When I started On Beyond Investing, it was to provide investment ideas, and to help educate investors. Too often I find that the financial media, particularly in Canada, just takes what a company’s presents without applying the necessary critical thought.
I want to provide the critical thinking that a recent article I read lacked. The article can be found here (apologies that it is behind a paywall) and it discusses Brookfield Real Estate Services Inc, ticker BRE (disclosure: I am short a small amount of BRE shares). If you can’t access the article you can read the companies annual meeting presentation here or the Q1 results presentation here and it will give you an idea of the narrative of the Globe and Mail article.
What I find contentious is that BRE, in this article, is telling investors:
“The business is moving to even more of a fixed-fee basis, which should take even more of the variability, the cyclicality, the ups and downs of the actual real estate market out of our operating results.”
“Mr. Soper noted, “If you look at transactional dollar volume specifically in our two largest cities, Vancouver and Toronto, you can see the transactional dollar volume did peak in 2016. It dropped in 2017, stayed essentially flat in Vancouver, and dropped further to the 2015 level in the GTA (Greater Toronto Area). So there has been some peaking and some spiking in transactional dollar volume... So if you look across these markets, you can see they have been peaky, or they have been volatile, but you don’t see that in our results because of the nature of our company”, referring to the company’s fixed-fee structure.”
Management at BRE claims that the fixed-fee nature of its business model makes it less susceptible to the cycles of the real estate market - I believe that is simply not true.
Before I get into my reasons why I think BRE is a risky stock I will first highlight some of the company’s strengths, before examining its business model, and then highlighting the obvious, large, risks that companies faces. I want to highlight that this is a risky stock, and investors should proceed with caution - a message this article should have noted, but didn’t.
BRE is a well managed company
BRE is a franchisor of two real estate brands Royal LePage and Via Capitale. They have grown realtors in their network by 5% yearly (from 16.8k in 2015 to 18.7k now). Being an agent at one of their franchisees does have many benefits, they have access to better technology, Canada wide advertising, and the brands have strong web presences. Realtors of BRE, reportedly, have $600k higher yearly transaction volumes than other Canadian realtors and overall BRE has a ~20% share of the Canadian real estate market. BRE itself is well managed and has operating margins of ~70%, well above other franchising companies that are generally in the 40 to 50% range (US peer Re/Max is in the 50% range, QSR owned by cost conscious 3G is at 37% margins). As an aside, a questions I have is how are their margins so much higher than everyone else?
Their business model is very simple. BRE gets paid fixed fees of ~$128 per realtor per month (Royal LePage’s ~17.7k realtors pay $128, Via Capitale ~1k realtors pay $190) and they get 1% of Royal LePage realtors commissions earned, capped at a yearly amount of $1,325. The fees they receive are contractually tied to CPI and thus are raised every year.
To sum up so far, BRE has a ‘toll-road’ type of business model where it receives a steady fee income from its 20% ownership of the Canadian residential realtor market. It runs an incredibly lean operation, it can continually raise its fees every year, and it returns most of its cashflows to shareholders through dividends. Not bad.
What is clear though is that BRE’s financial performance is based on the number of realtors it has in its network.
My question, is it reasonable to suggest that the amount of realtors in their network will stay flat as transaction volumes continue to decline? To me it is common sense, less real estate transactions, means less real estate commissions, less commissions means less realtors.
Canadian housing market transaction have been weak
The Canadian housing market has been weak so far in 2018. From CREA stats, actual activity in the Canadian housing market is down 16% year over year, and the average sale price is down 6.4% year over year. While recent data out of Toronto was slightly better, if you read the article it concludes with this quote,
"To be fair, sales were plunging on a month-over-month basis at this time last year, so an improved annual trend was inevitable," he said, in a note to investors. "At any rate, it does look like activity is stabilizing, though still at subdued levels.".
Expectations are still very poor, CIBC expects to issue 50% less mortgages in the second half of 2018 as it did in 2017.
Shouldn’t these headlines be a concern to BRE shareholders? I should point out that there is likely a lag between lower sales and less agents, as some unprofitable agents may pay fees for a while, hoping things get better, before giving up.
How many agents could BRE lose?
While the BRE investor presentations, and the Globe and Mail article, point out that most of the fees are not transaction based, I think this ignores the obvious correlation between a housing bull market and the number of realtors. The total value of Canadian residential real estate transactions has increased from a run rate of ~$110bil per year in the early 2000’s to $263bil in 2016. Along with this rise in transactions, there has been a huge increase in real estate agents in Canada. Royal LePage has seen its membership more than double in the past 15 years. However, I was told by a Toronto realtor that 50% of realtors in the Greater Toronto Area (~57% of BRE fee base) only do 1 to 2 deals per year, a level that is considered unprofitable to be an agent. With home sales in Toronto now lower, and so many unviable realtors out there, how many realtors will quit? In my opinion, BRE could see a large drop in their number of agents and we are likely seeing a cyclical top in revenues.
I like to look at our southern neighbours to get a sense of what the ‘right’ number of agents should be and also as a stress test for what this house price correction could look like for the number of realtors. Re/Max, one of the largest real estate franchise companies in the world, has a 9% market share in the USA and has 63k realtors. This would imply that the total amount of US real estate agents should be in the range of 680k. Adjusting for population that would imply that there should be ~75k agents in Canada. Currently, Canada has 122k realtors according to the Canadian Real Estate Association. This means Canada may have 40% more realtors than it should. If we look at Re/Max’s experience during the bubble, its agent count dropped 40% from a pre-recession peak of 88k agents to a low of 52k.
If we go back to the anecdotal evidence that 50% of GTA agents are unprofitable, and see what would happen if 50% of the agents in Toronto and Vancouver (the other major Canadian bubble city) quit, we would see a drop in agents of, again, 40%.
So I think a drop of 40% is a decent proxy for how many agents BRE could lose in a really bad market.
Could BRE outperform, meaning they lose less realtors than the rest of Canada does? Certainly they could. But it is clear, that they should see a drop in realtors if this correction continues - we can disagree on the magnitude.
What this drop in realtors means?
If BRE where to see a drop in agents of 40%, its fixed fees would simply drop by 40%. At the same time, variable fees from commissions would be down significantly too. Holding margins constant, generous on my behalf, in this scenario earnings would be down ~50%. BRE would now be earnings ~9mil per year (its current market cap is $178mil), and keeping dividend payouts constant, only paying out $0.66 per share in dividends - half of what it currently does.
Now you may say I am being overly bearish in my views that realtors drop 40%, and that’s fine. But with transactions down 16% so far this year, and good evidence to suggest that Canada has many more realtors than it needs, the situation is asymmetric. It is much more likely that realtors on BRE’s network will drop, than they will continue to grow. Therefore it is much more likely that future earnings are lower than higher. As a result, it is much more likely to expect lower dividends, and lower future stock prices in the future than higher prices and dividends. If you are more bearish like me, it is not hard to imagine much lower stock prices.
While I am short a small amount of BRE, it is far from the best Canadian company to short if you have bearish views on housing. There are poorly run companies that will fare far worse than BRE if this correction continues. BRE is a well run company, but it is cyclical and I think we are already past the cyclical peak in this Canadian real estate cycle.
The reason I wrote this article is because this stock is clearly a retail investor stock, it pays a very high, monthly, dividend. Given the recent drop in Canadian housing market transactions, the risks this company faces are clear. I take exception when a newspaper publishes an article where BRE can claim it has fixed earnings that are immune to the overall real estate cycles. This is simply not true. Common sense can see that lower housing transactions, means less realtors, which leads to lower earnings, dividends, and possibly a much lower stock price. The article should have mentioned these obvious risks, and help retail investors make a more informed decision.
Disclosure: I am short a small amount of BRE