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More Dirt Cheap Real Estate: Melcor Developments Trades for 30% of Book Value
Plus substantial ownership by the founding family and a 5%+ yield
Before we get started on Melcor Developments (TSX:MRD), allow me to take a second to update y’all on Morguard, which I wrote about a couple weeks ago.
I was frustrated Morguard was telling the market it and its REITs were trading at huge discounts to NAV, but didn’t do anything about it. I’m happy to report the company acquired a 2.5% stake in the REIT, boosting its ownership position to a little more than 78%, which includes shares owned by Sahi and other insiders. Additionally, Morguard Residential REIT has been using its NCIB to gobble up shares as quickly as allowed, buying back the maximum of just over 8,600 per day.
Excellent work, guys. And it just so happened both of those started right as I wrote about the company. I think I’m owed 100% of the credit.
Onto Melcor, which is another way for investors to buy dirt cheap real estate. But first, a little history.
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All about Melcor
Melcor can trace its roots to 1923, when Louis Timothy Melton founded the Stanley Investment Company, named after his son. This company specialized in West Edmonton real estate, eventually selling lots in the Jasper Place community.
By the mid 1940s, the company had been renamed L.T. Melton Realty and had morphed into a real estate brokerage. Louis had a certain amount of success and started expanding into various businesses, some related and others not so related, including petroleum, insurance, land development, housing, mortgages, and something called First Investors Corporation.
In 1947, Louis’s son Stan (remember him?) acquired the business, and over the next 20 years it expanded into real estate sales all across Western Canada. That business was eventually sold in the mid-1970s so the company could focus on land development, with a name change to Melcor Developments happening at the same time.
Right around the same time, Timothy Melton (Stan’s son) was put in charge of the business, a title he’d retain until 1999. Ralph Young took over as Timothy transitioned to the Chairman. Young was in charge until 2013, when Brian Baker takes over. After another change in 2017 and yet another in 2022, a presumably very old Timothy Melton is named CEO again.
Melcor is, at its core, a family company. Three of eight members of the Board of Directors have the last name of Melton, including Timothy, Andrew, and Kathy. The company also has Graeme Melton listed as VP of Community Development in Calgary.
The family also controls the company through its large ownership stake. Melton Holdings has a 50.2% ownership stake. Other family members have smaller stakes, including Timothy (7%), Andrew (0.67%), Kathy (0.14%) and Graeme (0.08%). Add in former CEO and current board member Ralph Young’s stake (4.5%) and we have insider ownership of approximately 63% of total shares outstanding. Also note there is an active share repurchase program happening, which should help to increase these ownership stakes over time.
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Onto the business itself. Melcor has five different divisions:
Land development and sales - bulk land sales and residential lot development
Property development - building property for internal use or to suit for third parties
Investment properties - including high quality commercial property and 476 residential properties
The REIT - Melcor controls Melcor REIT (TSX:MR.un) through a 55% ownership stake, and the REIT has the right of first refusal to buy all internally developed property
Recreational properties - Melcor owns four golf courses associated with its residential communities in Alberta
Put it all together and the strategy looks a little something like this:
Let’s talk about land development first. Melcor owns 9,857 acres of raw land, located in key Alberta markets as well as other markets like British Columbia, Saskatchewan, Colorado and Arizona. It slowly sells off pieces to developers (or develops them itself in certain instances), which tends to translate into lumpy earnings.
For instance, in 2021, the company sold 280 lots and an additional 155 acres in the United States, generating some $55M in revenue. In 2022, meanwhile, the company didn’t sell a single lot in the U.S.
Canadian results are less lumpy, but still not as consistent as you’d see in most businesses. Melcor sold 1,261 lots in 2021, following that up with 1,060 in 2022.
Here’s what the overall land portfolio looks like:
Next up, property development. Melcor has been a commercial property developer since the 1970s, building more than 2.5 million square feet of space. It has a development pipeline of 4.4 million square feet of space, mostly retail properties.
Here’s a glimpse of its pipeline:
I’ll remind everyone that the REIT has first right of refusal of any property developed by the parent.
In 2022 the property development division completed five buildings, consisting of 36,846 square feet. There’s an additional 61,850 square feet under construction. These buildings were retained in Melcor’s portfolio and not sold to the REIT. Note the REIT is struggling with its debt and isn’t overly likely to start loading up on property. More on that later.
Any completed properties are deemed to be sold by the development division to the investment property division when they are transferred. Not that it really matters because they’re all internal transactions, but just thought I’d throw that in there.
Up next is the investment properties division, which also includes Melcor’s property management operations.
First, let’s focus on owned real estate. Melcor owns 1.13M square feet of gross leasable space spread across 23 industrial, retail, and office buildings. Approximately half of this portfolio is located in the United States. This is a good time to note probably 60% of assets are in office space, including 100% of the U.S. assets.
Melcor also owns 168 apartments after selling off assets in Phoenix and accounting for a land lease community in Calgary it manages for the REIT. It also owns 11 different parking lots in western Canada, consisting of 2,749 spaces.
As mentioned, Melcor manages the REIT. It also manages a certain amount of property for outside investors and for certain partners. This works out to about 3.6M square feet of managed space.
Combined, the investment properties earned approximately $25M in NOI in 2022, including property management fees. This amount should slowly go up over time as the company adds more property via its development program.
First, a little primer on the REIT and then I’ll spend the rest of this section trying to wrap my head around how its managed.
Melcor REIT owns 39 different properties in Western Canada, spanning 3.2M square feet. Office makes up 50% of total square footage, with retail at approximately 40%. There’s a small smattering of industrial space and the aforementioned land lease community (aka trailer park).
I’m really tempted to crack out a “two trailer park girls go round the outside” meme here, but I won’t. I’m a professional.
NOI was down 3% year over year, which is pretty solid considering the year office had in 2022. Funds from operations decreased 7% and adjusted funds from operations were down 14% on more aggressive lease incentives. Fair value of the portfolio was decreased by $12M, or approximately 1.75% of total assets.
The assumption that a portfolio filled with office/retail space in Edmonton and Calgary only going down 1.75% in a year where interest rates went up 200%+ is probably not an assumption I would’ve made.
But forget about that, because there are plenty of other warts here. Specifically, what is the REIT doing with the distribution?
After years of paying 67.5 cents per share annually — and having an AFFO payout ratio of close to 100% — the REIT bit the bullet in 2020 and cut the payout to 36 cents per unit. COVID went away and the payout was increased to today’s level of 48 cents per unit.
Meanwhile, the REIT has struggled with debt for years. Including a recently issued set of debentures, Melcor REIT has a debt-to-assets ratio of 57%. That was too high when long-term rates were sub-3%, and it’s wayyyyyy too high now.
Rather than get serious about paying off debt and maybe putting itself in the position to acquire some of the development division’s upcoming projects, the REIT has once again put itself in the position of paying out almost all its precious cash flow back to unitholders. Why not retain some and start paying off the debt?
Remember, Melcor controls the REIT. They own 55% of it. They set the strategy, and I guess that means they see value in it. Maybe they want that nice string of cash flow to help with the development program. Maybe they really like these upcoming projects and want to make sure the REIT doesn’t get a sniff. I just don’t understand it.
Melcor owns two golf courses outright, has a 60% interest in a third, and a 50% interest in a fourth. Here’s a breakdown of all four, including rounds of golf played at each in 2022.
(Lewis Estates is my local course and I can attest it’s busy pretty much all the time and is a pretty nice course)
Note that 2021 and 2022 were really nice years for the recreational property division as more folks blew the dust off their sticks and started golfing again.
The golf courses are surprisingly profitable, turning a $1.7M profit on $10.4M in revenue in 2022. They’re also a nice store of value that can someday be redeveloped, but not really material to the business today.
How to value Melcor
If you believe management’s book estimate, Melcor is one of the cheapest stocks in Canada.
Management’s stated book value is $37.71 per share as of December 31st, 2022. As I type this, shares are trading hands for $11.39 each.
That’s an eye-popping 69.8% discount to book value.
No, that’s not a typo. If you believe management, Melcor is probably the cheapest stock in Canada.
I keep saying “if you believe management” because it’s pretty obvious most investors don’t believe management. So let’s try to put together our own half-assed method to value Melcor and see if we get anywhere close to management’s valuation.
Note I’m going to be excessively conservative here, because if there’s anything I like it’s a good margin of safety.
First, let’s start with the land development division. It owns 9,857 acres of land, with approximately 70% located in Alberta. Farmland is worth a little over $3,000 per acre in Alberta, but this is much different land. I don’t think it’s appropriate to value it that way.
Fortunately, we have a comparable out there. Dream Unlimited (TSX:DRM) owns 8,900 acres of Western Canadian land for development, which it values at $9 per share, or $396M. Since Dream trades at a substantial discount to NAV on its own, let’s value Melcor’s land at approximately $22,000 per acre, or half of Dream’s valuation. That values the land at $217M.
Next is the development portfolio, which we’ll conservatively value at nothing. The building development portfolio might have big plans, but there isn’t much happening today.
The bulk of Melcor’s value is going to be in the real estate holdings. This division recorded $25M in NOI in 2022, including property management fees for the REIT. If we assume the portfolio is worth an 8% cap rate, we get a gross value of $312M for the investment properties.
Next is the 55% stake in the REIT. In 2022 the REIT earned a hair over $45M in NOI on what is listed as $730M in total assets for a listed cap rate of 6.2%. If we assume the same 8% cap rate, the assets are worth $560M. Subtract the liabilities ($440M) and we get $120M in equity in the REIT. Melcor owns 55%, so we’ll assume the stake in the REIT is worth $66M.
Onto the golf courses. I’m really not sure how to value those, to be honest. These are courses in residential areas that are certainly worth more on a per acre basis than they’d be from a multiple of earnings basis. But at the same time, I don’t see any plans to close these courses down to develop or sell the underlying real estate. So let’s value them at 10x 2022’s earnings, or $17M.
Put it all together and we have:
Land worth $217M
Property worth $312M
Stake in the REIT worth $66M
Golf courses worth $17M
Plus cash of $77M
Minus total debt of $340M
Which gives us a value of $349M. Divide that by 31 million shares outstanding and that gives us a conservative valuation of $11.25 per share, or right around where the stock is trading today.
Why the big difference in my back of the napkin math versus Melcor’s official numbers? I used an 8% cap rate, while Melcor uses closer to a 6% cap rate. That explains a big bunch of the difference. It values the investment portfolio at $461M, while I value it at $312M. It values the stake in the REIT at $166M. I value it at $66M. And, perhaps most importantly, the difference in the value of the land is huge. I’m valuing it at $217M, while Melcor internally says it’s worth $749M.
One thing I know about valuing real estate is the liabilities are always good, so it pays to be conservative with the assets. I’m actually encouraged my ultra-conservative valuation model spit out a number pretty close to today’s price. That tells me true book value is probably somewhere in the high teens or low $20 range.
We could also just take the lazy way out and look at funds from operations. Melcor generated $1.88 per share in FFO in 2022. Slap a 10x multiple on that and we’re looking at $18.80 per share as fair value. I think that’s pretty close.
One last note on valuation. At least Melcor’s management is putting its money where its mouth is and aggressively buying back shares. On December 31st, 2021, it had 33M shares outstanding. At the end of 2022 that number had decreased to 31.2M, a decrease of 1.8M or more than 5%. No word yet on whether the company will repurchase additional shares in 2023.
Here’s the problem with Melcor, Dream Unlimited, and every company like it.
They’re cheap because there’s too much digging.
For a second let’s compare Melcor to Telus. The latter offers an easy to understand business, easily modeled earnings, and highly predictable cash flows. Melcor offers lumpy cash flows based on land sales, a mishmash of assets it took me approximately 1,000 words to value, and a bunch of different businesses that are also entangled in a REIT for some reason.
In other words, it’s complicated. It has a lot of moving parts. It’s not easy to understand. It’s not really a pure play on anything. It’s a bunch of assets packaged together.
I can already hear the objections from the value investing crowd. But Nelson! This is where the good stuff happens! Look at all the stuff I’m getting for free!
I’m the first to agree with that. Remember, I just said the stock is likely worth somewhere in the $18-$22 per share range.
The problem is two-fold. First is the catalyst. What is the one piece of news that will shoot Melcor’s shares higher?
$100 per barrel oil? Maybe. Crude was above $100 per barrel from Feb 1 to Jun 1, 2022, and Melcor hit a high of $17. But if you want to bet on crude, why not buy a bunch of oil futures or some highly levered producer? Why bother with Melcor?
Falling interest rates? Sure, that’ll help Melcor. But again, there are a million other more direct ways to play that.
Office coming back? Again, that’ll help Melcor. But if you want to bet on office, why not buy Dream Office REIT instead?
I really don’t know what the catalyst would be, barring an offer by the Melton family to take the whole thing private. But Melcor has been publicly traded for 50 years now. Why now?
The second problem is most investors are lazy. They take one look at a stock like this and immediately fire it over to their own Too Hard pile, instead focusing on some pure play. These kinds of stocks can linger in this place for a very long time.
Besides, if you were looking to buy a bunch of undervalued real estate, which one would you go for — a relatively unknown name like Melcor or basically world-famous Dream Unlimited, which every value investor on Twitter seemingly likes.
The bottom line
That last section made me sound pretty bearish, so let me clarify. I still think Melcor is worth approximately double today’s share price. I like the family ownership, the recent share buyback, and the newfound focus on the dividend. Shares currently yield 5.6%, a payout I think it quite sustainable over time.
But I also own Dream Unlimited, and I think that one has better upside potential. It certainly has more fans than relatively unknown Melcor.
So I’m passing on this one. It’s a little too much traditional value stock for me. I’m looking for something a little higher quality.
Disclosure: Author owns Dream Unlimited shares. No position in Melcor with no plans to enter into a position anytime soon