Look to Canada for Solid Income

12/26/2012 7:00 am EST


Roger Conrad

Chief Analyst/Managing Partner, Capitalist Times

In the US, income stocks have been bought up, and many are expensive for what you get in risk and reward. But this Canadian stock is a good value and kicking off some nice dividends, notes Roger Conrad of Canadian Edge.

There’s no more certain sign of a healthy company than dividend growth. Equally, a rising payout is the most reliable catalyst for capital gains, as share prices rise over time to reflect higher disbursements.

After long hiatuses, both of December’s Best Buys recently returned to dividend growth. And judging from bullish numbers and guidance, there’s plenty more where that came from for Canadian Apartment Properties REIT (Toronto: CAR-U) and Vermilion Energy (Toronto: VET).

CAP REIT’s 1.4% boost, announced in late November, is its second increase in as many quarters. The previous 3.3% increase, declared in mid-August, was the first boost since September 2003. Together they add up to a nearly 5% hike, and set a clear precedent for more growth ahead.

CAP REIT’s return to dividend growth has been made possible by an extraordinarily successful investment strategy over the past several years. The REIT had already carved out a secure reputation as a virtually bulletproof property owner, focused on only super-high-quality locations in the most stable real estate subsector (apartments).

The result has been steady rent growth and consistently high occupancy rates averaging 98% or better, even during the worst of the 2008-2009 recession.

Holding up well during a crisis of confidence kept CAP REIT’s dividend secure. That’s in marked contrast to the wipeout suffered by many US real estate investment trusts, and some of its Canadian rivals as well. This has given CAP REIT one of the lowest costs for expansion capital in its sector, and management has turned that to full advantage with a string of profitable acquisitions.

CAP REIT’s full-year 2012 revenue is expected to come in at C$411 million-plus, a gain of nearly 30% from 2008 levels. More important, the annualized payout ratio based on distributable cash flow has migrated down from the mid-90% range to under 80%, a trend that should continue to open up room for more dividend growth.

In fact CAP REIT’s ability to access low-cost capital is arguably at an all-time high. This week, the company closed an equity offer of 6.7 million units at $24 per, within a few percentage points of its all-time high. The $160.8 million in proceeds will repay a portion of its $328.2 million drawn on credit facilities, including a $100.2 million bridge loan to fund 17 acquisitions completed since June 29 at a total cost of $707.9 million.

CAP REIT’s debt load, meanwhile, is a modest 50.2% of total capitalization and 51% of gross book value. The latter figure is down from 55.35% a year ago, demonstrating management’s focus on its balance sheet as well as ability to raise equity capital to fund growth.

As is the case for most REITs, the vast majority of debt is held on the property level as mortgages rather than with the parent as ordinary bonds. Debt is mostly tied to cash flows from properties owned, providing a layer of insulation for the REIT’s own balance sheet.

The average interest rate on these mortgages is 4.03%, down from 4.63% a year ago. The average term to maturity, meanwhile, is 5.3 years, roughly flat with year-ago levels. These numbers should improve again in the fourth quarter, as the company closed $387.4 million in new mortgages with an average term to maturity of 8.9 years, at an average weighted interest rate of just 2.91%.

CAP REIT saw solid improvement in interest coverage and debt service ratios from 2011. And the Canada Mortgage and Housing Corporation insures 93.1% of its mortgage portfolio. That’s a clear demonstration that it’s taken advantage of record-low corporate borrowing rates to strengthen its balance sheet rather than lever up for short-term growth.

This conservative approach to the balance sheet applies to operating policies as well. Over the past few years, CAP REIT has expanded its portfolio from its traditional base in Eastern Canada to faster-growing areas in the western energy patch and along the Pacific Coast. The result is far better geographic diversification that’s insulated the company from regional market disruptions and speeded up growth as well.

Third-quarter revenue surged 17.6%, but occupancy remained high at 98.5% of available space, with much of the rest accounted for by upgrades.

Rents rose a steady 2.7% at properties owned for at least one year, and remain below market nationally, providing future upside as well as downside protection. And funds from operations per unit—the best measure of REIT profitability—rose 12.1% despite a 22% increase in outstanding units to finance growth.

The upshot is more distribution growth for Canadian Apartment Properties REIT, justifying a bump up in my buy-under target to $24.

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