A Rise In Capitalization Rates Could Jeopardize Bluerock (NYSEMKT:BRG)

Bluerock Residential Growth (BRG) is a REIT that focuses on higher-end multifamily residential properties with the goal of achieving price appreciation. In general, its holdings have higher capitalization rates (for their respective location) while its tenants have higher incomes and lower rent-to-income ratios. It generally operates in lower-cost areas of the U.S. such as the South and Southwest which have seen strong growth in recent years.

This strategy has many distinct benefits. Most importantly, it is unlikely to be hit too hard by COVID-19’s economic ramifications as most of its tenants have a lower rent-to-income ratio. As such, the company was able to collect around 97% of its rent due during Q2 (as of June) with solid occupancy of 94%. The company has also maintained a strong new lease volume with 88% of last year’s during the month of April despite using virtual leasing. The pandemic has also resulted in an increase in renewals which offsets the decline in new leases.

Despite seeing minimal material impacts from the virus, BRG is down 33% this year and has a solid 8.3% dividend yield. It has also steadily grown cash flow and has sold numerous properties at a gain over the past few years, yet its stock price has not moved since 2014. Given this, BRG may be a hidden, higher-quality, value opportunity for investors. However, the company also has a very high preferred equity leverage that may take away this opportunity. Let’s take a closer look at its fundamental situation.

Strong Growth, But Leverage is a Concern

As you can see below, BRG has substantially grown its revenue per share and cash flow per share over the past few years. Despite that, its stock price has generally been in decline:

Data by YCharts

Unfortunately, this does not give us the full story as the company has relied on preferred equity sales in order to achieve growth over the past few years. As you can see below, it has essentially no cash-flow growth after preferred stock dividends:

ChartData by YCharts

In general, the company’s cash flow after preferred dividends is $5-10M per quarter or around $30M per year, which gives it a more normal cash-flow valuation to common stock of 8-9X. This is still low, but its margins are so thin that physical depreciation costs likely bring its adjusted cash flow per share to zero.

Given this, equity investors in BRG are betting almost entirely on asset appreciation which is the goal of its managers. Yes, the company has an 8% dividend yield, but investors should expect this to come out of BRG’s book value as has been the case over the past few years. As you can see below, the increase in preferred equity has brought BRG’s tangible book value to nearly zero:

ChartData by YCharts

Overall, I believe it is clear that BRG’s leverage is extremely high as common equity represents only 3.6% of its total assets. Of course, a decline in small revenues due to COVID (or related economic issues) is unlikely to jeopardize its equity as preferred dividend payments are not mandatory, giving the company a significant buffer. However, it does give BRG substantial risk of a lasting dividend cut as arrears payments are made.

BRG’s balance sheet is undoubtedly atypical of REITs which can cause difficulty for investors. To put it simply, buying BRG is a highly levered bet on asset appreciation and should not be viewed as a stable income investment as are most REITs.

Can BRG Manage to Appreciate its Portfolio?

While BRG’s book value per share has declined substantially, that does not mean its NAV has as well since depreciation rarely represents true physical depreciation. Bluerock has a TTM NOI of about $120M and has recently sold assets at low cap-rates around 4-5%. Estimating under a 5% metric, the company’s portfolio is likely worth around $2.4B with other tangible assets totaling around $320M, giving it an estimated asset value of $2.72B.

Subtracting its $1.61B in total liabilities and $785M in preferred equity, we come to an estimated common NAV of $325M ($10.4 per share). This is 34% above BRG’s current market capitalization of $242M, indicating that the company may be undervalued if it can continue to sell its assets at a cap rate of 5% or lower. Of course, if this figure rose to 6% then BRG’s NAV per common share is likely negative which goes to show how highly levered it is.

Given this, as well as the fact BRG is unlikely to sell at cap rates below 4.5% (due to mortgage rates), the company will need to improve its NOI per property in order for common shareholders to gain. According to its last investor presentation, the company currently estimates that its current renovations will have an incremental NOI increase of around $7-8M. Using the same process as above (5% cap-rate, etc.), I estimate this would increase its NAV to around $485M or about $15.6 per share.

Again, this goes to show just how highly levered common shareholders are. A 6% increase in NOI results in a nearly 50% increase in estimated NAV.

The Bottom Line

Obviously, there are other factors one could use to come to a higher or lower NAV figure, but the bottom line is that common-stock investors in BRG have a lot to gain if the company can improve income and a lot to lose if it fails to do so.

Given its metrics last quarter in light of COVID, I would say the company is likely fairly valued or potentially slightly undervalued at its current price. While the virus has not resulted in a substantial revenue decline, it is still possible that it eventually results in an increase to U.S. multifamily capitalization rates which are at extremely low levels by historical standards. This is an extreme risk to BRG’s value as a 1% increase in selling cap-rates would likely result in its NAV per common share falling to zero.

However, if BRG can grow same-store NOI at its expected pace and multifamily property maintains its high valuation, investors are likely to be rewarded with 50-100% gains. While this is feasible, caution is warranted in today’s environment as evidence suggests that commercial property valuations are more likely to decline than continue to rise.

Put simply, BRG may be undervalued from a NAV standpoint but its high leverage makes it a high-risk opportunity that is probably best avoided.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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