debt to gross book value 52% - sprott school of business · 2017. 12. 14. · mainstreet is...

Mainstreet Equity Corp. (MEQ) Price: $34.00

Target Price: $50

Source: Bloomberg

Kyle Stolys

Portfolio Manager

B.Comm – Finance

[email protected]

Ticker MEQ

Price $34.00

Market Cap ($millions) 293

Enterprise Value ($millions) 998

# of Apartment Units 9,319

% Units in Alberta & Sask. 71%

Debt to Gross Book Value 52%

NOI Margin 67%

Occupancy Rate 90.8%

MV of Real Estate ($millions) 1,353

Debt ($millions) 706

NAV per share $65.7

Premium (Discount) to NAV -55%

Implied Cap Rate 6.7%

Implied per unit value ($000s) $107

Price to FFO (N12M) 10.9

Mainstreet Equity Corp

Inside this Report

☑ Initial

Reasearch

☐ Updated

Research

☐ Price Target

Change ☐ Rating Change

Investment Thesis

Niche business model generates ROE of 20%

Mainstreet operates within a niche of the multi-family rental industry that is

inappropriate for many REITs to pursue due to their cash flow focus. As a result,

Mainstreet has been able to consistently acquire apartment properties below

replacement cost, increase the asset-value through renovations, and reposition

the units at higher rents generating 20% ROE in the process.

Outstanding capital allocation history and signaling effect of current buyback

The founder owns 40% of outstanding stock and has proven to be an excellent

capital allocator. Mainstreet undertook a massive share repurchase in 2008,

retiring 29% of shares when the market severely depressed Mainstreet’s stock.

In 2016, Dhillon repurchased another 12% of outstanding stock due to the

dislocation between Mainstreet’s stock and its NAV, and we expect that this

will again prove to be a value-generating move for shareholders.

Rebound in rental markets without a bounce in oil prices

Mainstreet’s Alberta and Saskatchewan operations have been negatively

affected by poor economic conditions. In past cycles, the rental market has

rebounded without a bounce in oil prices and with population growth expected

to remain robust combined with falling multi-family housing starts, the rental

markets in these two provinces should recover over the next few years without

higher oil prices.

Trades at a significant discount to asset value

Mainstreet is currently trading at multi-year low valuations which discount the

company’s current asset value and do not account for the potential value-add

that Mainstreet can bring by acquiring properties at depressed market levels.

November 6, 2016

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1 EQUITY RESEARCH – TSX:MEQ

Figure 2: Six-step Value Chain

Source 2: Form 10-K

Company Overview Founded in 1997, Mainstreet Equity has grown it’s portfolio of owned and managed multi-family real estate units from 272 to

over 9,000 today in Alberta, Saskatchewan, and B.C. Mainstreet focuses on mid-market apartment buildings that typically have

less than 100 units per property and charge average rents of $1000/month. Mainstreet is structured as a real estate

corporation, and is not a REIT. Instead of paying dividends, the company opts to reinvest its cash flows.

Mainstreet is a focused real estate operator with a business model that has remained in place since its founding. The company

specializes in acquiring underperforming apartment buildings that have usually been neglected by the prior landlords and are in

significant need of repair. Mainstreet acquires these properties, conducts heavy renovations, and repositions them on the

market at higher rents. The company calls this model its “Value Chain” and a summary of the six step process is below:

Acquistions: Mainstreet identifies and purchases underperforming rental properties at prices well below replacement cost.

These buildings are always in need of significant upgrades and in some cases have vacancy rates in excess of 20%.

Capital Improvements: Mainstreet conducts substantial renovations on the interior and exterior of acquired properties that

take between 12 and 24 months to complete.

Operational Efficiencies: Mainstreet installs new energy efficient appliances, windows, toilets, and lighting that reduces utility

costs and future maintenance costs. Mainstreet clusters its acquisitions within a 5-block radius that allows for economies of

scale among the operations crew. Per cluster of buildings, Mainstreet only needs a single property manager, leasing manager,

groundskeeper, maintenance person, and marketing manager, allowing the company to operate at lower cost than

independently owned buildings. Mainstreet also implements information management systems that reduce management

expenses relative to small property owners.

Value Enhancement: Following renovations, Mainstreet repositions properties under the Mainstreet brand at higher rents. In

many cases, Mainstreet will increase revenue on a property by 50% through reduced vacancy and growth in rental rates. This

increases the market value of the property.

Financings: Mainstreet finances its acquisitions using cash on hand and a line of credit. Following renovations, Mainstreet takes

on a mortgage at the higher appraised value which minimizes the amount of equity invested in a property. In some cases,

Mainstreet is able to reduce equity to negative levels.

Divestitures: Occassionally, Mainstreet will sell mature properties to redirect capital into higher potential properties.

Figure 1: Units owned by market

Source 1: Form 10-K

1812

3729

1066

937

1775

Calgary/Southern Alberta

Edmonton

Saskatoon

Abbotsford, BC

Surrey/New West, BC



Industry Dynamics Legislative

In Canada, each province has a separate tenant act that regulates a landlord’s ability to raise rents and conduct renovation on

units with existing tenants. Alberta and Saskatchewan have the most landlord friendly tenant acts in the country. In Alberta,

there is no limit to the amount landlords can raise rents on existing tenants but rents can only be raised every 12 months1. In

Saskatchewan, the same laws apply but landlords can raise rents every 6 months2. In B.C., landlords can increase rents on

existing tenants once per year, and only by the amount permitted by law, which is 2% above inflation3. The Residiential

Tenancy Board (RTB) sets the exact figure every year and for 2017 the maximum rent increase is 3.7%. However, if the landlord

conducts significant renovations they can submit an application to the RTB to raise rents in excess of the allowable amount.

This is practice that Mainstreet regularly conducts.

Replacement cost of apartment properties

The multi-family rental industry is attractive based on the fact that existing rental apartment properties trade at prices below

replacement cost. It is difficult to attract investment in building new mid-market rental apartments because prevailing market

rental rates do not support the cost required to build apartment buildings. This is why the apartment stock is 40+ years old. For

a sense of what the current cost is to build apartments, one of Mainstreet’s primary competitors – Boardwalk REIT – recently

acquired several brand-new properties in Edmonton at a cost of $180k/unit. These properties were initially constructued as

condominiums and the developers intended to sell the units individually, but due to current housing market conditions they

elected to sell the entire property to Boardwalk. Considering the circumstances, it is likely that Boardwalk was able to acquire

these units at a price near the total cost of construction, providing an estimate of replacement costs in the market today. As a

comparison, Mainstreet acquired properties in July for less than $100k/unit.

Oil price effect on Alberta vacancy rates

To consider the impact of low oil prices on the Albertan rental market, it is important consider the historical relationship. The

below chart shows that during periods of falling oil prices, vacancy rates have typically increased. However, if oil prices were to

remain at today’s prices for several more years this does not necessarily mean that vacancy rates will remain at above average

levels. The 1990’s serve as a useful example where oil prices dipped in 1994 and after a few years of volatility dipped even

lower in 1998. In 1994, vacancy rates increased to over 7% but in 1998 vacancy rates declined to below 2%. This is because

continued periods of economic distress tend to shift people from home ownership to the rental market, and the level of new

home construction declines rapidly, reducing the level of incoming supply. In Alberta today, vacancy rates have continued to

rise, but multi-family housing starts and building permits have fallen over 30% throughout the year. This should eventually have

a stabilization effect on the market.

1 http://www.landlordandtenant.org/notices/rent-increase/ 2 https://www.saskatchewan.ca/residents/housing-and-renting/renting-and-leasing/rent-increases 3 Guide for landlords and tenants in BC (pdf)



Demand

The biggest driver of long-term rental demand is population. Over the last several years, Alberta and Saskatchewan

experienced strong population growth in excess of 1.5% with net births, immigration and interprovincial migration all having a

positive impact. With the downturn in commodity prices, interprovincial migration has been negative in Saskatchewan for three

years, but has been offset by net-births and immigration. In Alberta, interprovincial migration turned negative in Q4 2015, and

has remained negative for three quarters in a row (as of Q2 2016). This came as a surprise to the CMHC, but they are still

calling for a pick-up in Alberta’s interprovincial migration in 2017. Despite the effect of reduced interprovincial migration, net-

births and immigration remain strong contributors to population growth in Alberta and Saskatchewan. Immigrants to these

provinces have not been deterred by the weaker economic conditions and it is expected that immigration flows will remain

robust. Immigrants have sought after Alberta and Saskatchewan due to their reputation for being culturally diverse, and for

having an historically attractive job market. Net-immigration is particularly positive for rental markets, because immigrants are

more likely than the rest of the population to be renters4.

4 2014 Canadian Housing Observer (2-6). CMHC

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Figure 4: Alberta Population Growth

Source 4: Statcan: Table 051-0004

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Figure 5: Saskatchewan Population Growth


Figure 3: Alberta Vacancy and WTI relationship

Source 3: Boardwalk Q2 2016 Presentation



Supply

Rental rates and vacancy rates are heavily dependent on the supply of rental units. With the decline in oil prices, many planned

construction projects have been put on hold, with multi-family housing starts down 35% in September5. This limits the amount

of new supply coming to the market. However, many condominiums previously built and intended to be sold have entered the

rental market, increasing overall supply. This could put pressure on near-term rental rates and vacancy rates if demand remains

low.

Labour availability is an important concern for Mainstreet because its business model depends heavily on its cycle time to

renovate acquired assets. During previous boom periods, there were shortages of skilled and unskilled labour that had a

negative effect on its cycle times. In the current downturn, Mainstreet has taken advantage of greater labour availability by

internalizing functions of its maintenance team and expanding the management team to prepare for its next phase of growth.

Competitive Positioning

Porter’s Five Forces Multi-family rental properties

Threat of new entrants – HIGH

There are low barriers to entry in multi-family rentals, with small amounts of capital required to purchase a property, relative to

other business ventures. This is evidenced by the fragmented nature of the industry with the top 10 apartment owners

accounting for 10% of Canadian market share6.

Threat of substitutes – MED

Instead of renting a multi-family unit, consumers can rent a single-family home, own a single-family home or own a

condominium. The threat of substitutes has varied over time and is dependent upon general economic conditions. In periods of

strong economic growth and low interest rates, home ownership becomes more attractive to the detriment of rental demand.

However, this impact is felt more heavily by higher-end rental properties, and mid-market apartments are more shielded to the

cycles of the economy.

Bargaining power of customers - HIGH

Customers are price sensitive and have low switching costs when renting an apartment, giving them strong bargaining power.

Further, landlords generate optimum revenue when vacancy rates are minimized, making them susceptible to changes in the

supply and demand of rental units. This pressures landlords to set rental rates near the market rate and experience trouble if

rents are raised too aggressively.

Bargaining power of suppliers – MED

Suppliers are mainly composed of human resources for the operation and maintenance of properties, as well as materials used

for renovations. The majority of materials needed for renovations (windows, sinks, flooring, paint) are commoditized products

with an array of suppliers limiting bargaining power. For maintenance and renovations, landlords need skilled and unskilled

labour, the supply for which has historically been tight in Western Canada. But with the economic downturn in Alberta and

Saskatchewan, unemployment has increased, and demand for labour has declined, reducing labour costs.

Competitive Rivalry – HIGH

Landlords compete for the acquisition of rental properties and tenants. Rental units are difficult to differentiate and customers

are price sensitive with low switching costs. This creates very high competitive rivalry with low returns on capital.

5 http://www.finance.alberta.ca/aboutalberta/at-a-glance/current-economy-indicators-at-a-glance.pdf 6 https://www.reminetwork.com/articles/top-10-in-the-canadian-apartment-industry/



Competitive Advantage Mainstreet’s competitive advantage can be broken up into four points shown below:

Management team: Mainstreet’s primary competitive advantage is its management team and their talent at identifying

properties below replacement cost, combined with their experience in quickly renovating units. This model could be duplicated

by a competitor but would take time to build the scale and system for identifying the right assets and efficiently conducting

renovations.

Focused business model: Mainstreet is a focused business that operates within a niche. Many other real estate companies

invest in apartments of all price points in many different geographies and have even moved towards developing their own

properties. Throughout the past 19 years, Mainstreet has not deviated from its initial model and because of this focus,

continues to generate strong returns on equity and excellent growth in NAV per share.

REITs are cash flow driven: Mainstreet’s business model is designed for the long-term and when growth is pursued, it is at the

detriment of short-term cash flow. This type of model is inappropriate for most REITs who have income-oriented investors. As a

result, REITs tend to acquire properties with already high occupancy rates that require short turnaround times to begin

generating cash flow. This reduces the Mainstreet’s competition when bidding on properties.

Cost advantage from property clusters: Multi-family real estate remains highly fragmented with a number of individual

landlords. Mainstreet seeks to acquire its properties within 5-block clusters allowing for economies of scale. This gives

Mainstreet a cost advantage over individual landlords and even some institutional-sized real estate investors. While Mainstreet

is a much smaller company than many of the publicly-traded Apartment REITs, the company has high market share within the

communities it operates in.

Financial Statement Analysis

Source 6: Form 10-Ks, Bloomberg

Figure 6: Financial Condition Ratios Financial Condition (September 30 FY) 2011 2012 2013 2014 2015

Solvency

Current Ratio 0.14 0.46 0.22 0.07 0.07

Debt to Gross Book Value 52% 52% 49% 48% 47%

Debt Service Coverage Ratio 1.31x 1.39x 1.50x 1.44x 1.55x

Profitability

NOI Margin 65.6% 67.2% 66.5% 66.4% 67.1%

EBIT Margin 55.5% 56.8% 55.9% 56.4% 58.0%

Return on Invested Capital* 6.4% 6.5% 6.8% 7.4% 7.6%

Return on Equity Invested Capital* 20.4% 14.7% 16.1% 21.3% 19.4%

Activity

Accounts Receivable Turnover 28.6x 35.5x 60.6x 68.9x 100.2x

Accounts Payable Turnover 4.0x 5.0x 4.3x 4.2x 5.3x

Cash Conversion Cycle -77 -63 -79 -81 -65

Total Asset Turnover 0.07x 0.07x 0.07x 0.07x 0.08x

Growth

Revenue growth 7.2% 17.4% 17.0% 15.7% 11.0%

NOI growth 12.6% 20.3% 15.9% 15.5% 12.0%

Same-Property NOI growth 17.2% 21.3% 19.0% 17.8% 6.4%

FFO per share growth 44.9% 9.2% 45.6% 33.5% 18.7%

NAV per share growth 15.6% 12.7% 14.5% 14.9% 12.7%

* ROIC calculations explained in profitability section



Liquidity and Solvency Ratios Mainstreet’s debt to gross book value ratio (Total debt/MV of real estate) has declined over the last five years as the business

has matured. However, the ratio recently ticked up to 52% due to a decline in the appraised value of Mainstreet’s real estate

from to the poor economic conditions in Alberta and Saskatchewan. Mainstreet’s debt service coverage ratio has increased

over the last five years and is currently 1.48x. Mainstreet’s leverage levels are in-line with comparable multi-family REITs. The

majority of Mainstreet’s debt is in the form of mortgage loans but it also has $36 million in bank debt. Mainstreet’s long-

standing policy is to keep its debt to capitalization ratio below 70%, but the banking facility contains financial covenants with a

maximum debt to capitalization ratio of 65% and a minimum debt service coverage ratio of 1.2x. While Mainstreet is only

slightly above the 1.2x coverage ratio, their interest and debt principal payments are not expected to balloon in coming years.

Further, if Mainstreet was at risk at tripping one of the covenants they should not have an issue with repaying the $36 million

of bank debt with funds from operations and/or mortgage debt.

Mainstreet’s current ratio is less than 0.1 because the majority of their current liabilities are short-term debt, part of which is

bank debt from the line of credit, which doesn’t mature, and the other is mortgage debt which will be paid off with cash flows

or refinanced.

IFRS and Taxes In 2012, Mainstreet switched from GAAP to IFRS accounting. Under GAAP rules, investment properties fall under property,

plant and equipment and are measured at cost. Under IFRS, investment properties are measured at fair value. As a result, the

book value of Mainstreet’s investment properties is the market value as appraised by third-parties. Any increase in fair value is

shown on the income statement as a fair value gain.

Mainstreet paid a small amount of income tax in 2015 ($1.5M) and did not pay any income tax in the previous four years.

Under CRA rules, Mainstreet is still able to depreciate its properties and the depreciation offsets its taxable income. During this

time, Mainstreet has built up a deferred tax liability (DTL) of $117 million which will affect future cash flows if they dispose of

assets. Mainstreet very rarely disposes of properties, and the DTLs are unlikely to affect future cash flows at this time.

Profitability Ratios Mainstreet’s most important metric for tracking profitability is Net Operating Income (NOI), and over the last five years, NOI

margin has been stable ranging between 66% and 67%. EBIT Margin, which includes G&A expenses has increased slightly over

the past five years due to economies of scale.

Return on Capital Decompostion

Mainstreet’s business model is grounded on the fact that they generate value from their process of acquiring and renovating

properties. As such it is important to understand whether they are actually creating value and to what extent. One issue with

analyzing real estate companies is the difficulty in calculating returns on capital due to their lack of taxable income and the

measurement of investment properties at fair value. To estimate the returns on capital we obtained the gross book value of

Mainstreet’s properties as of 2011, prior to their switch to IFRS. Using this figure as a base, we added the value of Mainstreet’s

property acquistions and building improvements to obtain the actual value of its invested capital. We then added Mainstreet’s

negative working capital balance to obtain total invested capital for the years 2011-2015. Using EBIT which was calculated as

NOI less G&A expenses and PP&E depreciation, we obtain ROIC for each year, shown below. Over the last five years, ROIC has

increased from 6.4% to 7.6% in 2015. While these rates of return would be considered low for most businesses, they are not

unreasonable for real estate due to the capital intensity and high level of leverage used to finance acquisitions.



To adjust EBIT and invested capital for leverage, we subtract the annual mortgage expense from EBIT to obtain “Levered

operating income” and subtract the average mortgage payables during the year from invested capital to obtain “Equity

Invested Capital”. As shown below, mortgages compose a large amount of invested capital which increases the returns on

equity to approximately 20%. This demonstrates the value creation effect that Mainstreet’s business model has.

It’s important to note that the 20% ROE does not simply come from ‘stacking’ leverage on a low return business. Part of the

increase is due to Mainstreet’s financing approach. Properties are acquired with cash on hand and bank debt. Following

renovations, the appraised value of the properties typically rises substantially, and Mainstreet takes out a mortgage on this

higher value, reducing its equity investment. As the below example shows, by taking out a mortgage on the higher appraised

value rather than the original acquisition cost, Mainstreet is able to minimize equity and increase returns.

Activity Ratios Mainstreet’s asset turnover has increased over the past five years, contributing to higher ROIC. Mainstreet also has a negative

working capital balance due to their negative cash conversion cycle. However, working capital makes up a small portion of total

invested capital and is not material.

Growth Ratios Revenues and net operating income have grown at a 5yr CAGR of 13.5% and 15%, respectively, while NAV per share has grown

at 11%. This is due to Mainstreet’s fast acquisition growth in prior years, with cash flows ‘catching up’ to value.

Management & Capital Allocation Mainstreet’s management team is focused exclusively on generating shareholder wealth, and this is best exemplified by an

excerpt from their annual report in 2000: “Many would say Mainstreet Equity Corp. is in the real estate business. The truth is

we’re in the business of making money. And the real estate sector happens to be our vehicle for doing that”. The company’s

founder and CEO, Bob Dhillon, owns 40% of the company, and has an outstanding record as a capital allocator. Dhillon is of Sikh

Return on Invested Capital 2011 2012 2013 2014 2015

Rental EBIT 31,594 37,955 43,714 51,026 58,215

Less: Mortgage expense (19,386) (21,531) (23,163) (24,118) (25,020)

Levered Operating Income 12,208 16,424 20,551 26,908 33,195

Avg Gross Invested Capital 492,211 583,316 641,530 693,564 768,020

Less: Avg Mortgages payable 432,440 471,772 513,923 567,077 596,964

Equity Invested Capital 59,772 111,544 127,607 126,488 171,057

ROIC (EBIT/Gross Inv Cap) 6.4% 6.5% 6.8% 7.4% 7.6%

ROE (Lev Op Income/Eq. Inv Cap) 20.4% 14.7% 16.1% 21.3% 19.4%

Financing Effect

Acquisition Cost $100

Building improvements $10

Total Cost $110

Appraised Value $150

Mortgage (50% of capitalization) $75

Invested Capital $110

Mortgage $75

Equity Investment $35

Return on Invested Capital 2011 2012 2013 2014 2015

Rental EBIT 31,594 37,955 43,714 51,026 58,215

Avg Gross Invested Capital 492,211 583,316 641,530 693,564 768,020

ROIC (EBIT/Gross Inv Cap) 6.4% 6.5% 6.8% 7.4% 7.6%

Invested Capital 2011 2012 2013 2014 2015

Gross Property Investments - Beg 540,435 630,129 661,401 736,137

Additions related to acquisitions 80,224 74,940 62,884 59,061

Building improvements 9,470 10,718 11,852 13,222

Ontario assets sold (est gross BV) (54,386)

Gross Property Investments - End 540,435 630,129 661,401 736,137 808,420

Working Capital -1,426 -2,507 -5,963 -4,447 -4,070

Gross Invested Capital (Property + WC) 539,009 627,622 655,438 731,690 804,350



descent, immigrating to Western Canada at a young age, and has been a real estate investor throughout his life. In 2015 Dhillon

received the RBC Top 25 Canadian Immigrant Award, and is currently a board member of the CMHC.

The company does not pay dividends, opting to reinvest cash flows back into the business, but from time-to-time has

undergone substantial share repurchase programs. In 2008, the stock fell from $15 to $5, a level Dhillon believed to be at a

significant discount to NAV. In response, the company bought back 29% of outstanding shares at an average price of $6.35, and

five years later, the stock was trading at $35. The company made a few small share repurchases in the years following, and in

2016, with shares trading at a 50% discount to NAV, they repurchased 12% of outstanding shares at $36.00. Management’s

focus on shareholder value and conviction in its capital allocation decisions should lead to continued great returns for investors.

Executive Compensation Mainstreet’s compensation program is ranked as weak. Executive compensation is comprised of base salary, annual

performance bonus, and a stock option plan. The performance bonus is based on return on shareholders’ equity and personal

goals set by the CEO. It is unclear how Mainstreet defines ROE and what other metrics make up the bonus. As part of the

company’s option plan, Mainstreet is able to grant options of up to 20% of outstanding shares. Currently, 828,200 granted

options remain outstanding, equal to 9.3% of shares outstanding. This plan has the potential to be very dilutive, but has not

been used to compensate executives since 2009 when the company granted 925,000 shares to officers and directors.

CEO Dhillon also receives commissions for property transactions conducted by Mainstreet in his capacity as a licensed real

estate broker. These commissions are not paid by the company but by the selling party in the transaction. In 2015, Dhillon

earned $371,500 in commissions, in addition to his $1.9 million in salary and performance bonuses.

Overall, Mainstreet’s executive compensation lacks transparency and fails to reward managers for performance exceeding one

year. Mitigating this compensation risk is Dhillon’s 40% ownership of outstanding shares which places his interests directly

inline with shareholders.

Growth and Risk Analysis

Growth Outlook Prior expansion plans outside Western Canada

Mainstreet began operating in Calgary, expanded to Edmonton, followed by B.C., and later Saskatchewan. Those three

provinces are its only markets today but Mainstreet has attempted to expand east in the past. In the mid-2000s Mainstreet

expanded to the Greater Toronto Area, owning 664 units by 2007. However, the company had limited success in the market,

struggling with tighter rental legislation, and weak operating margins at its properties. Mainstreet sold the properties in 2011

and 2012, opting to focus on the Western Canadian markets.

Mainstreet has also shown an interest in expanding to the U.S. In 2011, the company began exploring its options for a U.S.

expansion, since they believed there were opportunities to acquire distressed mid-market properties. In 2012, they reiterated

their interest but ultimately did not make any deals. The same opportunities that existed in 2011 and 2012 when the U.S. real

estate market bottomed, are unlikely to be present today, but the potential for a future expansion remains possible.

Organic growth

Current growth for Mainstreet can come organically from the stabilization of its 1000 unstabilized units (those being

renovated), decreases in the vacancy rate, and growth in rental rates. In the scenario where all of its units are stabilized and the

vacancy rate is 5% (a level the company believes to be “normal”) net operating income would be 10% higher than 2015 levels.

However, due to the current state of the Alberta and Saskatchewan economies, such vacancy rates appear to be a long way off.

The below chart displays Mainstreet’s average stabilized vacancy rates since 2011. In 2015 the average stabilized vacancy rate



was 6.5%, and in the first nine months of 2016, this figure increased to 8.5%. However, as of June 2016, the company stated

that stabilized vacancy had risen to 10.2%, pointing to continued weakness in the Alberta and Saskatchewan rental markets.

The increase in vacancy rates puts pressure on rental rates, and it is unsurprising to see Mainstreet’s average vacancy rate

decrease in the first nine months of 2016. Average rental rates are now below $900/month and could fall further should

weakness persist.

Inorganic growth

Mainstreet intends to continue reinvesting cash flows into a greater number of properties, and inorganic growth is likely.

Mainstreet’s main markets are Edmonton, Calgary, Saskatoon, Surrey, B.C. and Abbotsford, B.C. Using CMHC data we found the

total apartment stock in each of these municipalities and computed Mainstreet’s market share. Within Mainstreet’s operations

in B.C. metropolitan areas, it holds 15%+ market share and future expansion is possible but has become increasingly difficult. In

Alberta and Saskatchewan, Mainstreet appears to have room for growth and with the downturn in these economies,

management believes there are excellent opportunities to continue acquiring properties. Despite this belief, management did

not acquire any properties in the first nine months of FY2016, anticipating a potential drop in real estate values. However,

subsequent to the end of Q3 2016 (June), Mainstreet acquired 478 new units, stating they have now “hit the reset button” on

acquistions, and are likely to pursue more acquisitions in the future.

Figure 9: Total Apartment Stock and Mainstreet’s Share

Source 9: CHMC; Form 10-K

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10%

2011 2012 2013 2014 2015 2016 (Q3)

Figure 7: Mainstreet’s Stabilized Vacancy Rates

Source 7: Form 10-Ks

Figure 8: Mainstreet’s Average Rental Rates


600

650

700

750

800

850

900

950

2011 2012 2013 2014 2015 2016 (Q3)



Major Risks Population growth

Provincial in-migration

With oil prices having declined there is a risk of negative provincial in-migration from Alberta instead of the net positive trends

the province has experienced over the past decade. Currently, CMHC expects in-migration to decline from the levels of years

past but to remain positive in 2017 and 2018. Further, Mainstreet operates in major cities, with all of its Alberta properties

located in Edmonton and Calgary and these cities have not been hit as hard as smaller towns that are dominated by the oil

industry. Additionally, with increases in unemployment rates, people tend to switch from home ownership to rental units. This

mitigates the impact that Alberta’s economic decline will have on Mainstreet.

Immigration trends

CMHC currently projects population growth in Alberta and Saskatchewan to remain above 1.3% for the next two years. Driving

this growth is strong net-immigration. Should immigration trends change, the rental markets in these provinces would be

impacted. The current federal government has a favourable stance on immigration which should promote future immigration

growth, however this is a risk to be aware of.

Rental unit supply

Mainstreet’s success is dependent upon the supply of real estate. When overbuilding takes place it increases vacancy rates for

all landlords and negatively impacts rental rates. Currently, the risk of overbuilding is low in many of Mainstreet’s markets. In

B.C., there are geographical limitations to building new residential units, and in Alberta and Saskatchewan, the current rental

market has caused multi-family housing starts to fall 30%+ in 2016.

Interest rates

Mainstreet’s largest operating cost is its interest expense. Over the company’s 19-year history, Mainstreet has benefited from

falling interest rates and has been able to refinance mortgages at lower rates, increasing its profitability as it has grown. If

interest rates were to increase, it would impede Mainstreet’s ability to profitably operate and would limit their ability to

acquire new properties. Mainstreet is well aware of this risk and has locked in long-term CMHC insured mortgages at a

weighted average interest rate of 3.49%. Over 80% of its mortgage debt matures in more than five years, and the majority is

fixed rate debt, limiting the impact of interest rate increases over the intermediate term.

Changes in Rent Control Legislation

Mainstreet’s success has come in part from operating within landlord friendly provinces. There does not appear to be any plans

to change current tenancy laws but any changes restricting Mainstreet’s ability to raise rental rates would have an adverse

effect on the business model.

Impact of mortgage rule changes – stress testing at higher rates

In an effort to cool Canada’s housing market, CMHC recently announced that they would be stress testing future mortgage

borrowers at higher interest rates to anticipate a borrowers ability to maintain solvency in a higher interest rate scenario.

Mainstreet is currently in a sound position and this plan shouldn’t restrict their ability to borrow.

Utilities

Mainstreet is responsible for heating costs at its properties leaving them sensitive to changes in natural gas prices. To mitigate

the risk of rising natural gas costs, the company regularly enters multi-year natural gas contracts capping costs.

Availability of CMHC-insured Mortgages

Mainstreet is dependent upon CMHC insured mortgages to provide low interest rates, and have frequently refinanced its

mortgages over its history. If Mainstreet became unable to refinance mortgages it would negatively impact the company but it



would still be able to operate with 80% of its mortgages maturing in five-plus years. Of note, is that in 2007, Mainstreet had

40% of its mortgages scheduled to mature the following year, which became one of the worst times to refinance a mortgage.

Mainstreet did not have an issue refinancing its mortgages at that time and due to reduced interest rates from the Bank of

Canada, was able to reduce its average interest rate.

Why Mainstreet?

Mainstreet’s peers are all REITs making comparisons between the firms imperfect. Regardless, Mainstreet has a leverage ratio

in-line with the peer group, and a higher vacancy rate due in part to their unstabilized properties. Notably, Mainstreet’s NOI

margin is higher than the peer group. This is partially due to Mainstreet’s portfolio clustering which gives them high market

share within certain communities, increasing economies of scale, as well as the substantial renovations that they conduct

following acquisitions that reduce future maintenance costs. Further, Mainstreet mainly owns low-rise apartment buildings

that do not have underground parking or elevators to maintain, reducing maintenance costs.

Boardwalk REIT

The most comparable firm to Mainstreet in terms of Western Canada exposure is Boardwalk. Boardwalk is the least levered of

the peer group and maintains low vacancy rates despite the weak operating conditions. Following Mainstreet, Boardwalk

trades at the largest discount to NAV and has the highest implied cap rate of the peer group. Boardwalk has also initated a

share repurchase program to take advantage of what they believe is a valuation gap. Boardwalk is a best-in-class operator that

has a long history within multi-family rentals and the company appears attractively priced. Boardwalk has an excellent

management team that has 25% ownership, and a history of executing well over multiple economic cycles. However,

Boardwalk’s strategic focus differs from Mainstreet’s. Boardwalk’s priority is to optimize net operating income among its

existing asset base with a constant focus on maximizing occupancy levels, versus growing its asset base. Over the last ten years,

Boardwalk has reduced the number of units it owns but has grown FFO/share by expanding NOI margins. Boardwalk is an

appropriate investment for the income-oriented investor seeking a safe asset with a high dividend yield but low dividend

growth potential, and its discount to NAV provides additional opportunity for capital gains. However, Mainstreet trades at

lower current asset multiples than Boardwalk and has a business model designed to generate wealth through expansion. This

Company

Mainstreet

Equity

Corp

Boardwalk

REIT

Canadian

Apartment

Properties

REIT

Northview

Apartment

REIT

Killam

Apartment

REIT

InterRent

REIT Median

Ticker MEQ BEI-U CAR-U NVU-U KMP-U IIP-U

Price $34.00 $43.38 $30.13 $18.93 $12.07 $7.15

Market Cap ($millions) 293 2,254 4,077 1,057 803 505 930

Enterprise Value ($millions) 998 4,557 7,498 2,927 1,819 1,216 2,373

# of Apartment Units 9,319 32,947 46,790 24,621 18,846 8,389 21,734

% Units in Alberta & Sask. 71% 71% 6% 24% 2% 0% 15%

Debt to Gross Book Value 52% 41% 48% 60% 56% 55% 54%

NOI Margin 67% 62% 59% 58% 59% 58% 59%

Occupancy Rate 90.8% 97.6% 98.7% 91.1% 95.8% 94.2% 95.0%

MV of Real Estate ($millions) 1,353 5,570 6,863 3,093 1,850 1,201 2,472

Debt ($millions) 706 2,272 3,270 1,867 1,045 661 1,456

NAV per share $65.7 $69.4 $26.6 $24.6 $12.1 $7.7 $25.6

Premium (Discount) to NAV -55% -32% 13% -14% 0% -7% -10%

Implied Cap Rate 6.7% 6.5% 4.3% 4.3% 5.4% 4.0% 4.9%

Implied per unit value ($000s) $107 $138 $160 $119 $97 $145 $129

Price to FFO (N12M) 10.9 15.0 16.7 8.6 13.4 16.1 14.2



combination should result in Mainstreet compounding value at a higher rate than Boardwalk over the long-term and is a more

appropriate investment for the total return oriented investor.

Valuation We estimate Mainstreet’s value on a number of absolute and relative valuation metrics: NAV, P/FFO, value per apartment, and

implied cap rate. Without factoring the potential value-add from future acquistions, Mainstreet appears to trade at depressed

levels. Its currently priced at a 55% discount to NAV, vs. a peer group average of 9%; a multi-year low P/FFO multiple; per

apartment value of $108k compared to $132k for the peer group; and an implied cap rate of 6.5% compared to a peer average

of 4.8%. Overall, the market appears to be discounting Mainstreet’s value due to its small size, lack of dividend income, and

heavy Alberta/Saskatchewan exposure.

Potential Catalysts Many of the reasons for Mainstreet’s discount (small size, lack of dividend income) are likely to continue to depress

Mainstreet’s value. Potential catalysts that could bring Mainstreet’s in-line with our estimate include the following:

Stabilization in rental markets: If rental markets in Alberta and Saskatchewan begin to stabilize, this could increase investor

confidence in Mainstreet and push up the multiple. We expect that this will take place in coming years as consumers find

renting more economic than home ownership.

Large growth in units: If Mainstreet begins to aggressively acquire units, it could signal to investors that the company will grow

FFO at higher than expected rates, and increase the multiple.

Higher oil prices: If oil prices were to rise substantially, it’s likely that sentiment surrounding the economies in Western Canada

would become more positive and Mainstreet’s stock would be more sought after.

Change in sentiment on Canadian real estate: Canadian real estate is broadly viewed as overvalued and this could be deterring

investment in the real estate industry. A change in this sentiment could be positive for Mainstreet’s stock.

Additional share repurchases: If Mainstreet were to remain at its current valuation levels, then Bob Dhillon would likely initiate

another share repurchase program that could have a positive effect on the share price. However, the stock has declined since

the 12% repurchase in early 2016.

Net Asset Value & P/FFO As mentioned, Mainstreet’s investment properties are regularly appraised by third-parties to determine fair value. Using this

valuation we can obtain Mainstreet’s Net Asset Value of $65.7/share, 100% above the current share price. This discount was

Dhillon’s motivation to repurchase 12% of shares earlier in the year. However, using these estimates, Mainstreet has

historically traded at a discount to NAV, as shown in the below chart. Part of this historical discount was due to Mainstreet’s

rapid acquisition growth, where in 2007, half of its units were undergoing renovations, versus 10% today, depressing cash

flows. As a result, Mainstreet traded at a large discount to NAV but a P/FFO (N12M) of >20x. With a greater number of

stabilized units, Mainstreet’s cash flows are higher and its FFO multiple is at multi-year lows. With a higher level of stabilized

units, Mainstreet’s 50% discount to NAV, and P/FFO of 11x, appear unreasonable, and Mainstreet should trade up to a smaller

NAV discount in future years.

Mainstreet Equity Corp. Metric Note

NAV per share $65.7 - moves to 30% discount $45.97

Implied Cap Rate 6.7% - shift toward median; reaches 5.5% $53.36

Implied per unit value ($000s) $107 - Shift to median of $130 $52.06

Price to FFO (N12M) 10.8 - trades up to 7yr avg of 15x $45.00

Average $50

Implied share price



Value per Apartment unit An alternative approach to estimating Mainstreet’s value is to compute the market implied value per Apartment unit and

compare this to other publicly traded firms. As shown below, Mainstreet trades a substantial discount to its peers on a per-

apartment basis, while its appraised value per unit is more in-line with the peer group. If Mainstreet’s value per unit were to

rise to $130k, its share price would be $52.

Implied Cap Rate Based on 2015 net operating income, the implied cap rate is 6.6%. However, this figure includes many unstabilized properties

that aren’t operating up to their potential and will eventually do so. Mainstreet identifies the ‘optimum’ scenario to be one

with 5% vacancy and the market rate of rent is charged at their units which as of June 2016 is $1,026/month. Using these

assumptions we compute NOI of $73M vs. $67M in 2015, which results in an implied cap rate of 7.1%. Compared to the peer

group median of 4.8%, Mainstreet appears attractive. Should Mainstreet trade at a T12m cap rate of 5.5%, its share price

would rise to $53. Details can be found in the appendix.

Investment Recommendation

Buy, Price Target $50

Investment Thesis Niche business model generates 20% ROE

Mainstreet operates within a niche of the multi-family rental industry that is inappropriate for many REITs to pursue due to

their cash flow focus. As a result, Mainstreet has been able to consistently acquire apartment properties below replacement

cost, increase the asset-value through renovations, and reposition the units at higher rents generating 20% ROE in the process.

CEO aligned with shareholders and has proven excellence in capital allocation

Bob Dhillon founded the company and owns 40% of outstanding stock, placing his interests directly in-line with shareholders.

Dhillon has proven to be an excellent capital allocator electing to reinvest cash flows in the business at an ROE of 20% rather

than pay out dividends, and has selectively repurchased shares, with a massive repurchase in 2008, retiring 29% of shares when

Enterprise Value 1,025 1,353 4,775 7,490 2,912 1,857 1,256 2,385

Total Units 9,345 9,345 32,947 46,790 24,621 18,846 8,389 21,734

Implied Value per unit ($000s) $110 $145 $145 $160 $118 $99 $150 $132 $180

% Sask/AB 71% 71% 6% 24% 2% 0% 15%

Replacem

ent Cost

Killam

Apartment

REIT

InterRent

REIT MedianValue per Apartment unit

MEQ

Appraised

Val

Boardwalk

REIT

Northview

Apartment

REIT

Mainstreet Equity Corp.

Canadian

Apartment

Properties

REIT

Figure 11: 10-Year P/FFO (N12M) history


0

5

10

15

20

25

30

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Figure 10: Mainstreet’s discount to NAV


-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%



the market severely depressed Mainstreet’s stock. This added substantial shareholder value. In 2016, Dhillon repurchased

another 12% of outstanding stock due to the dislocation between Mainstreet’s stock and its NAV, and we expect that this will

again prove to be a value-generating move for shareholders.

Distressed Alberta and Saskatchewan economies creating an opportunity

Mainstreet has 70% of its portfolio in Alberta and Saskatchewan which have been negatively affected by the poor economic

conditions. In past cycles, the rental market has rebounded without a bounce in oil prices and with population growth expected

to remain robust, combined with falling multi-family housing starts, the rental markets in these two provinces should recover in

future years.

Attractive valuation that discounts the company’s growth potential

Mainstreet is currently trading at multi-year low valuations which discount the company’s current asset value and do not

account for the potential value-add that Mainstreet can bring by acquiring properties at depressed market levels.

Risks to the Thesis Immigration flows could shift to other provinces

A major risk to our thesis is if immigration patterns change, and immigrants shift away from Alberta and Saskatchewan due to

the poor economic conditions. We view this as unlikely since Canada remains an attractive country for immigrants to move to,

and the level of net-immigration has not been affected by the poorer economic conditions. However, should economic distress

continue over the long-term, immigrants might view the provinces less attractively, slowing the rate of growth.

Higher interest rates could affect profitability and asset value

Throughout Mainstreet’s 19 year history interest rates have fallen, and the company has not been tested during a period of

rising rates. If interest rates are to increase significantly, Mainstreet’s profitability would be impaired as would the asset value

of their properties. To mitigate this risk, Mainstreet has locked in fixed rate mortgages with an average maturity of 7.4 years.

Depressed asset prices could impair company’s ability to obtain debt

If the housing market in Alberta and Saskatchewan weakens, Mainstreet’s asset value might be impaired which would increase

their leverage ratios and could impact their ability to refinance mortgages or expand.

High market share deterring growth runway

Mainstreet has built up a large market share in some of the metropolitan areas it operates in, which provide economies of scale

but limit the company’s ability to expand but limits its growth potential, which it has an appetite for.




Figure 13: Annual Real GDP Growth by Province

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

Saskatchewan Alberta British Columbia Canada

Figure 12: Annual Unemployment Rate (%)


Sask:6.8

Ab: 8.5

B.C: 5.7

Can: 7.0

0.0

2.0

4.0

6.0

8.0

10.0

12.0

19

90

19

91

19

92

19

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16 (

Sep

)

Saskatchewan Alberta British Columbia Canada

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Edmonton Calgary Saskatoon B.C. Metro areas

Figure 14: Historical Vacancy Rates

Source 14: CMHC

-10%

-5%

0%

5%

10%

15%

20%

25%

30%

19

90

19

91

19

92

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Edmonton Calgary Saskatoon B.C. Metro areas

Figure 15: Historical Rental Rate Growth

Source 15: CMHC

Diluted Shares Outstanding 9,712

Price $33.00

MV of Common Stock 320,481

+ Total Debt 705,840

- Cash 1,384

Enterprise Value 1,024,937

2015 Cap Rate

Revenue 100,392

NOI Margin 67%

NOI 67,322

NOI Cap rate (NOI/EV) 6.6%

Optimum operating scenario (5% vacancy)

Total units 9,345

Vacancy Rate 5%

Units occupied 8,878

Rent per unit/month $1,026

Annual revenue 109,303

NOI Margin 67%

NOI 73,233

NOI Cap rate (NOI/EV) 7.1%

Implied Cap Rate (Oct 26/16)Historical Net Asset Value ($M CAD)

Market Value of Investment Properties 1353

Total Liabilities 831

Deferred Tax Liabilities 116

Total Liabilites (net of DTL) 715

Net Asset Value (MV - Liab.) 638

Diluted Shares Outstanding (millions) 9.7

NAV per share 65.7

Current Share Price 33.00

Discount to NAV 50%

Appendix A

debt to gross book value 52% - sprott school of business · 2017. 12. 14. · mainstreet is...

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