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A tale of two REITs
Investors see challenges at Boardwalk, while CAP REIT remains a market darling. Maybe they aren't quite as dissimilar as they seem
Special to The Globe and Mail

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Tuesday, November 21, 2017 – Page B11

When the third quarter rolled to a close, Canadian Apartment Properties Real Estate Investment Trust, or CAP REIT, told its unitholders that it was continuing to post strong results, maintaining what it had called a "20-year track record of strong growth and solid operating performance," with a payout ratio of just under 70 per cent. The units have returned more than 20 per cent this year, and hit a 52-week high after the report.

Things aren't as swell at Boardwalk Real Estate Investment Trust, which has a strong concentration of apartments in Alberta and Saskatchewan. Faced with oil-patch-related vacancies, the company has decided to spend more on its properties to prepare for a western rebound. That decision has sharply cut its cash-flow performance and pushed its payout ratio, it says, above 100 per cent - before it slashed its dividend by more than half last week. The units are the worst performer among REITs in the S&P/TSX composite this year and hover near a 52-week low.

Canadian investors, always hungry for income, love REITs because of their generous payouts, borne from the tax requirement that they distribute the bulk of their income to their unitholders. (The payout ratio indicates the percentage of earnings paid out as dividends or distributions.)

Investors who dig deeper into the two REITs' disclosures, and apply a healthy skepticism to their capital spending, may come to the conclusion that CAP REIT's payout isn't as safe as it appears - and Boardwalk is in even worse shape. And they will get a better understanding of why both REITs are the target of shortsellers, who profit when stocks decline, rather than rise. Boardwalk has been among the most-shorted stocks on the TSX, according to IHS Markit, and CAP REIT remains a target of a New York hedge-fund manager who's been negative on the units for more than a year.

To understand the bear case, we must go to the math. The key measures that REITs emphasize are "funds from operations," or FFO, and related metrics, "adjusted funds from operations," or AFFO, and "adjusted cash flow from operations," or ACFO.

Both AFFO and ACFO typically subtract capital expenditures the REITs spend on their existing properties, recognizing that funds spent in this manner aren't funds available for an investor distribution. The wrinkle, however, is that the convention among Canadian REITs is to label a small portion of capital expenditures as "maintenance capex," or something similar, and deduct only that amount in the AFFO/AFCO calculation. The remainder of the capital expenditures on existing properties are labelled "growth capex," or "value-enhancing capex," and are not deducted in arriving at AFFO/AFCO. Boardwalk, for example, believes that replacing a worn carpet or linoleum floor with laminate or vinyl-plank-type material has greater appeal and will allow for higher rates - and is thus valueenhancing.

The idea is that maintenance capex are necessary short-term expenditures, while the other bucket of capex will allow the REIT to raise rents in the future. Therefore, growth or value-enhancing capex shouldn't be deducted for AFFO/ ACFO. What falls into each category, however, is subject to much discretion. Further, many REITs use estimates of capital expenditures, not actuals, in calculating ACFO for each quarter.

The result is that REIT payouts look quite healthy in comparison to these adjusted measures, because the adjustments, arguably, aren't big enough.

CAP REIT, for example, labels its capex "non-discretionary" and "discretionary," with the former "essential for the safety of residents and to ensure the structural integrity of the properties," and the latter "not essential to operation of the business in the short-term." However, CAP REIT, in its management discussion and analysis, says spending on boilers and elevators is discretionary, and therefore doesn't get deducted from ACFO. (The company declined to comment for this article.)

This is how Boardwalk chops up the cost of its capital expenditures: It estimates the useful life of each project, placing the first year of spending into the "maintenance" category and the remainder to "value-enhancing," spread over the remaining useful life of the project.

In the third quarter, Boardwalk reported ACFO of $21.7-million, which included $5.3-million in "maintenance" capex. However, the company reported just more than $48.4-million in "value-enhancing" capex.

The $28.6-million in total distributions represented almost 132 per cent of ACFO. But further subtracting the $48.4-million in additional capex, Boardwalk posted negative cash flow of $26.7-million - before the distributions were made.

Investors recognize the challenges at Boardwalk just from the unadjusted numbers the REIT shares in its news releases and have pushed the stock price down accordingly. But look at CAP REIT, which remains in favour: The third quarter saw ACFO of $63.9-million, including $14.3-million of "non-discretionary" capex.

CAP REIT's discretionary capex estimate for the quarter, though, was just less than $31-million. Subtracting that additional spending takes cash flow down to just less than $33million - and increases the payout ratio on $44-million in distributions from 69 per cent to 134 per cent.

To suggest that ACFO and AFFO should be adjusted to include all capex - and that this makes the stocks less attractive - is an outlier opinion in Canada. Eight of the 12 analysts covering CAP REIT have a "buy" rating, according to Bloomberg data. (Boardwalk, with its challenges and an always-displeasing earnings guidance cut in the recent picture, has four buys versus seven holds and two sells.) However, the way Canadian REITs do their capex math attracted the attention of Richard Rubin of Hawkeye Capital, a New York hedge fund. Mr.

Rubin believes CAP REIT's true three-year average AFFO payout through the end of 2016 is 800 per cent, versus a reported number of roughly 75 per cent. My own math suggests the 2016 payout was 525 per cent, with $133.3-million in discretionary capex subtracted from ACFO of $164.6-million, knocking cash flow down to $31.3-million, versus $164-million in distributions.

Mr. Rubin also believes the annual "maintenance" spending by Canadian apartment REITs is well below what's truly needed to maintain an apartment unit. In a September, 2016, report to investors, the firm Green Street Advisors looked at U.S.

REITs and said the REITs "know true capex costs are huge, but never speak of them - like a crazy aunt in the basement." Green Street estimates U.S. apartment REITs have spent an average of $1,350 (U.S.) a unit annually since 1996, with the figure reaching $1,950 a unit in 2015.

By contrast, Boardwalk tells investors its estimate of "maintenance" capex for 2017 works out to $629 (Canadian) a suite in 2017, while its "value-enhancing" capex was estimated at $3,636 a unit for the first nine months, an amount that could push the number to $5,000 for 2017.

CAP REIT says it plans to spend $1,177 per suite in non-discretionary capex in 2017, down from $1,251 in 2016 and $1,365 in 2015.

It all adds up to an awful lot of money spent on the apartments - money that each REIT tells investors they shouldn't worry about when it comes to paying out distributions.

Holders of the two REITs, however, should wonder whether year after year of "value-enhancing" off-thebooks spending will continue to enhance the value of their units.

Cdn. Apt. Properties REIT (CAR.UN)

Close: $37.36, up 16¢

Boardwalk REIT (BEI.UN)

Close: $39.20, up 63¢

Huh? How did I get here?
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