New England Realty Associates, LP is an NYSE-listed real estate partnership that trades at a 30%+ discount to a conservative estimate of asset value. “NERA” is lead by Boston real estate magnate Harold Brown. The partnership has produced exceptional returns for its partners since inception. Though the market has begun to wake up to NERA’s substantial value in recent years, the partnership remains undervalued due to its small size, limited liquidity and confusing structure.
New England Realty Associates, LP (ticker NEN) was founded in 1977 and currently owns 24 properties in and around Boston, Massachusetts. Of these properties, 17 are residential buildings, 4 are mixed use, 3 are commercial buildings and 1 property is comprised of individual units within a condo complex. as of June 30, the partnership owned 2,412 apartment units, 19 condo units and 108,043 square feet of leasable commercial space. Additionally, the company owns partial interests in another 9 properties, a mix of apartments, commercial space and a parking lot.
NERA’s properties are located in central Boston and in surrounding affluent suburbs. The partnership got its start in Allston, and four of the properties are located there.
I’ve done some poking around on various apartment rental sites, and NERA seems to target young professionals and students to fill its rentals, many of which are located in busy settings near universities. Rents seem on par with the local market, and NERA (via Hamilton Company, which manages its properties) gets good reviews as a landlord. (This may be a recent development. There is no shortage of older articles criticizing the company’s property management practices.) NERA’s properties boast occupancy rates near 100%.
Like many realty partnerships, NERA’s ownership structure is made up of multiple classes of units. NERA has two classes of limited partnership interests, Class A and Class B, plus General Partnership Units. Class A units have an 80% ownership interest, Class B unitholders own 19%, and the General Partner owns 1%. None of these units are publicly-traded. What is publicly-traded are depositary receipts that are the equivalent of 1/30th of one Class A Unit. Class A units themselves are not tradable, but may be converted into depositary receipts at a 30-to-1 ratio at any time, then traded. Because of the odd depositary receipt structure, many financial data providers do not accurately report NERA’s market capitalization or units outstanding. This lack of good data contributes to NERA’s mis-valuation.
NERA has a long history of profitable operations. The company does not always report a GAAP profit, but does produce consistent and growing funds from operations. As I’ve mentioned many times before, GAAP net income is a terrible metric for evaluating real estate companies. Non-economic expenses like depreciation and accounting for partial interests obscure actual profitability. What matters is distributable cash flows, and NERA excels at creating these. Here’s a look at the partnership’s historical results. Results are in millions and are taken from the partnership’s annual reports, without any adjustment for restatements or amendments.
NERA’s annual funds from operations have more than doubled since 2008, while gross rents rose 39%. That’s a nice result. But the truly impressive achievement is NERA’s tax efficiency. From 2008 to 2014, the partnership recorded a sum of just $5.0 million in continuing net income for its partners. Yet it produced $77.4 million in funds from operations, a very close proxy for distributable cash flow. What’s clear is that NERA’s management understands the “secret sauce” of real estate investing: leverage and depreciation. Reasonable leverage allows a partnership to control a large asset base while the associated interest expense creates a tax shield. So long as the cap rate on the assets acquired is below the cost of the associated debt, positive cash flow results. The second part of the equation is to continually add new properties to the roster, bringing in fresh depreciable assets to further shelter cash flows from taxation. Because high quality real estate tends to appreciate over time, this depreciation is merely a “phantom” expense and a valuable tax shield.
On a trailing basis, NERA produced nearly $16 million in funds from operations. This figure will almost certainly increase as rents rise and as the company continues to pay down debt. Also, the company just closed on the purchase of another rental complex, the 94 unit Captain Parker Arms in Lexington, Massachusetts. The purchase price was $31.5 million, 79% of which the company funded using its Keybank line of credit. The partnership has also begun converting the parking lot it owns into a 49,000 square foot, 48 unit apartment building. Both of these projects will contribute substantial cash in years to come.
There’s one other area where NERA excels: buying back its units. Since inception, NERA has repurchased a full 30% of its issued units. In the last twelve months, the company reduced its fully-diluted units outstanding by 1.9%, and is set to continue buying back units. In March, the board of directors approved an expansion of the unit repurchase program sufficient to repurchase an additional 13.2% of outstanding units within five years.
But what is NERA worth? The answer to the question depends on determining the proper multiple of net operating income for Boston-area apartment properties. While NERA also holds some commercial properties and condos, the vast majority of its assets are invested in apartment assets. Unsurprisingly, the average cap rate for class A Boston apartment assets is extremely low. The Boston real estate market has long been one of the tightest in the country, and cap rates reflect this. Recent transactions have been done at cap rates as low as 4%! More typical transactions have crossed in the 5% range. For anyone interested, there are a number of market reports available via a little Googling. Here’s one.
For conservatism’s sake, I’ll use a cap rate of 6%/16.7x net operating income to estimate the value of NERA’s properties. The chart below lays out the value of NERA’s fully owned properties and its stake in equity-accounted projects, net of debt.
It’s very easy to get to value of over $255 million for NERA’s properties and investments, net of debt. Using market valuations for the Boston metro yields an even higher value. The chart below shows the values of New England Realty Associates, LP depositary receipts at various cap rates.
At a 6.0% cap rate, NERA depositary receipts are worth just over $70, 48% higher than the current trading price. This value does not include the increased cash flow from the newly-acquired apartment complex, or the value to be created by developing the parking lot into a residential property. If we assign even modest value to those new assets and nudge the cap rate down just slightly, the fair value of NERA’s depositary units approaches twice the current trading price. At NERA’s current trading price, I think it’s fair to say the market is valuing the company’s holdings at a cap rate of around 7.5%, well above market cap rates.
NERA’s valuation is compelling, but potential investors must be aware of a few potential risks. First, NERA’s two largest unitholders, Harold and Ronald Brown, are quite elderly. These men together own over 40% of NERA’s units. In the not distant future, NERA may face succession challenges. NERA also holds many highly appreciated properties, and unitholders may find themselves with an large tax bill should the partnership ever be wound down for any reason. And finally, because NERA is a pass-through entity, unitholders must be sure to handle the associated tax complexity carefully, including paying state taxes to Massachusetts.
For those unconcerned by these risks, NERA could be a great way to create a portfolio of quality Boston properties at a cap rate unheard of on the ground.
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Thanks for an interesting article, more so, since I live in the area where a number of these properties are held.
I have a couple of observations. One of the Brown brothers is 79, while the other is 90, so I am a little less concerned about age vs. if both were around the same age as the older brother. Other course, I don’t know what arrangements exist when one of them leaves this planet. The company has been repurchasing depository receipts (2 million authorized through March 2020. Whenever, receipts are repurchased, B and GP units have to be repurchased to maintain the current distribution between A, B and GP units. So it appears that the brothers are shrinking the equity base over time. The increases in rent seem to be modest overall, but that may be part of a strategy to keep properties rented. I don’t know if that makes sense given that market conditions for real estates are overall favorable in the Boston area. On the other hand, these guys have done very well. Finally, with respect (and I mean that), as real estate empires go, this one is on the small side, but I understand you want to get the reader’s attention.
I appreciate the comment. You’re right that there are far larger real estate empires out there, but several hundred million in gross asset value seems pretty large to me! The brothers are reducing the equity base, and its the most investor-friendly move they can make. They’re essentially investing at a 7.5% cap rate. Good luck finding real estate projects of equivalent quality in the Boston metro at that valuation. I’ve also heard the Browns like to keep rents a little below market rates. It helps them attract a quality tenant base (because with more applicants, they can be very choosy) and it reduces tenant turnover, one of the most important factors in landlording.
Do you know how the apartment mortgages are financed? It sounds line they use a line of credit for the acquisitions and then do some kind of more permanent financing later. My guess is that the rates are probably variable and the apartment loans come due as balloon payments in 5-10 years, but if some of there financing is in place for the long-term that could turn out to be fairly valuable asset over time when/if interest rates ever go up.
NERA’s financing is entirely at the property level, with the exception of their credit line. Like you said, their current model seems to be tapping their credit line to acquire properties quickly, then arranging permanent financing once the deal is closed. Prior to July 2014, the company did not have this credit line at their disposal.
The company eschews variable interest rate mortgages almost entirely, so yes there is likely some valuable financing in place. The only variable components of the company’s debt I have found are the credit line, and the $2 million mortgage on the parking lot/new building development.
If the units are held in a non-taxable account is the tax complication negated?
Unfortunately, no. I am not a tax advisor, so don’t take this as authoritative. But the issue with partnerships is that they produce Unrelated Business Taxable Income, or UBTI. Accruing too much UBTI in one year in a qualified account can result in nasty tax issues. Better to hold securities like this in a taxable account. NERA’s managers are fairly skilled at keeping taxable income to a minimum, anyway. They don’t like paying taxes either.
“The Receipts, each representing one-tenth of a Class A Unit, are listed on The NYSE Amex Exchange (AMEX®) System under the symbol NEN. Receipts may be purchased and sold at any time through a personal securities broker and Computershare. The Receipts, unlike the Class B and General Partnership Units, are freely transferable, except as restricted by the Partnership Agreement and the Deposit Agreement.” from their website In your post you stated 1 to 30 . Why the difference?
There was a 3 for 1 split in late 2011. http://www.thehamiltoncompany.com/default.aspx?matrix=67
Great piece OTC, well done.
Just a couple of philosophical point differences in thinking about real estate valuation than a criticism:
1. I have never understood why depreciation is added back to income as a cash flow, without a suitable deduction for maintenance capital expense, just like any other asset. Real estate requires up-keep to produce sustainable rent and rent increase. As buildings age, modernisation and restoration is required. For example, this is a very real and nasty surprise to apartment owners for example, when buying into an apartment complex that needs a new lift and outside window system for example (which can costs far more than originally thought in the budgeted community fund that is probably 20 years old).
2. Why value real estate assets at a cap rate of NOI (cash flow) of 6-7.5%, if other potential business investments would be compared to a 8-10% discount rate for example. I understand that as a one off purchaser of a residential property to live or investing in, you must look at comparable pricing. But is this appropriate when comparing to a universe of investment opportunities for a equity portfolio?
I would be most interested to hear your and other readers’ thoughts.
Good issues for discussion. Let me see if I can address the points you raised.
1. I do think it makes sense to add back nearly all depreciation, if not all. Yes, capital projects are occasionally required and a savvy investor will make allowance for these. But as long as routine upkeep and maintenance are performed, most commercial real estate really does hold its value and enjoy moderate appreciation from year to year. And it isn’t as if real estate companies do not expenses maintenance and repair figures. NERA spent $6.6 million on repairs and maintenance in 2014, equal to 16% of rents received. In other words, they are not sweating their properties. I think it is reasonable to assume that spending 16% of rents received is adequate to maintain the value of properties and offset most depreciation.
As for the low cap rates compared to other investments, there are a few factors in play. First, real estate investors are not purely cash-flow oriented. Many invest in the hopes of enjoying rising rents and property values. If I buy a property at a 5% cap rate and I successfully predict that rents will rise 5% annually for the next decade, I’ll have done extremely well! In some markets with high demand and structurally limited supply, assuming high rates of increase in rents and property values may be an entirely reasonable outlook and justify low cap rates. The other reason is that real estate investments are uniquely suited to the use of leverage. By employing borrowed capital, an investor can easily turn an investment done at a 6% or 7% cap rate into a structure yielding a double digit cash on cash return. In these scenarios, what matters most is not the cap rate in absolute terms, but the spread between the cap rate and the mortgage financing rate available. The higher the spread the better, but in general it is possible to create a cash-flowing real estate investment as long as the spread exists. Today’s uniquely low interest environment certainly contributes to depressed cap rates and elevated real estate values by design.
Great article, and I enjoyed the comments on REIT valuation.
Thank you for the article. Just out of curiosity, given the upside and conservative nature of the company, what risk has kept you away from buying it? The succession risk issue should not be so bad since Carl Valeri has worked at Hamilton for a long time and is young(er). It seems he more or less runs the show. The younger brother is 79; so may still have some gas left. On the tax side, as you have pointed out, they are quite savvy so isn’t it unlikely that they’ll liquidate assets in a way that causes significant tax leakage? If they wanted to sell, could they do a Code Section 721 transaction (UPREIT)?