BSR REIT: Houston, We Have A Problem (OTCMKTS:BSRTF)

Summary

From the beginning of 2021 to its peak in early 2022, BSR’s unit price nearly doubled. Shortly following its peak at almost $22 per unit, the market darling has come on hard times. BSR’s units have roughly halved from their peak, are down ~17% over the past year, and barely participated in the recent REIT rally (n.b., up <4% over the past month).

In this report, we dive deep into the factors that have contributed to BSR’s underperformance and converse why we admire the business and management team but are not interested in buying today.

Although we are rating BSR a Sell right now, it has many attributes we admire in a business and a stock. Fundamentally, we admire the socioeconomic tailwinds that benefit residential demand in the Southern US, and intelligent management teams focused on shareholder/unitholder value. We admire REITs with relatively small portfolios (in terms of the number of assets) and structures. With ~90% of its portfolio in three Texas MSAs and the remainder split across only two MSAs, we can get much more granular in our analysis of BSR than other larger, more complex REITs. This allows us to be much more precise in our valuation and diligence. For these reasons, we will add BSR to our “closely watched” watchlist.

History

BSR began as a privately held real estate company with a history dating back to 1956 with the founding of the Bailey Corporation. Over the years, the company evolved to focus on multi-family properties and expanding its portfolio with significant help from the Bailey and Hughes families.

Prior to its IPO on May 18, 2018, it was privately held by 400 members. As part of the IPO, the legacy holders received ~23MM Class B units. The Class B Units are economically equivalent to common units and are exchangeable on a 1:1 basis, though they have no voting rights. The founding Bailey and Hughes families collectively owned ~16MM Class B and ~4MM common units following the IPO, giving them a ~36% ownership stake.

Since the IPO, BSR has engaged in a highly successful capital recycling program, through which it has high-graded the portfolio into predominantly class A assets in primary markets in Texas (DFW, Austin, and Houston), Arkansas, and Oklahoma.

Portfolio Snapshot

BSR owns 31 properties with 8,666 total units across 5 MSAs: Dallas-Fort Worth, Houston, Austin, Little Rock, and Oklahoma City. Nearly 90% of NOI is generated in Texas.

Since its IPO in 2018, BSR has undertaken an extensive capital recycling program by selling class B properties in non-core markets and reinvesting in higher-quality class properties in core primary markets. Its last acquisition and disposition activity occurred in Q4 ’21, selling 760 units in DFW and Austin and acquiring 1,059 units in the same markets.

Since then, the portfolio has remained stable at 8,666 units. Organic growth has been strong, with total portfolio NOI growing at a ~5% CAGR (n.b., including a pro forma adjustment for Q4 ’21). DFW and Houston have been the most significant contributors to NOI growth, driven by improving occupancy and strong rent growth.

Recent Performance

Earnings and Cash Flow Evolution

In this section, we unpack the drivers of BSR’s earnings and cash flow evolution from year-end ’21 to Q3 ’23. In the table below, I imputed BSR’s rental revenue and other property income (n.b., predominantly cost recoveries and charges for amenities) based on its unit count, average monthly rent (“AMR”), and occupancy. The imputed revenue is within 1% of the reported figure except for Q4 ’21, as the impact of acquisitions in that quarter was only partially recognized.

As shown in the table below, BSR’s revenue has grown ~7% over this period, driven almost exclusively by rent increases.

Using the imputed revenue figures above to account for the Q4 ’21 acquisitions, we looked at the NOI evolution. YTD, NOI has grown ~9% YoY as revenue grew by ~7% and margins expanded 94bps.

Next, we turn to FFO and AFFO as our preferred cash flow metrics. We use the reported figures for this part of the analysis for simplicity. YTD, FFO has grown ~13% YoY as NOI growth outpaced net finance costs. While G&A grew faster than NOI, the magnitude of this line item is significantly smaller than net finance costs. A ~9% boost in the unit count was dilutive to FFO per unit, which is up ~11% YTD.

AFFO is up ~12% YTD, and ~10% on a per unit basis, as maintenance capex requirements have grown significantly (n.b., +22% YTD).

Next, we turn to BSR’s NAV evolution.

NAV Evolution

In this section, we unpack the drivers of BSR’s reported NAV evolution from year-end ’21 to Q3 ’23. As shown in the table below, BSR’s NAV has grown at a 1.6% CAGR over this period (n.b., ~3% cumulative growth). Here, it is important to note that the Class B units are carried on the balance sheet as a liability (at market value) but are combined with unitholders’ equity to derive the reported NAV figures. From Q4 ’21 to Q3 ’23, the ~4% cumulative refuse in the value of investment properties was partially offset by a ~16% refuse in total liabilities (n.b., ~10% refuse excluding the Class B units, ~11% refuse in gross debt). In simple terms, BSR’s assets have been marked down modestly while it has reduced leverage, and the value of Class B units has fallen. As the Class B units are economically equivalent and convertible to common units, BSR’s declining share price through this period has artificially decreased its reported NAV. We can also see that its average portfolio cap rate has expanded by 80bps, and its valuation NOI has increased at an 8.3% CAGR, though it declined modestly in Q3.

Below, we see that the declining value of the Class B units and decreasing liabilities have been the most significant drivers of the NAV, with the markdown of investment properties being the next most important. We also see that the 80bps of cap rate expansion has outweighed the NOI growth. NAV per unit has declined at a -3.4% CAGR, significantly worse than the total NAV. While the net positive developments on the balance sheet would have contributed $ 0.97 of NAVPU growth, a ~9% boost in the unit count contributed to $2.13 of NAVPU dilution.

Next, we present three scenarios exploring the theoretical NAV evolution holding certain variables constant. First, we look at the average cap rate. As seen below, had BSR not seen the 80bps of cap rate expansion, total NAV and NAVPU would have grown at a 20% and ~14% CAGR, respectively (n.b., ~38% and ~26% cumulative growth, respectively). This would have resulted in a NAVPU ~46% higher than actual.

Second, we look at NOI. As seen below, had BSR not seen the ~15% cumulative NOI growth, total NAV and NAVPU would have declined at a -12% and -16% CAGR, respectively (n.b., -20% and -27% cumulative refuse, respectively). This would have resulted in a NAVPU ~15% lower than actual.

Lastly, we look at the other balance sheet items. As seen below, holding total liabilities, the value of Class B units, and assets other than investment properties constant, total NAV and NAVPU would have declined at a -4% and -9% CAGR, respectively (n.b., -7% and -15% cumulative refuse, respectively). This would have resulted in a NAVPU materially the same as the actual value.

Valuation

BSR trades for 11.9x and 12.9x ’23E FFO and AFFO, respectively. With a $0.52 per unit annual distribution, it yields ~4.7%. Based on my NAV calculate, the market is pricing BSR at a ~18% discount and ~5.7% implied cap rate.

Our NAV calculate of ~$13.5 per unit assumes ~$82.8MM of NTM NOI (n.b., ~1.7% YoY growth) and a 5.23% blended cap rate. Our cap rate assumption is based on an LQ NOI-weighted average market cap rate. Our sources for market cap rates for each MSA can be viewed in the following links: DFW, Houston, Austin, Little Rock, and Oklahoma City. The sources also supply the market price per unit we use in the downside case presented in the Risks section.

Our cap rate assumption is more aggressive than sell-side brokers, though our NOI assumption is significantly more conservative (n.b., ~10% below consensus). We feel comfortable that our cap rate assumption is well supported and that near-term supply issues in Texas will weigh on NOI through the next several quarters.

The major balance sheet adjustments for the NAV are shown in the table below.

We apply a 5% discount to NAV to derive our target price. In the Risks section below, we converse the impact of new supply in Texas that we expect to weigh on BSR’s units through the first half of ’24. Our target price implies ~16% upside to the current unit price and ’23E FFO / AFFO multiples of 13.8x / 14.9x.

With the backdrop of heightened new supply deliveries over the next few quarters and the likely deceleration of rent growth that will accompany it, we see the current valuation as unattractive.

Risks

New Supply

RealPage data suggests that new supply will peak in Q3 ’24 for DFW and Austin, but remain elevated relative to Q3 ’23 through the end of ’25. Houston is expected to peak in Q2 ’24 and return to levels comparable to the first 2 quarters of ’23 by the end of ’25. Construction activity in a few key Texas submarkets can be seen in the table below.

Dallas News has recently published several articles that supply additional data points that should be of concern for holders of BSR.

Dallas-Fort Worth’s 72,900 apartments under construction — the mostanywhere in the U.S. — will grow the North Texas market’s inventory by 8% … Before we get to 2025′s slowdown in apartment deliveries, the key metros in Texas will add encourage big blocks of rental housing during the remainder of this year and during 2024.(Dallas News)

As indicated above, while new starts in these markets are already slowing sharply, it will take quite some time for the upcoming supply glut to clear and for landlords to regain meaningful pricing power. As we see in the table and chart below, BSR has seen a significant degradation in pricing power over the past 5 quarters as deliveries of new supply have accelerated. Recall from earlier that rent growth was almost the preeminent driver of NOI growth, which in turn was the primary factor preventing significantly worse NAV destruction. Without pricing power, BSR will be left without its single most important lever of value creation/preservation. Already, we see management turning to the NCIB as its new go-to tactic to drive value.

Smart real estate investors look harder at replacement costs when supply becomes a concern. Using the sources we relied on earlier for our cap rate assumptions, we valued the portfolio based on the prevailing market price per multi-family unit. We calculate an average price per unit of ~$151,000 for BSR’s total portfolio.

This results in a gross property value of ~$1.3Bn (n.b., ~17% lower than our direct cap value and implying a cap rate of ~6.3%) and a target price of ~$8.7 per unit (n.b., ~21% downside). Despite using the same sources, there is a significant disconnect between these two approaches, so we ran the following sensitivity to find the breakeven price per unit.

The breakeven (or market implied) price per unit is 10% higher than our market calculate. Our valuation is highly sensitive to this assumption, but we are comfortable taking the $8.7 per unit price as our downside target.

As you may have noticed, the valuation now appears moderately asymmetric, though in the wrong direction. The positive “payoff” (i.e., our base case return of ~16%) is ~70% of the magnitude of the downside case payoff. Considering the expected value, you would need conviction in a ~58% chance of realizing the base case return. We find this a tough sell.

Catalysts

NCIB Activity

BSR began its first NCIB (n.b., TSX share repurchase authorization) in October ’22, through which it repurchased ~1.48MM units at an average price of ~$13.25 per unit (n.b., ~2.5% of units cancelled). In October ’23, began a new NCIB with authorization to repurchase up to ~3.2MM units. Under the new NCIB, BSR purchased 44,800 units at an average price of $10.73 (n.b., ~0.1% of fully diluted units).

While this is a testament to management’s disciplined capital allocation, the historical pace of its NCIB activity has been inadequate to materially better its per-share metrics or arrest the unit price.

With only ~$3.9MM of unrestricted cash, BSR could only repurchase ~0.6% of its fully diluted units. However, AFFO less distributions in Q3 would be sufficient to repurchase ~0.7% of units. Of course, it cannot use all of its excess cash flow to repurchase units, but it indicates that management could make a meaningful dent in the unit count.

Tightening Supply (2025+)

As discussed earlier, new supply deliveries are expected to peak in late ’24. This would be a natural point to begin expecting a recovery in pricing and market sentiment. However, this is well known by the market (or at least the sell-side), so we would expect any potentially attractive entry point (which we believe to be right around $10 per unit and below) to occur within the first half of ’24, though this is contingent on how rents trend over the coming quarters.

Conclusion

BSR is a well-run US multi-family REIT with an intelligent and well-aligned management team focused on growing unitholder value. New supply deliveries in its key markets have eroded the pricing power BSR has relied on to conserve and drive value. The introduction of new supply is expected to speed up for several quarters before peaking in late ’24. We do not see an attractive risk/return profile for BSR at its current price. Valuation notwithstanding, we BSR’s assets and the socioeconomic tailwinds that should benefit its core markets over the long term. We will continue to monitor the supply picture in the coming quarters and look for a more attractive entry point below $10 per unit.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.