Rabbit Holes
Owning rental real estate is a simple business: investors can look at the buildings, walk in them, sit in them, or even kick them, if they get testy about their portfolio performance. Rent comes in regularly and generally under long-term contracts, so investors can see into the future more than some other types of companies. People buy and sell real estate all the time, so investors have a handy gauge of how much their properties might be able to fetch from potential buyers.
The simplicity of real estate can sometimes lull investors into complacency. Some real estate companies are not so simple and hold many layers of properties and other assets in confusing structures. Jump down the rabbit hole and parse through the strange balance sheets of these companies and we can find investments that offer safety and potentially outsized returns.
Empty Smiles
Like the Cheshire cat that menaced the inhabitants of the original rabbit hole, some real estate companies can put on a smiling facade while mostly offering investors mischief. They may appear friendly to investors for a while, but risk disappearing at inconvenient times. Workspace (WKP) is a British company that owns 100 office space properties around the greater London area, over 5.2 million square feet of space. In 2013, WKP brought in just under €50 million in net rental income. Looking past its direct property holdings, it owns some joint venture investments and manages a small handful of properties through a separate trust.
It's an easy to understand business, but outside its primary properties, WKP owns little of value. That simple structure helps investors smile when they see WKP's shares. They're willing to buy shares at a 2% cap rate (the yield from net rental income on the market value of the company, including debt) or 1.7x the net market value of WKP's properties. There's some story to WKP's price: it caters disproportionately to startups, but that hardly seems to justify overpaying for what amounts to four walls and a roof.
Growing to Unusual Size
Down the rabbit hole, Alice found that there was more to the colorful inhabitants than she first observed. This is a lesson investors can apply to evaluating real estate balance sheets: sometimes they are not what they first seem. Sometimes we can find odd holdings that contribute substantially to the value of a company, but are ignored or misunderstood by others because of their relative oddness. Affine (IML) is a French real estate company that owns office, retail and logistics properties in France and Belgium. Most of its properties show up on its books in the same way as WKP's properties. However, IML occupies the other end of the value spectrum from WKP; its price is much lower relative to the underlying value of its properties. IML's shares trade for 0.6x the market value of its properties compared to 1.7x for WKP.
IML becomes even more interesting when we consider that the company owns several valuable assets that are not immediately evident on the face of its balance sheet. It holds a 50% stake in a Belgian property re-developer, Banimmo (BANI) and a 50% stake in a large mixed-use development in Bordeaux. These assets don't show up under IML's property assets nor do they generate the net rental income that investors typically use to value real estate companies.
BANI is a publicly traded company in Belgium and, kicking over a few more stones, we find that the market price of BANI is also deeply undervalued compared to the prices it has been fetching for properties it has sold.
BANI is also the other 50% owner to IML's Bordeaux property. Late last year BANI and IML reached an agreement for IML to purchase the 50% of the property owned by BANI. This exchange will increase IML's net rental income by over 10% when it eventually shows up on its P&L.
Investors would know none of this by a cursory review of IML's financial statements. While IML's shares currently change hands at €14.90 per share, the assets we've identified could represent value of nearly €30 per share.
Waking Up
Sometimes a real estate company is just a collection of buildings generating consistent income. Other times companies own real estate, but in a complicated structure that clouds its true value. By evaluating these companies with a view that they might hold assets that other investors are missing, we can identify opportunities, like Affine, where these hidden assets are worth a great deal more than what we have to pay to get them. Eventually other investors will wake up and realize this, the shares will rise to reflect the full value of the assets and we'll enjoy handsome returns.