Why US hedge funds are not buying investment properties in Vancouver

Hedge funds in the US have raised more than $8 billion to buy properties in the US lately and I am wondering why Canadian hedge funds are not buying properties in Canada like their peers in the US.  

"According to investment bank Jefferies & Co., major financial firms led by Colony,Blackstone Group LP,  Och-Ziff Capital Management and Oaktree Capital Group LLC have raised more than $8 billion to buy houses, largely in markets pummeled by the housing crisis."

http://online.wsj.com/article/SB10000872396390443696604577644700448760254.html

Professional investors make their decisions on real estate investments based on Cap rate (capitalization rate). Cap rate is calculated with this formula:

Operating income of the investment properties (rent minus the expenses like property tax) / price you pay for that investment.

If you paid $250,000 for your investment property, your cap rate is 10% if you receive $25000 in operating income (rent minus all expenses excluding mortgage interest).

Let’s find out what kind of return US hedge funds are getting on their property investment. As per the article from bloomberg.com, US hedge funds estimated they can earn 9% annual yield on their investments. It seems the Cap rate of some US properties can be as high as 9%.

“Sylvan could buy a home for about $50,000 that needs another $50,000 in repairs, such as replacing windows and air conditioning, plumbing and electrical systems, Chang said. The houses will rent for about $1,250 to $1,500 a month, he said…... Based on that cost, investors would get about 9 percent annual yield on their money.”

http://www.bloomberg.com/news/2012-08-01/ex-morgan-stanley-analyst-forms-firm-to-buy-rental-homes.html

What about the Canadian real estate market? Everybody knows the Canadian real estate market is cooling down lately but it outperformed bonds or stocks investments in the past 5,10 years. Smart investors have made lots of money in bricks and mortars, so are the smart guys in hedge funds piling in to take advantage the soft market conditions in real estates? I did a little research on the Cap rate in one of the hottest real estate market in Canada -- Vancouver--- according to vancouvermarket.ca, Cap rates of residential properties in Vancouver are at a multi decade low - 4%

When will we witness the end of declining capitalization rates? Logic would dictate that this trend cannot be sustained; however, with continued low bond yields, debt financing can continue to be characterized as ‘cheap’, and many investors will continue to be attracted to Vancouver’s overall low-risk profile.”

http://www.vancouvermarket.ca/2012/07/13/cap-rate-compression-how-much-longer-can-it-last/

So how safe are investment properties in Vancouver? Let’s say you have paid 20% down on a $250,000 rental property and the cap rate is 4%, you have secured a 5 year mortgage of 3% with 20 year term. For real estate investors in Vancouver, they can earn a net return of 1% above their cost of capital as long as they can secure 3% mortgage rate until the mortgage is paid off in 20 years. So what is your margin of safety in earning a positive return?

Canadian 1 year mortgage rate - data from Bank of Canada:

2011: 3.35% to 3.5%

2010: 3.35% to 3.6%

2009: 3.6% to 5%  

High and low over the last 20 years: 12.25% in 1991 and 3.1% in July 2012

http://www.ratehub.ca/5-year-fixed-mortgage-rate-history

Movement in interest rates are unpredictable, however mortgage rates are at 20 year low right now and the odds of mortgage rates rising might be high over the next 20 years. If your cap rate is 4%, the odds of earning a positive return relative to your cost of capital over the next 10, 20 years might not be good.

What about making a capital gain in your investment properties? Will hedge funds buy properties in Vancouver to take advantage of rising prices in the future? Institutional investors like hedge funds figured: Real estates are long life assets, if the odds of earning a positive return above the cost of capital (mortgage rates) is low, the odds of prices going much higher like the past 10 years might be low as well --- So hedge funds might not buy rental properties in Vancouver, they might go elsewhere looking for opportunities with higher cap rates.

Price is what you pay, Value is what you get. Hedge fund managers might determine the value of properties in the next 10-20 years based on the price they have to pay now, value of investment properties can not be determined by how prices behaved in the past 15 years.

                                         

Winpak - why boring companies can be a good investment

Company background:

Winpak(WPK-T) is in the business in manufacturing high quality packaging materials and the production of related innovative packaging machines. Winpak distributes products to customers primarily in North America for the protection of perishable foods, beverages and in health care applications. Winpak is closely aligned with Wipak, which is one of Europe’s leading manufacturers of packaging materials. Wihuri Oy of Finland is the controlling shareholder of Wipak and Winpak.

Winpak integrates the whole production process of its products from getting the raw materials to delivering the end product to customer. Winpak can react quickly to market requirements and can readily design materials that respond to a customer’s special needs. This core competency is supported by a technical organization with its engineering expertise and low cost manufacturing through the use of advanced technology.

Company performance:

Dividend yield: 0.81%

Return on Equity: 14.6%

Median Return on Equity (last 5 years): 11.5%

Net debt to total equity: 0

5 year compound return on stock price: 17% per year

10 year compound return on stock price: 3% per year

Winpak stock price increased 204% or 17% per year over the past 5 years. Over the past 10 years, the stock returned 23% or 3% per year. Compound growth of EPS was 22% per year and 9% per year over the past 5 and 10 year period. Expectation was high on the stock back in 2002 and the average PE was 22 times earnings back then, investors got disappointed and the stock sold off and reached a bottom average PE of 11 to 12 times in 2008-2009. The stock rallied strongly off the bottom from 2009 to 2012 when EPS grew nicely due to improving profit margins and modest sales growth.

Compound growth rate of sales was 7% and 8% in the 5 year period and 10 year period. Compound growth rate of EPS in the last 5 year and 10 year period was 22% and 9%. Winpak is targeting to grow its revenue to over 1 billion by 2015. This represents a higher compound revenue growth rate compare to the previous 5 and 10 year period.  

EPS has been growing faster than the growth rate of sales in the last 5 years due to the company’s effort to increase the profit margin of the business, in fact EBIT margin almost doubled from 6.85% in 2007 to 14.66% in 2011. Winpak’s profit margin is one of its strength and it is among the group of companies with the highest margins in the industry.Significant growth in profit margins might not be possible for the next 5 years but profit margins can be improved with enhanced production efficiency. Return on equity was 7.4% in 2007 and it doubled to 14.6% in 2011. Decent ROE ratio shows the quality of the management team in delivering growth and efficiency gains. 

The ability to generate cash is one of the strength of the business. Record operating cash flow in 2011 is the result of high profit margins and modest sales growth. Winpak focus on its organic growth opportunities and spent a record $48.9 million on capital expenditure in 2011. Cap ex in the last 3 years was $21.4 million, $39 million and $48.9 million, this all covered by the operating cash flow of the company. The company was increasing its cash balance on the balance sheet in the last 4 years and the cash balance covers all the liabilities according to the latest quarterly report.

The dividend yield on the stock is low @0.81%. Although the company was growing at a modest rate over the last 5 and 10 year period, the dividend was not increased for over 10 years. The operating cash flow of the company is more than enough to cover all the capital expenditure and the dividend but the company’s priority is to grow the business instead of returning cash to shareholders.

Major shareholder:

Antti Aarnio-Wihuri of Finland holds 52% of the shares of Winpak as per INK company insider report. Winpak is closely aligned with Wipak, which is one of Europe’s leading manufacturers of packaging materials and is ultimately controlled by Wihuri Oy of Finland.  Antti Aarnio-Wihuri is the controlling shareholder of Winpak, Wipak & Wihuri Oy and he is the board chairman of Winpak since May 18 1985.

Recent analyst downgrade:

Two analysts cover the stock as per Reuters with 1 buy rating and 1 outperform rating. Earnings missed analyst estimate in the last 2 quarters by -12.3% and -8.8% .  In the past 90 days analyst downgraded EPS estimate of 2013 by -5.8% and price target was revised downward by -3.2%. 

Valuation:

PE ratio (trailing 12 months): 14.3 times

Median average PE (last 5 years): 12.10

Price to book value ratio: 2 times

Median average price to book value ratio (last 5 years): 1.46  

Price to cash flow ratio: 9.9 times

Winpak’s trailing 12 month PE ratio and price to book ratio are above the median values of the last 5 years. The company have reported record sales and EPS for 5 consecutive years and this is priced into the current stock price. The company seems to be fairly priced @ 12 times forward earnings, valuation is above peer average but the performance of Winpak is also superior.

The company’s cash and cash equivalents balance at the end of third quarter 2012 is $120.3 million. There is no long term debt and the cash on hand is enough to cover all the liabilities stated on the balance sheet. According to the annual information form “With the amount of cash on hand, existing term loan facility, an informal investment grade credit rating and the company’s ability to generate positive cash flow from operations, the company is in a good position to fund an acquisition if needed”. The valuation of the company’s share is above peer average and this increase the chance of Winpak in making an accretive acquisition. However, the management team of Winpak is conservative and they made two acquisitions only over the last 10 years (2002 &2008). The chances of Winpak making an accretive acquisition might be low due to its conservative management style.

Verdict:

Winpak is well-financed and is in a good position to pursue acquisitions that will result in a positive surprise in the share price. However, the track record of this management team seems to favor organic growth instead of mergers and acquisitions. The probability of an accretive acquisition might not be high but a dividend increase is possible if the company realizes they are not going to pursue a big acquisition in the medium term. A dividend increase might result in positive response in the share price in the near term.

The business of Winpak is well run and it is backed by a patient controlling shareholders with a long term view on the development of the company.  The growth target of the management team is reasonable. Winpak is a good company with good ROE numbers, stable growth & steady profit margins. You might consider adding it to your portfolio if you like good boring business with modest growth potential.

In the first 9 months of 2012 revenue increased 3.4% and net earnings increased 10.5% to 77 cents per share. Profit margin was more or less unchanged. It seems growth in earnings might slow down after 5 consecutive years of out-performance.  Recent analyst down grade of the stock is pointing to the fact that investor expectation might be high but not unreasonable.