ARA Analysis - Part VI

Valuations

With this outlook, which is reasonably decent - not breakaway growth but a steady ~10% - 20% growth in the bottom line in the next upturn for the real estate and equity market cycle - should we buy it? The answer to that is - at what price? Is it worth it at the current price?

At its current price, ARA's market cap is ~S$500m. Depending on the forecast, net profit is ~45 to 50m, which places P/FY09E at 10 to 11x. P/B is about 5x. Net cash of ~S$16m. ROE currently is 45% to 50%. Assuming a 10% growth rate in the bottom line, PEG is 1. And we are talking about 5 to 6 years before we recoup our investment.

All in all, valuations are not cheap. But not expensive either. If Credit Suisse's research is to be believed, ARA's P/E is below that of comparable peers (to verify).

Why Should You Buy ARA
Buyers of ARA should have a positive outlook on the real estate market. Taking a step back, potential buyers of ARA should be interested in the real estate market in general. The choice then, is not just whether to buy ARA or not. Rather, it should be why ARA and not other property stocks.

For discussion purposes, let split property stocks into 2 general types - REITs and property developers. Let us characterize the 2 types. The first type -REITs - offers exposure to the yield/rental component of a real estate investment but little exposure to the capital value component (only via increase in leverage made possible by a growing capital values of their assets). The second type - property developers - offer exposure to the capital value component but not the yield.

Comparision with REITs
REITs offer anywhere between 4% to 10% yield. The problem with REIT is that the yield doesnt really grow relative to your initial purchase price. DPU might increase across time and correspondingly, your yield (DPU/initial purchase price) might go up. But beyond a certain level (the actual yield achieveable in the real estate market/cap rates), no more yield accretive acquisitions can be made. And to make more acquisistions (so as to justify the REIT manager existance), equity has to be raised and which will bring DPU and yield back down. So as a REIT-owner, you really don't have much capital upside and your average yield/initial price will be quite steady across time.

ARA's yield, assuming a 70% dividend payout ratio, is ~6.4% to 6.9% - comparable to a REIT. On a 100% dividend payout ratio (like the way a REIT would and no reasons why ARA should not pay a 100%, unless it has plans to use the remainding amount - like to seed new funds), the yield would be 9.1% to 9.8%. Admittedly, this comparison is not perfect. For starters, the REIT's dividends comes solely from rental revenues, while the ARA dividends comes from both rental revenues (via the perf fee) and capital values (via the base fees). It was not possible to to do a like-for-like comparison because ARA doesn't provide the break-down between perf and base fees. Putting that aside, the key point is that ARA's yield is comparable to a REIT and the difference is that the yield will grow across time unlike a REIT's.

Therefore, ARA is superior to a REIT investment.

Comparison with Property Developers
Property developers benefit strongly from an upturn in the real estate market - the capital value component. However, they provide little yield - they do not have strong underlying cashflow to support a strong dividend yield.

ARA, in its current form, provides limited exposure to the capital value component. However, as it raised more private funds and as it continues to own a share in these private funds, ARA should increase its exposure and benefit from changes in capital values. This is because these private funds are capital-gains-focused.

As ARA changes as a company (to having more pte funds), one might argue that an investment into ARA is superior because it offers the capital value exposure and a decent yield at the same time. Note that I do not fool myself to believe that the share price for developers will perform worse than ARA when the real estate market turns. The developers have higher beta and their share price will move more because the yoy change in their profit levels are much more significant - its a famine and feast model. But this comes with increase volatility and increased risk. What I am proposing is that ARA may offer a better risk/reward proposition with its more stable cashflow, even as it provides a similar exposure to the capital value component.

Therefore, ARA may be a comparable investment to developers stock

If an investor is strongly convinced that the real estate market will turn and turn strongly and therefore the capital value component outweigh the yield component, I will suggest shares of developers. But if you want a wait-and-see approach, while still getting some dividends when waiting, then I say buy ARA.

Note that you can have both ARA and stocks of developers in a portfolio - not mutually exclusive. And may not be a bad idea - get dividend from ARA while holding some investments in developers stock which may provide the real kick in share price appreciation as and when the real estate market turns around.

Conclusion: ARA and developer stocks may complement each other