A Boston Real Estate Empire at a Discount - New England Realty Associates, LP: NEN
|Sep 29, 2015|
New England Realty Associates, LP is an NYSE-listed real estate partnership that trades at a 30%+ discount to a conservative estimate of asset value. "NERA" is lead by Boston real estate magnate Harold Brown. The partnership has produced exceptional returns for its partners since inception. Though the market has begun to wake up to NERA's substantial value in recent years, the partnership remains undervalued due to its small size, limited liquidity and confusing structure.
New England Realty Associates, LP (ticker NEN) was founded in 1977 and currently owns 24 properties in and around Boston, Massachusetts. Of these properties, 17 are residential buildings, 4 are mixed use, 3 are commercial buildings and 1 property is comprised of individual units within a condo complex. as of June 30, the partnership owned 2,412 apartment units, 19 condo units and 108,043 square feet of leasable commercial space. Additionally, the company owns partial interests in another 9 properties, a mix of apartments, commercial space and a parking lot.
NERA's properties are located in central Boston and in surrounding affluent suburbs. The partnership got its start in Allston, and four of the properties are located there.
I've done some poking around on various apartment rental sites, and NERA seems to target young professionals and students to fill its rentals, many of which are located in busy settings near universities. Rents seem on par with the local market, and NERA (via Hamilton Company, which manages its properties) gets good reviews as a landlord. (This may be a recent development. There is no shortage of older articles criticizing the company's property management practices.) NERA's properties boast occupancy rates near 100%.
Like many realty partnerships, NERA's ownership structure is made up of multiple classes of units. NERA has two classes of limited partnership interests, Class A and Class B, plus General Partnership Units. Class A units have an 80% ownership interest, Class B unitholders own 19%, and the General Partner owns 1%. None of these units are publicly-traded. What is publicly-traded are depositary receipts that are the equivalent of 1/30th of one Class A Unit. Class A units themselves are not tradable, but may be converted into depositary receipts at a 30-to-1 ratio at any time, then traded. Because of the odd depositary receipt structure, many financial data providers do not accurately report NERA's market capitalization or units outstanding. This lack of good data contributes to NERA's mis-valuation.
NERA has a long history of profitable operations. The company does not always report a GAAP profit, but does produce consistent and growing funds from operations. As I've mentioned many times before, GAAP net income is a terrible metric for evaluating real estate companies. Non-economic expenses like depreciation and accounting for partial interests obscure actual profitability. What matters is distributable cash flows, and NERA excels at creating these. Here's a look at the partnership's historical results. Results are in millions and are taken from the partnership's annual reports, without any adjustment for restatements or amendments.
NERA's annual funds from operations have more than doubled since 2008, while gross rents rose 39%. That's a nice result. But the truly impressive achievement is NERA's tax efficiency. From 2008 to 2014, the partnership recorded a sum of just $5.0 million in continuing net income for its partners. Yet it produced $77.4 million in funds from operations, a very close proxy for distributable cash flow. What's clear is that NERA's management understands the "secret sauce" of real estate investing: leverage and depreciation. Reasonable leverage allows a partnership to control a large asset base while the associated interest expense creates a tax shield. So long as the cap rate on the assets acquired is below the cost of the associated debt, positive cash flow results. The second part of the equation is to continually add new properties to the roster, bringing in fresh depreciable assets to further shelter cash flows from taxation. Because high quality real estate tends to appreciate over time, this depreciation is merely a "phantom" expense and a valuable tax shield.
On a trailing basis, NERA produced nearly $16 million in funds from operations. This figure will almost certainly increase as rents rise and as the company continues to pay down debt. Also, the company just closed on the purchase of another rental complex, the 94 unit Captain Parker Arms in Lexington, Massachusetts. The purchase price was $31.5 million, 79% of which the company funded using its Keybank line of credit. The partnership has also begun converting the parking lot it owns into a 49,000 square foot, 48 unit apartment building. Both of these projects will contribute substantial cash in years to come.
There's one other area where NERA excels: buying back its units. Since inception, NERA has repurchased a full 30% of its issued units. In the last twelve months, the company reduced its fully-diluted units outstanding by 1.9%, and is set to continue buying back units. In March, the board of directors approved an expansion of the unit repurchase program sufficient to repurchase an additional 13.2% of outstanding units within five years.
But what is NERA worth? The answer to the question depends on determining the proper multiple of net operating income for Boston-area apartment properties. While NERA also holds some commercial properties and condos, the vast majority of its assets are invested in apartment assets. Unsurprisingly, the average cap rate for class A Boston apartment assets is extremely low. The Boston real estate market has long been one of the tightest in the country, and cap rates reflect this. Recent transactions have been done at cap rates as low as 4%! More typical transactions have crossed in the 5% range. For anyone interested, there are a number of market reports available via a little Googling. Here's one.
For conservatism's sake, I'll use a cap rate of 6%/16.7x net operating income to estimate the value of NERA's properties. The chart below lays out the value of NERA's fully owned properties and its stake in equity-accounted projects, net of debt.
It's very easy to get to value of over $255 million for NERA's properties and investments, net of debt. Using market valuations for the Boston metro yields an even higher value. The chart below shows the values of New England Realty Associates, LP depositary receipts at various cap rates.
At a 6.0% cap rate, NERA depositary receipts are worth just over $70, 48% higher than the current trading price. This value does not include the increased cash flow from the newly-acquired apartment complex, or the value to be created by developing the parking lot into a residential property. If we assign even modest value to those new assets and nudge the cap rate down just slightly, the fair value of NERA's depositary units approaches twice the current trading price. At NERA's current trading price, I think it's fair to say the market is valuing the company's holdings at a cap rate of around 7.5%, well above market cap rates.
NERA's valuation is compelling, but potential investors must be aware of a few potential risks. First, NERA's two largest unitholders, Harold and Ronald Brown, are quite elderly. These men together own over 40% of NERA's units. In the not distant future, NERA may face succession challenges. NERA also holds many highly appreciated properties, and unitholders may find themselves with an large tax bill should the partnership ever be wound down for any reason. And finally, because NERA is a pass-through entity, unitholders must be sure to handle the associated tax complexity carefully, including paying state taxes to Massachusetts.
For those unconcerned by these risks, NERA could be a great way to create a portfolio of quality Boston properties at a cap rate unheard of on the ground.
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