Seemingly the only variable that will dampen Canadian Real Estate

I’ve written a lot about this in the past, but Canadian real estate in urban centers is simply about too much capital chasing too little yield. Financially it makes sense to borrow at 2.83% like REITs such as Rio-Can (unsecured debt!!) and turn it around and invest it in a real estate yield product at 5.8% and pocket the difference in income.

This only becomes dangerous when credit markets start shutting down and you’re facing a cascade of debt maturities, or the collateral backing your loans (in this case, real estate) has a material mark-to-market drop (and then your debt leverage ratios will go out of whack and nobody will want to lend you money).

So I will bring your attention to interest rates. I’m fairly convinced at this point that until interest rates start rising (or we start seeing provincial governments enact serious foreign capital restrictions that can’t be easily bypassed like it is in British Columbia) we are not going to see any collapse in real estate pricing in Canada.

However, the US Federal Reserve is going to start to rise all boats fairly soon, and this will likely have knock-off effects in the rest of the world, including Canada.

I’m looking at Canadian interest rates at the Bank of Canada, and notice those longer term yields start to creep up again – 5-year government bond rates are at 1.23% and the trend on yields are seemingly upwards.

It remains to be seen whether this is white noise or whether this is the start of a trend, but it is something worth watching. If interest rates normalize to something resembling historical standards (e.g. 2% higher than present levels), Vancouver residential real estate that is currently renting for a 3% cap rate would be selling for a 5% cap rate – the result would be a 40% drop in price. This is not a prediction, it would be financial reality if a 2% rate increase occurred. Leverage has gotten to the point where such a change in interest rates would cause significant financial dislocation and this is likely why central banks are very afraid to make sudden changes to short term rates.

Difference Capital – Year-End 2016 Report

I wrote about Difference Capital (TSX: DCF) in an earlier post. They reported their 4th quarter results a couple days ago and their financial calculus does not change too much. They have CAD$29.6 million in debentures outstanding, maturing on July 31, 2018. Management and directors own slightly under half the equity, and thus they want to find a dilution-free way to get rid of the debt.

At the end of 2016 they have about CAD$14.4 million in the bank, plus $60.8 million (fair value estimate of management) in investments. One would think that in 2017 and the first half of 2018 some of these investments could be liquidated to cover the debentures. The situation is similar to the previous quarter, except for the fact that they’ve retired about 10% of their debt in the quarter, which is a positive sign.

Due to their investment portfolio not making any money (they have been quite terrible in this respect), they have a considerable tax shield: $186.3 million in realized capital losses, plus $41.9 million in non-capital losses which start to expire in 2026 and beyond. If you assume that they can realize both of these at half of the regular tax rates (I just quickly assumed 13% for the capital losses and 26% for the net operating losses), that’s $17.6 million.

Considering the market cap of the corporation is $26 million, there’s a lot of pessimism baked in. Mind you, there are a lot of corporations out there with less than stellar assets, a ton of tax losses, and tight control over the corporation (TSX: AAB, PNP quickly come to mind) so it is not like these entities are rare commodities. The question minority shareholders have to ask is whether the control group wants to bleed the company through salaries, bonuses and options or whether they are actually genuinely interested in profitably building the corporation (in all three cases, to date, has not been done).

Higher prices means more dangerous times

If the market perceives less risk, prices rise.

This is counter-intuitive, but an example should illustrate.

If risk-free rates are 1% and something is trading at a guaranteed yield at 2%, that something will trade at double the price of the risk-free product (all other variables being equal).

If that guarantee is less than 100%, then risk will cause the price of that instrument to decline.

Thus, it can be assumed that higher prices means that the market is pricing in less risk that a specific investment will fail to achieve their projected return on equity (or debt, whatever the case is).

The S&P 500 is up 6.4% year-to-date, despite all expectations. I’m willing to wager that most fund managers are underperforming this index and are starting to feel political pressure for their underperformance (“you’re in bonds???”). The way that psychology tells you to compensate for underperformance is to increase risk (i.e. equities) and join the party because it is the only way to “break even”.

The mentality shift that we are starting to see is startling – no longer is holding cash and being cautious is part of the game, rather, we are starting to see a more aggressive leaning towards risk-taking. Valuations? Who cares about valuation when you’re being left behind like a renter in the Toronto real estate market!

While I am not suggesting that you go out and purchase shares of Snap (Nasdaq: SNAP), be cautioned that I believe we are going to be entering a mania phase that will be punctuated with volatility that will be higher than what we have seen over the past year. Volatility means both up and down.

The federal reserve will try to dampen this process, but they will probably be too slow to react.

To outperform in the markets, despite what literature says about timing, market timing is everything. You want to be in cash when the markets are cratering, and you want to be fully invested when the markets are rising. While it sounds easy, it most certainly is not.

During periods of heightened volatility, an investor pays dearly for liquidity. Stocks and bonds that trade at reasonable valuations and seem like a “lock” suddenly are sold and taken out in the back and shot like cattle with mad cow disease. When the markets are like this, it is the time to be deploying cash instead of trying to shift things around in the portfolio to raise it.

The core reason for my outsized performance gains is not necessarily by doing well (yes, this helps), but rather being able to side-step market crashes when they occur. Sometimes my alarm clocks strikes and there is no need to wake up (I was ridiculously cash-heavy in 2014 and 2015), but better safe than sorry.

This is not a prediction for a market crash, but rather that I’m paying extra judicious caution when it comes to the portfolio. When you have Drudge and Trump bragging about the gains the stock market has seen since his election, coupled with friends asking you about investing, it makes me extra paranoid.

Pengrowth Energy – dodged a bullet

Pengrowth Energy’s debentures (TSX: PGF.DB.B) will be redeemed on March 31, 2017 and the company has also announced it will be redeeming USD$300 million in senior debt (announced February 21, 2017).

I own the convertible debentures and will miss their presence once they mature. I’m probably one of the few people that invested in the company and actually made money.

They also announced their year-end results on February 28, 2017. The operations of the company are fairly simple to understand – they are losing a relatively small amount of cash in the existing oil price environment, which they assume is at WTIC US$55/barrel and a 0.74 CAD/USD rate. Management has made some good decision-making on their oil hedges, but they have now closed them (for cold hard cash) and are completely at the whim of the oil commodity markets.

If you take their 2017 guidance to heart, you will end up with $195 million in “funds flow through operations”, a non-GAAP metric that is a proxy for operating cash flow excluding the impact of financing expenses and remediation. The GAAP statements are a mess to read because of derivative accounting (for oil price hedges), exchange rate adjustments, and require some mental massaging to be read properly.

All things considered, the corporation is not in terrible shape.

This is, however, except for the debt maturities coming up which need refinancing.

The company did have a $1 billion credit facility at the end of 2016. It was untapped, probably because the credit facility has a covenant similar to the senior debt. I believe the original intention of management was to use the credit facility to pay off the senior debt as it became due.

The corporation pre-announced in Q2-2016 that if oil prices continued their relatively low level, that they would be potentially in breach of their covenants. What was new in the Q4 announcement was that they alleviated their senior debt (before working capital) to book capitalization ratio covenant, at the expense of amending the debt agreement to redeem senior debt in the event of asset sales and also to reduce the ceiling of their credit facility to $750 million.

There are three other covenants remaining that an investor needs to pay attention to. The most material of them is the senior debt before working capital to adjusted EBITDA ratio, which ended at 3.1 in 2016, but needs to be below 3.5.

Pengrowth, to its credit, walked investors through their covenant calculations (page 10 of their MD&A). Doing some pro-forma (after debt repayment in the end of March) analysis, we have about $1,250 million in debt for covenant purposes, which means adjusted EBITDA needs to be above roughly $360 million for them to clear the mark. They did $581.6 million adjusted EBITDA in fiscal 2016, which gives them a relatively healthy margin of error – even though guidance is taking their production down about 10% for the year despite $120 million in projected capital expenditures.

So as long as oil prices don’t crash, they’ll probably use the credit facility to pay off the remaining US$100 million in debt due in July 26, 2017. The next major maturity is CAD$15 million + US$265 million on August 21, 2018, and if nothing changes between now and then, they will use the credit facility to pay that off. At that point, they will have about CAD$500 million utilized in their facility, plus the (presumably negative) amount of cash flow they burn through operations in the next couple years.

If oil does slip, there is a point where they will get into covenant trouble.

They did note in the MD&A:

After the above debt repayments, Pengrowth anticipates it will remain in compliance with its covenants through the end of 2018. In order to comply with certain financial covenants in its senior unsecured notes and term credit facilities through 2017 and 2018, Pengrowth has run a scenario, that accesses the capital markets before the end of 2017, and includes an improvement in realizations for oil and natural gas.

They will probably tap the asset market to give them a higher degree of comfort. This is what Penn West did when they gave up their Saskatchewan operations to stabilize their balance sheet.

In retrospect, I think the company erred in not using shares to repay the convertible debentures – they probably should have bit the bullet and increased their margin of safety by cheaply equitizing the convertible debt. Now, management is basically gambling that oil will be going up in the next couple of years and are basically playing a waiting game.

How not to sell covered call options

Most retail investors use covered call options as a cash generation device. The algorithm generally goes like this: “I’m going to sell a call option at a strike price that I would have sold the shares at anyway – if the stock does not get up to the strike price, I would have held onto the shares, and if the stock goes above the strike I will be cashed out anyhow, so why not make a few pennies selling the call option?”

Unfortunately, such thinking is more damaging than not as investors are usually selling such options at an implied volatility that is lower than what the option should be priced at. Most of this is evident in illiquid option markets (such as the options that trade on most of Canadian issuers on the Montreal Exchange).

The reason selling low-priced covered calls is hurtful is because of the “lottery” aspect of stocks (statistically speaking, this is referred to as the “fat tails” of a price distribution curve) – stocks sometimes do not move in continuous prices, although these jumps do not occur frequently. For example, when selling a call option, you are giving up most of the takeover premium that you would potentially receive. Another example is jumps during quarterly earnings reports. The other significant disadvantage of using covered calls is giving up liquidity – in most retail cases, selling a covered call obligates one to hold the capital in the common shares until expiration, or unwinding the position (which requires paying a spread on less liquid options).

So when somebody is willing to sell you 8 weeks of time on a call option at a strike price that is about 5% away from the money for about 0.8% of the market value of the common shares, they’re probably letting things go for cheaper than they realize. This option is still likely to expire worthless, but the potential upside is far, far better than the price paid simply because it can rocket higher than the 0.8% of premium paid. So I spent a few bucks (far, far less than 1% of the portfolio) on hitting somebody’s low asking price.

Covered calls do have their usage in portfolios, but they typically are constrained to high volatility situations when the action to sell calls seems to be a difficult decision.