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. 

Dream Unlimited Power

Dream Unlimited Power 

Dundee Real Estate Asset Management otherwise known as DREAM Unlimited... Or in accordance with the thought I frequently have when hearing "Unlimited"...Dream Unlimited Power is the real estate company central to today's article. 

$DRM.TO is in my opinion a highly underappreciated Canadian company... Or at least it was until we decided to pop the real estate bubble and take prices back 30 years because construction cost no longer matters due to the fact that we're never going to construct another building. So +20 years of great results don't matter, obviously it's different at this time.

With that in mind, I'm going to write the rest of this as though I'm oblivious to that paragraph.

I want to talk for a second about book value. Quite basically, book value is normally what money you put into something. There are of course adjustments in some instances, some RE gets marked to fair value depending on the structure... But if you were to build a service, that would have no tangible value. If you buy a ski hill that now generated annual profits in excess of what you paid for it (growth or inflation) it can generate very high returns on equity because it's book value isn't fair market value. Land, same thing. The more you can use those assets for incremental return, whether that's through leveraging some of their true value for capital, earnings incremental returns on those assets or something else it gives companies the ability to, over time, amplify how far above book value their intrinsic value is. The only limit with this compounding ability over the long term is to keep finding high return places to deploy capital.

Dream 1.0 was 20+ years of growing real estate book value very quickly. They grew at high teens to low 20% CAGR for a long time because they were very good at deploying capital & developing real estate. In and of itself that's probably worth a nice premium to a book value that gets further outdated by the day... Or at least would if we still needed more real estate in the future. Sorry Dream 1.0 

Dream 2.0 is what we're starting to witness and what we were thinking about last year. Dream is now focusing on the unlimited power of capital light business. Growing a capital heavy business, like real estate or industrial (etc.) quickly means you're good at spending money. Your main limitation is money. You only have so much to spend because you only have so much. What if you could have more... You know

"Shut up and take my money",... And pay yourself a little fee to invest it.

Dream's recent pivot has been & I believe is very close to demonstrating why book value was nice while it lasted. They're building an expansive and rapidly growing asset management platform. Adding an additional business that can... In the right market... Grow at an almost unlimited pace. Better yet without needing to devote the bulk of their capital to achieve incremental growth.

Asset Management & Dream Industrial

Some people believe Dream should sell the Dream Industrial vehicle. It's a good point to think about. Dream would walk away with +$270 Million. Dream Office would also be infused with roughly $450M in pretax cash. Both could do a lot of accretive capital allocation with that much capital in this environment. It would equate to maybe ~25x trailing EBITDA on the asset management fees.

My problems with that scenario are;

1: Deploying that capital would be difficult. The trading liquidity of the in house options coupled with the facts that DRM & Cooper already have enormous stakes limit the open market buying potential. Then take-privates would need to happen closer to book (if not at or above it if the business is going to be desired in the future) office could almost SIB itself to private... If you want more office exposure.

Impact, Residential and Dream don't trade. 

So they're left with trying to take control of a REIT they don't own or essentially selling at private market prices only to buy at private market prices.

2: They'd be leaving their biggest public exposure to the strongest real estate asset class. DIR is probably their best shot of near term being able to grow public AUM. DIR also allowed Unlimited to add a private US industrial AM business line & $6B in private Industrial AUM with the GIC/Summit transaction. It's their biggest, most relevant tool for casually stumbling into more asset management growth.

It's weird but this spin off of a spin off business is probably a core asset at this point. Besides, they haven't got to the best part yet.

Asset of Tomorrow

 

Dream is a chimera (part lion, part goat, part dragon) it's difficult if not impossible to value for that reason. The main asset of today is used to create the main asset of tomorrow. It's the mark of quality business and capital allocation. So what's the asset of tomorrow?  What gets minimal notice today but is a company maker in the future?

For me, it's the $DIR-UN.TO performance incentive bonus. Looking at P/E or EV/EBITDA or any trailing metric for that reason and you might think it's worth 0. Next year perhaps something but very little eventually...

Well, it goes something like this Dream Industrial has a hurdle rate for their FFO. It increases by half of CPI. Currently it's roughly $1. For every cent over it, DRM gets roughly $0.01 per share in pure profit (EBITDA).

(Twitter: @CDNVALUESTOCKS aka Tyler) highlighted this in another one of his great and extensive write-ups on dream. Seen Here If you're interested in the company after this I recommend reading both of his write-ups. I do weigh in some here indirectly but 100% respectfully. He suggests a discounted cash flow to model what this asset is worth. 

I don't love DCF's as a rule, they aren't fair to tails in compounding. Using a reasonable mean isn't how things play out. I understand that a model is meant to be approximately what's coming not an exact representation of the future but their linear look at the evolving future rarely captures dynamic markets.

In this case there are a few aspects that have me unreasonably un-consensus on this asset.

Let's say that after this year FFO will be flat vs the hurdle... Worth exactly $0 in earnings but any incremental growth is 1:1... I don't think people appreciate how strong industrial real estate has been. Rents are up significantly in recent years even into Q1 of 2023 they were up relevantly QoQ. Canadian rents in DIR's portfolio had a 50% spread to market. After Q1 that's probably higher... On higher rents. But that doesn't matter for our 'after 2023' scenario right? Wrong. For the same reason that this spread exists, it will continue to exist. Only about 10% of rents roll over each year to capture the new, much higher rents. Higher rents and FFO... And incentive fee. So REITs who normally return most of their capital and don't grow much, have pent up growth well beyond forward CPI. 

Also, DIR just entered a JV with GIC to buy a REIT with lots of development land. A JV which will pay them the capital light property management fees in addition to letting them deploy capital at rates to further compound FFO/Unit. Barely to mention, taking them up to their target leverage ratio while further growing.

Ok but all this you can kinda model out right? I mean you can be more or less aggressive but it's somewhat straight line... What you can't is this. What happens next time that the public market likes industrial REITs (of which basically 3 remain in Canada). So what happens if they work their was through the pent up growth to for a random example 1.50 in FFO vs 1.20 hurdle... Then REITs are interesting again and they can grow unit count 33% in an accretive way. 0.30 becomes 0.40 from units then 0.45 from the accretion. I guess I can also just point to the many layers of factors that influence the future value as things that would complicate a model.

Plus if you can get further ahead of the hurdle, the more of DIR's incremental growth benefits DRM. Basically, the compounding potential of this asset is incredible. Tremendous leverage to the success of DIR and that's in addition to the rest of the NAV based asset management fees. Yet today, it's not part of the picture. In my honest opinion, that's why they're not looking too closely at selling the REIT for what would be a significant windfall profit relative to today's DRM market cap. The long term potential of the dual stream of profits from the partnership are very valuable. 

For reference to DIR's FFO of the last few quarters was:

0.22 in Q3 2022

0.23 in Q4 2022

0.25 in Q1 2023

At the end of 2022 the hurdle was 1.00 (Note their guidance was 90s so it sounds like there's a step back coming. Also Interest expense will likely be less favorable to DIR going forward)

The whole asset management side of the business is "In addition to" 

AM is in addition to asset growth

Performance bonus is in addition to asset management fees.

Neither requires more money once set up... That's a nice offset to the capital heavy development business.

Industrial real estate is in my opinion the crown jewel of real estate in markets recently. Public markets still (or again) are trading at discounts & development demand is pretty strong. It's not the cheapest of the categories but offers some organic growth. It's fortunate that DRM is overweight it on the asset management side. I think it offsets some uncertainty on the office side. Not to mention that their office equity should probably be supported by the DIR stake. (Note this was written before *that* I'll address it later)

I've stated in the past in a few conversations that a pure play industrial on NAV reversion was probably a simple trade that works... Unfortunately I was too stupid to do it because I viewed there as being far cheaper ways to get industrial exposure... Which have naturally vastly underperformed. Sum of the parts discounts, (while often great value and value add opportunities) sure do drive you crazy in the intermediate term...

More Leverage 

Their western Canadian land holdings... Held at old cost. They can use debt from that spread to incrementally develop at a higher yield than interest. That's incremental recurring income growth from tomorrow's assets. If we look at what the dream iMPaCT trust has been able to do (pull capital from paper gains on assets and use it to develop other assets) I think we can develop an appreciation for what's possible with Dream's land developments. Real estate in general fascinates me in this regard. Land + reputation= great potential. If they can develop to a high enough yield on cost to cover debt + amortize, the returns on the incremental equity that the company needs to provide are... Ummm... High? Yet for now, again, this land isn't generating any recurring value based on how the company (and I) would measure it. The 'dead money' land assets can generate great ROEs going forward.

Problems With Measuring Development

The elephant in the room is almost becoming the 'Build to sell' segment. It's irregularities mean I don't ascribe much value to the develop to sell business' cashflow on any given year. I almost certainly should. It is after all what has driven a tremendous amount of value to date. I prefer not counting on anything that isn't recurring when discussing multiple (this is probably why I'd willingly suggest that it's not incredibly special from a earnings perspective). This also hurts construction businesses. The market doesn't adequately appreciate them. The earnings & cashflows are all over the place. Some years are great, others completely lacking. Normally this type of erratic line of business would be valued off of book value. Which makes it highly unfortunate that I believe that 'book value' is about to be out of date in a big way.

People prefer stable cashflow and linear growth. They want a model to point to a cashflow that goes up and to the right otherwise every time Dream has a good year it proceeds to set off the "declining EPS" alarm bells right after. There's a cohort of investors able to use their brains and not their computers to work past this but it makes the idea of a FFO multiple less likely to be helpful or useful either way. Western Canada may have some type of regularity or not but I don't think city development ever will. Neither will ever be as stable as real estate NOIs or asset management fees.

I don't know what the answer is to this. They should definitely keep developing, it earns great returns. Even if (I &) the market doesn't appreciate it adequately when the profit arrives with a multiple, from a 30000 foot view we can appreciate the snowball effect. Having your own NAV estimate somewhat works but guarantees perpetual discounts.

Discounts are mathematically almost irrelevant to the long to infinite term investor. Half of 50 still doubles to reach half of 100. Valuation can of course improve or deteriorate but if value keeps going in the right direction the bulk of the returns will be the same. I say that with the full realization of what the last decade held for Dream's stock. There's a realistic limit to multiple contraction. I highly doubt we're going to 0.05x book. I suspect the valuation will eventually revert to something that looks more reasonable... whether that's fundamentals catching down or price catching up, it's too soon to say. The latter is better. If they keep doing their thing and shareholders keep holding, the day to day price doesn't matter as much anyways.

Dream Residential

Dream residential is a very odd asset but I wanted to mention it briefly. It IPO'd at a very unfortunate time. They missed the period where they may have been able to raise 10s or 100s of millions and entered the market when everything was falling apart. It's ideal to have a residential REIT in the public markets as sometimes it can probably be a great AM exposure to have. That said... having a US focused REIT listed in USD on the TSX seems a little abnormal to me. Don't get me wrong, it's not the only one & can still do well in the right environment but it's different. For a combination of reasons, it's now sitting there at 45% of NAV paying a +5% distribution & buying back units. DReaM's stake in it is relatively small for the time being but I still like their optionality with this vehicle. I was a bit surprised at the launch about the US focus. After all it was Cooper who said on the iMaPCT conference call that the capital necessary in Canada to accommodate growth was 'insane.'

Tweaking Estimates 

It's not all good news. 

Their much higher interest expense from last year will likely be higher still this year. 

Stabilized income from the same assets will likely be higher.

New properties come online so that portion of the debt can get cheaper (mortgage debt is cheaper than construction loan/line of credit). Other completed assets can be sold to free up capital.

The SG&A will likely come down a little without the settlement. 

Impact Trust's distribution was cut by 60% which will more than offset increased stake.

AM likely to increase.

Still I can make the argument that measuring it even on a FFO or at least recurring FFO perspective, they're not all that impressive today. There are certainly peers that trade at lower equity cashflow multiples & equally large discounts to assets.

I also believe that some of the torrid book value CAGR has been or is being sacrificed to support growth in the asset management platform. Essentially less doubling down on short term bets and more conversion to stable value... I hope this is more of a start-up feature of having exposure to many classes of RE to grow from. the asset management growth has been spectacular. That is more a function of having all the fishing poles in the water than the adding of own built assets. It's hard to argue with the book value growth results from DREAM's development business running it as they did for the long term.

There's also office exposure that, while above average in the asset class, is still office.

They also do some bizarre things from time to time that I don't quite understand but trust their experience. Spending millions on a stake in the distillery district with REITs trading at half NAV... While also directionally targeting having more liquidity. Or starting a debt venture... Which could be great or terrible but I don't have the information to know yet.

There's also higher interest rates across the board which isn't great & is punishing development... Great policy for dealing with expensive housing right!!! 

Also, most listed REITs trade at substantial discounts to their Net Asset Values. So while this provides dream an effective way to amplify the capital they deploy... It also limits their otherwise almost unlimited ability to raise new outside money. I would point out that they're doing well with their balancing of public vs private asset gathering. One is virtually always at a premium to the other. Having this balance allows them to bridge the valuation gap by raising capital on one side and buying assets from the other. It works and can make sense in both directions.

Pre-GIC numbers on top, Post GIC chart below. 2020 dip was Dream Global sale in 2019.

Value

It's difficult for me to point to a metric and suggest it should trade at AxB or Q% of Z. If the market wants to look at a P/B relatively in line with an arbitrary market number, that's fine. Trading inexpensively doesn't hurt anyone. I believe we are in a transition period. Asset focus to asset management focus. We're still in the murky middle & I believe that's caused excess volatility.

What's it worth? if you want a specific answer, No idea. There are too many moving parts... None of which tell you about the much bigger question... What will it be worth. To that I dare not give my answer to where I believe the fair value will be in the distant future. 

TD

Toronto Dominion... (Wow I feel old calling it that) estimated Dream Unlimited to have a NAV of $70/share a few months ago. I don't know that I can come up with a better number for a net asset value. Now, as I said before sum of the parts often get discounts ✅. Real estate is out of favor ✅. People hate office exposure ✅. Land public market discount ✅. 

They say that makes them worth $43 to the market. Based on very little I had something like $45 in mind as a reasonable valuation in this kind of environment. 

TD's NAV of $31.5 for the asset management arm both feels quite high and doesn't. I pencil it at $15-18 today (Up from $10-12 last year)... But...if I told you that there was this asset light business growing sales nearly 50% CAGR and had $1/share of run rate free cash flow (as they might going forward), it's the type of thing that I could imagine the market assigning a multiple which some might find ridiculous. (Well above 30). I think it alone will eventually be worth enough to make this an attractive investment. My assessment of today's $15-18 reflects a skeptical real estate market offsetting past AM growth and a less forward looking market when it comes to growth trends. In plain English, I believe that numbers will be low if things go mostly as planned.

Measuring the assets is far messier. Public REIT equities trade at severe discounts to their stated NAVs, sometimes justified, sometimes not. Depending if we want to discuss today's NAV price, today's market price or what could be the value years out in XYZ scenario you can come up with 0 or a lot of value. Different discounts for different assets make coming up with an exact number both pointless and impossible.

I don't particularly want any kind of separation because, while I think the shares might initially like the simplicity, I think there are benefits to the complicated structure. Using strengths to capitalize on weaknesses. A discount to "whatever" fair value is, can be a positive if it means fair value can be grown faster.

Point and case being the ability to use EBITDA generated from AM to cover development debt interest service. Also, it's not like many of the parts would be fully appreciated in this market either.

As much as I rave about the Asset Management business, I'm reminded of a spin-off example used in a book. Marriott spun their assets out from their management business (or vice versa) hotels sucked and were out of favor... Hence the spin. The spinoff asset heavy business (hotels... yuck) proceeded to outperform the capital light business. I'm not saying that in favor of a spin but instead to point out that there can easily be a tremendous amount of value hidden in assets that the market hates... Again. It's almost like asset heavy businesses can be good over the long term or something... nah.

I'm half shocked at how cheaply shares can be had at this juncture, given the prospects and risk/reward. 

A rapidly growing asset management platform 

Quality Real Estate

Great Capital Allocation

Great Reputation

Then I remember

Office is dead

Residential is toxic because of "Bubble" narrative (This is the story I take the biggest issue with)

Land is irrelevant (until it isn't)

Debt is more of a burden

And the asset management income was still relatively small.

Dream is fairly small company that trades less than $1M/day with 1.5 analysts.

Last Quarter

Looking at the last quarterly results I think we saw all of this. Asset management had a good quarter even on half a quarter of GIC. A-Basin had strong numbers, it's only a shame that this small and seasonal. it had nearly 20% YoY growth.

Then you had the known step down in FFO from unit distributions (Dream Impact Trust cut their distribution). As much as a quarterly $8.7M from real estate distributions feels like it would warrant a decent value multiple. The strength of the two trusts that constitute that might tell a different story. The stability of real estate revenues is somewhat undercut but the fact that the segment is lower YoY and Office yield is high.

Then you have every other segment which, in this quarter looked like liabilities. My main reason for thinking reporting FFO wouldn't do much is apparent in the Development GTA/Ottawa line... 

2022 FFO = $30.5M

2023 FFO = $-1.7M

That's why this looks erratic, any given quarter a future asset looks like a liability because of the debt and interest on the development.

I showed this chart next to 3 others which underperformed it but were more stable and asked which people preferred. Most people placed this last because of the instability making it look riskier.

Net it all out and you get a relatively illiquid real estate company with average metrics... To the average observer. Remember, metrics are a snapshot at a point in time.

At some point, earnings, dividends, cash flows, whatever you want to measure with... Will show up in a big way. The stock will eventually track some kind of fair value. If bulls are right that's higher today and will be far higher in the future. If mistakes are made, or markets change in unexpected ways, value may well be lost first. I'm content with the bigger picture I see and the direction I believe is being set up for years and decades to come. That's why I continue to own. 

Addendum On Dream Office Move

I wrote the core of this before Dream Office's recent DIR sale + Substantial issuer bid. 

As I reflect on in the core of the article, Unlimited has a lot of their portfolio exposure in industrial; most of their AUM & a substantial portion of indirectly held equity. Now the recent headache has been their strongest performer of recent years (industrial) is held within their weakest performer (office).

Office is effectively trying to trade half of their Industrial for 1/4 of their (Office + Industrial).

The added wrinkle being that DRM (which owns 36% of that entity, may tender some of their stake into this transaction at nearly half of their stated NAV.

You could read this as "Their one chance to escape sinking Office"

I'm not sure I but that because if you valued office at $0 you'd only be paying something close to NAV for the DIR+ residential density added development.

So is office really that bad that they want out at $0? Well here's where there are more pieces to the puzzle. Office isn't the only entity trading at a huge discount to their stated net asset value. MPCT, DRR and DRM itself. Selling $1.00 for $0.50 sounds pretty dumb and demeaning to that $1.00 but if that capital can then be used to buy $1.00 for $0.33, you'd add a lot of value from the transaction.

However, neither would particularly explain the other point of debate on the transaction... Why sell industrial units at 84% of NAV when (assuming NAV is real and accurate) you could sell buildings at 100% of NAV. I'd assume that at a minimum, the liquidity to easily make the sale isn't easily available.

Of course skeptics would point to the "obvious fact" that NAV is effectively a made-up number. Particularly for Office. Many people will ironically effectively use this argument to decide that the only true answer to "Then what's it actually worth?" Is "Less." Less than NAV? No... Less than the market cap. Anyway. I'm still in the camp that I wouldn't be in office at NAV but half NAV for good locations, asset level debt & long term leases seems more likely a bit much.

I truly don't know what to think about the transaction. I was actually mainly getting quite interested in D-UN because it was DIR +Dev with Office free. The market had no care about anything beyond the office name. In that way, selling the DIR to get more levered long office makes it less appealing from that perspective. I was content with them NCIB &SIB-ing themselves to private by disposing of the incremental office. I wanted DRM to effectively own the core of the portfolio.

I'm not sure I much prefer the capital going to MPCT (which while cheaper has a large DRM stake and overlap already with DRM and also trading liquidity headwinds) or DRM directly which is again, trading volume constrained & Cooper stake limited with how much can realistically be bought. DRM has also been discounted vs NAV more and longer and so when measuring the discount vs the normal discount & weighing that against external opportunities to add value it's less special.

Ie: If you can always buy $1 for 0.70 in DRM buybacks (with the limited amount you can buy DRM) so for a similar discount it makes more sense to put the money elsewhere when those opportunities present.

In the end, I suspect the whole situation on both sides was about right-sizing exposures as much as other things. They may not want to have that much capital in the office exposure, may want to add some to MPCT or Buybacks. I don't think their % ownership will be much lower after this... Particularly because the response has left a large spread between tender price and trading price... People seem to assume that it will be more than fully tendered. (Holders may get less than their desired fill & the price is assumed to fall afterwards). I don't want to speculate at who or how much at this point. They will own between 16% and 50% after, they may simply tender 25% of their holdings inline with the offer and see what happens with what everyone else wants to do. I've watched this type of thing go both ways in extreme manners (seen essentially only large insiders tender & seen insiders tender 0). There are lots of effective places where capital can be put in real estate (if NAVs are remotely accurate) so I'm not overly concerned.

A Concluding Note

Investors gravitate towards a single story. Sometimes that means getting tomorrow's price, sometimes it means the share price is being cursed by a fraction of your exposure. I believe Dream is built in a way where there is tremendous long term value add potential. I also believe it's built in a way that makes it unlikely for the market to reflect all of that in real time. Fair value will continue to be a longer term center of gravity.  

There are a few potential catalysts for the recovery of the stock/sentiment. We seem to have flown right past the Toronto RE price rally we've seen off the recent short term bottom but if that keeps going, at some point it will be evident that DRM and MPCT are doing well with those projects. Rate decreases would probably do a bit to get people taking a fresh look at real estate. My confidence in central banks doing something reasonable was minimal but completely evaporated 8 months ago. Anyways, the Canadian consumer is beyond tapped out and has organically growing mortgages at these rates. Without human QE we'd be in a severe recession with the blame squarely on the bank of Canada. That's just an opinion, the rails saying we're currently in a mild recession amid 2% population growth are facts. I believe rates should be and will be lower eventually. I think that will double juice real estate (cap rates on higher mark to market rents & lower interest). A peak & reversal in office vacancy could also make things interesting in slow motion. If D-UN no longer looked like a value black hole there's a rather large spread to overcome between stated private value and assumed value. If MPCT-UN completes their development without issue and de-levers they too might look pretty interesting at higher levels.

The foray into asset management has this far been very successful but with the exception of perhaps a few months last year, has been mostly ignored. It's actually pretty amazing what they have been able to do with GIC in this rather awful environment for asset managers... but no one cared. At this point, and this price, that's getting a bit nonsensical. I think within 2-3 years it'll be apparent that only the asset management business should be worth more than today's market cap. We'll probably still be talking about a discount to NAV then. The development business will still look like a drain in all the quarters it doesn't deliver 10s of millions in profit. The asset base will likely be larger too.  It definitely seems like a target rich environment to deploy incremental capital. I believe they'll be adding long term value with every dollar they deploy on the asset side so even with all the AM focus I think the asset value (book) per share will continue to do just fine.

I think the price is extremely washed out at this point.  You could almost argue that you're getting a discount on the half of the company that you prefer and the other half free. I don't know when that will change but I believe long term shareholders can find significant potential that should be rewarded with patience. Time is the friend of the great company.

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.