate, there'd be less supply and even higher prices. No... Adding speculative supply isn't jacking up prices. I understand it's an emotional topic but please think logically.

I know someone is going to read this and want to tell me why they're evil for different reasons. "They're funding the wrong type of housing, they're adding one bedroom that no one wants" again, I understand that people see the need for more family sizes units but understand that those take much more space and much more money to build. Understand also that if there weren't huge amounts of demand for those (despite the narrative) that prices & rents would look different and the market would react differently.

Demand to live in Canada and those cities has been enormous. It certainly hasn't been handled perfectly but the situation is far less inexplicably crazy or bubble-like than many imply.

People really hate people keeping properties as investments but again, they put up the same capital that can be used to build more and use that unit to (in their own small way) push down rent prices. Every unit rented out is added supply. Added supply reduces rent.

1988

There was a news article from 1988 about how unaffordable Toronto was. Seen Here Everyone wanted to be there then and everyone wants to be there now. Things that everyone wants, not everyone can have. That comes out by things being deemed unaffordable. P.S. if you invested in a condo in 1988, you did ok on price. If you include the leverage that a mortgage would provide, you did great financially.

Gold vs Toronto

Toronto Real Estate is a bubble... I mean according to everyone... But is gold?

Prices that keep going up always inspire people to jump to bubble conclusions. Meanwhile, a crappy currency like ours (not complaining, there are certainly far worse) loses value all the time. If populations are going to grow, costs of real estate will be tied to costs of production. Declining currency into a broadly increasing economy means more wealth chasing the most core in demand locations... Higher demand. Some people's ideas of affordable may not match the realities of building a house. Plus as Tim Melton put it, Even back when houses were under $20'000 all people could talk about was how expensive they were. The more things change, the more they stay the same.

Taxes

Speaking of costs of production... I think people would be astounded at how much of the cost of new housing is essentially tax. This report Will Feds Answer the Call identifies the huge percentage of the cost of production that is effectively tax. hint it's HUGE.

Yes that's 288k or nearly 1/3 of the price that are taxes just being passed along to the final purchaser... That's almost triple the developer's margin & more than wages of the team spending months building the house.

It's also been growing as a share

It's pretty crazy to think about. At 5% interest rates it's mean paying an added $1200 per month in interest... just on the tax

 So if we want to improve this in a sustainable way this is, to me, the simplest, best and least intrusive way to make things much better. (Targeted tax breaks for certain aspects of the industry). I think we could get prices down 25% with the right policy... Of course that would be temporary as the currency depreciation aspect and others will essentially mean over time prices likely keep going up.

FHSA

The FHSA isn't the best idea but isn't the worst. It also demonstrates a willingness for a targeted solution. For those not following: the First Home Savings Account or (First home tax free savings account) is something that I believe most young, income earnings non home owners should look into. It's tax deductible like a RRSP but has the benefit of not being taxed in the future (like TFSAs) the catch being that it must be used towards the purchase of a first home within a certain (but quite long) time. It's targeted because only non-homeowners can open one. Imperfect because on a basic level, if everyone has more money to bid for a price that doesn't improve the competition dynamics.

Interest Rates

People (who ignored history, logic and data) thought that higher interest rates would make housing more affordable. It's an easy story to tell yourself. Rates up = price down... that must be good for affordability right? WRONG. The price goes down BECAUSE there's less affordability at the prior price. Affordability only improves when rates stop increasing. Homes aren't bought all cash, what's actually purchased in an ongoing payment. Although the price goes down, the payment actually goes UP. Don't take my word for it, look at the last 50 years of data and see if you can see what happens to affordability ever time interest rates are raised.

Unfortunately, it's even worse than that... We agree that interest rate hikes drive down prices... so let me ask you, with lower prices, foes that incentivize more or less supply?

Unfortunately, it's still even worse than that... Building houses is expensive. Lots of money is needed up front to build. Raising interest rates is the definition of making that money more expensive. Just like with taxes... that cost must at some point be passed on to end buyers... or result in less volume at the margin.

We're really stupid.

ACTUAL IDEAS

Cut taxes on labor, materials, land transfer, development, sales etc.

Ease zoning restraints, if people want to spend lots of money on building residences don't make their life hell.

    Also, if someone wants to replace an office building with residences... let them

Offer developers lower interest rates for their construction.

Look, I've probably convinced no one of anything. So here's my suggestion. If you believe that houses are ridiculously expensive, build one and sell it... Make a fortune... if you can.

Release Valve 

It does bring up the question of a release valve. I mean we didn't solve much on pricing in this post... We just looked at why it's the case. So if people can't afford to live in downtown Vancouver, where can they afford?

Perhaps more interesting, why is there cheaper? After all, one of the best arguments I've heard for being bearish an asset with thousands of years of track record of being an appreciating asset is that it's just too dang expensive an entry point. The answer I come to is, 1: cheaper land. 2: easier permetting (less development timeline) 3: more favorable construction industry. IE lower costs, lower costs and you guessed it... lower costs.

The one I keep seeing, perhaps because all the options in the public equity market seem to point there, is Alberta. Alberta had both spare capacity from the last oil boom & one of the most conducive building environments... Also with spare capacity. Well, they've tightened significantly last year along with much of the rest of the country.

Note: Q1 of 23 was 'only' 45k (source Statistics Canada & me)

Just because I give you This table of declining vacancy rates doesn't mean that the market cares.

In reality we're nowhere near the equity prices of the last time people cared about Alberta. We're perhaps on average 1/3 of the valuation vs last time. On one hand that makes sense. People got burned by the excitement last time. We still haven't recovered from that. People now look at any boom as an inevitable bust. On the other hand, in the last cycle, such a ridiculous amount of money was first made in Alberta (pre 08)... That expectations may have became unhinged. My favorite anecdote is a company (which I didn't own then) that increased their dividend 100x through the cycle. Another company with land in the region was trading at 3x book value. Today the first company trades at 1/3 of their book value & the other, I'd argue the land is free in today's market cap.

We've gone from forgetting busts exist to forgetting booms exist.