Another way to make money from property
Global returns and interest rates are so low that in Denmark borrowers are finding their mortgage balances are declining, even without making payments, because interest rates are negative. Elsewhere, high-quality companies are trading at eye-watering multiples. In private equity, too much money is chasing too few opportunities, and meanwhile investors are happy to buy property that is yielding barely more than bank interest despite the higher risk profile.
In such an environment, it is next to impossible to find high quality businesses that are still cheap compared with our estimate of their value.
However, one of those companies is REA Group (ASX: REA), which has just reported a 20 per cent increase in revenue in the third quarter. In fact 3Q16 revenues were reported by the company at $147m, which was up 20 per cent year on year.
Investors could be forgiven for feeling slightly anxious on the back of the news coming out of Australia’s real estate market. In the space of a few days we have had: The revelations of dubious real estate financing, as mortgage brokers reportedly put foreign buyers with poor documentation through to the major banks; Reports of large falls in apartment prices in Melbourne, and; Reports from McGrath Limited (ASX: MEA) of listing volumes declining by about 25 per cent in some areas of Sydney.
REA’s revenues are primarily driven by the sales of premier/highlight listings on the realestate.com.au website, and data that records listing volumes can be used as a proxy for where said revenues are headed. While nationwide listings are down since the end of December as per the seasonal trend, on a year-on-year basis, considerable growth is observed. And in a market where listings volumes have been under pressure, REA’s revenues have grown more than 50 per cent on the back of price increases and changes in the volume of premier ads (i.e. ‘mix shift’). This resilience — a function of pricing power — is an attractive quality to owners of the business.
For the nine months to the end of March 2016, group revenues rose 20 per cent year on year to $461m. This result was partly boosted by the consolidation into the accounts of the acquisition of the iProperty Group announced November 4, 2015 at $4 a share. Operating expenditure of $69m had risen 21 per cent year on year, which was not a surprise to the market, and so EBITDA rose by 18 per cent year on year to $77m.
Of the $6bn spent on marketing properties in Australia each year, real estate agents collect about 86 per cent and REA Group’s realestate.com.au website collects just 5 per cent (with the rest of the pie being split between traditional media and competitors). My investment thesis is partly reliant on the idea that real estate agents do not deliver 86 per cent of the value in a real estate transaction and that real-estate.com.au delivers more than 5 per cent. The change in the equation — in favour of REA Group — will be initially effected by a change in the willingness of vendors to accept higher prices for advertising on realestate.com.au but not higher charges from real estate agents. The second phase of the change in the equation will be that realestate.com.au’s higher prices will eat into the total spend of the vendor such that vendors will insist on lower fees from the agents.
We were pleased that REA introduced a price rise from July in the range of 10 per cent to 15 per cent, which beat some analysts’ expectations and confirms the pricing power of the model as well as reinforcing our thesis of being able to ultimately take a larger share of the total real estate market pie.
Encouragingly, REA also confirmed that despite investing aggressively, further EBITDA (earnings before interest tax depreciation and amortisation) margin expansion in the fourth quarter should be expected because marketing costs will be lower then. The company also announced that the US business Move Inc is now EBITDA positive.
Our REA valuation is currently $65 (against about $54.70 now) this compares with analysts we know who have price target/ valuations between: $52.19 and $56.50. The implication is that if we are right, not only could we make more money for our investors but it could happen quickly if the rest of the analyst community rerates the company.
The downside risk is that even though we expect the company to make more money in a property market downturn — because more properties will be listed and for longer — sentiment towards REA Group’s share price could turn negative.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Paul Muscroft
:
I would be interested in your opinion as to how high the barrier to entry is in this market. There is Domain too that appears just as functional – but surely there are some 20 somethings looking at this and contemplating a ‘Gumtree’ version? Is there an overseas equivalent (perhaps an real estate ‘Aldi’ waiting in the wings)?
Roger Montgomery
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There have been real estate ‘wannabe’ websites around for a decade or two. None have gained traction. This tells you it is very easy to set up a website, but very hard to win an audience.
Greg Bradford
:
Your article begins with ‘it is next to impossible to find high quality businesses that are still cheap’ and then you spend none of the subsequent 9 paragraphs discussing why that is your view. I have no doubt that it’s got a rosy revenue and growth outlook, but that alone does not a stock make cheap.
Anyone can bang on about growth prospects but I challenge you to discuss the basis for, and assumptions in, your $65 valuation if you’re so confident.
Roger Montgomery
:
Thanks for the Challenge Brad. Could we challenge you to share your reason for disagreeing?
Max Zan
:
Hi Roger
I like the way you challenge my thinking.
I have no doubt that in ten years time the REA share price will be higher than $55, but by how much it’s difficult to say. Over the last decade the business grew from a low base and going forward it’s difficult (but not impossible) to repeat that level of growth.
We both agree that REA is a great business with a very bright future but in the near term it’s my view that at current prices the business is priced for perfection.
Max
Andrew
:
I’m starting to see your point Roger.
I bought REA at $46 last October. (Alas only a small parcel). I do also have a residential property. It makes me about $580 a week net of costs (not counting tax benefits from the gearing & the depreciation). Now if I’d liquidated the property last October & put all my equity in it into REA at that time, I’d’ve made $117k instead of $18k.
Here’s another pardox……to find the tenants to pay me that rent, guess where I have to advertise the property?
Grrrrrrr….
Max Zan
:
Thanks for your reply Roger.
My back of the envelope calculation puts the current book value per share at no more than $5. Based on the current share price of around $55 the shares are trading at about eleven times book value. My estimate of return on equity is approximately 36% based on $5 book value so if shares are trading at eleven times book value then it follows that represents a return of 3.27%.
I appreciate that a lot more goes into valuing this stock then simple arithmetic like mine and I would not be surprised to see the price move higher. It’s a great company with plenty of growth potential and that may explain why it’s trading at such a valuation but the margin of safety appears to be non existent
Max
Roger Montgomery
:
Hi Max, and what if the equity rose almost twelve fold in the next ten years – as it has in the last decade? Would that change your thinking?
Pierre
:
This is a great example of thinking that goes against intuition and the crowd. I bet the average reasonable investor would be startled to learn that more people list their property on the market in a downturn than in an upturn.Ask a real estate agent, and I bet they will say the opposite. Either off market transactions have been significantly holding listings down, or the agents have it backwards. Appreciate the myth busting from Montgomery. I still think my property developer father would laugh at the suggestion.
Max Zan
:
Hi Roger
Do you know the current book value of REA Group and how much return on equity it currently generates on that book value?
If the price was to reach your valuation of $65 what return on equity would that represent?
Cheers
Max
Roger Montgomery
:
We do Max. We know it well. The return on equity however is independent of the price. If you are asking what ROE we have assumed to a drive at our valuation, that is a different question and I can disclose that we rarely if ever assume better than what is currently being achieved and our assumption is often more conservative.