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DomaCom (ASX: DCL) – Valuable Fractions of a Huge Pie

Revolutionary Fractional Investing property platform

DomaCom Limited (ASX: DCL), a Melbourne-based property fund manager, has developed fully regulated products that have the potential to revolutionise property investing in Australia. Its unique online fractional investing platform allows investors to invest in only a fraction of a property, enabling them to build a leveraged portfolio of real estate assets.

Equity Release: Ideal for ‘asset rich, cash poor’ retirees

DCL’s new Equity Release product is expected to be launched shortly. It is primarily targeted at baby boomers looking to release equity (capital) from their family homes to fund retirement and for inter-generational wealth transfer.

Strong adoption expected by financial advisors

As DCL’s two products add another vital asset class to the toolbox of financial advisors, we expect these products to garner strong market support. DCL is targeting the property segment of Self-Managed Superannuation Funds (SMSFs), valued at A$700bn and the A$500bn retiree home market.

Valuation range of A$0.35-0.46 per share

We value DCL at A$0.35 per share (DCF model) in a very conservative base case (due to lack of historical information) and A$0.46 per share in a scenario in which Funds Under Management growth accelerates in line with management’s expectations, i.e. on the back of the new residential property debt facility through La Trobe and potential conversion of the trial with a Big-4 bank into a commercial agreement.

 

Introducing DomaCom Limited

DomaCom Limited (ASX: DCL) is a Melbourne-based, ASX-listed operator of
investment platforms. DCL’s fractional investing platform enables retail investors to part-own real estate. DCL is the first registered operator in Australia that provides an online platform for fractional investing in property.

The company operates through the DomaCom Fund, a registered Managed Investment Scheme (MIS). Through this, DCL provides a structured investment vehicle that is a combination of a managed fund and an online crowdfunding platform. The company’s platform supports online property
listings, real estate trading, unit registry, and book build processing for
existing properties and proposed developments. DCL earns revenue by
providing management and platform services to the DomaCom Fund.

Currently, DCL offers only one product – Fractional Investing. It has already
received the required regulatory approval to launch Equity Release, that will
compete against the reverse mortgage product for retirees but allows the
release of equity in the home to be funded by the large SMSF market.

DomaCom Fund: Structured vehicle for fractional investing

DomaCom Fund is an Australian Securities and Investments Commission
(ASIC)-registered scheme that allows retail investors to build a portfolio of
real estate investments through fractional investing. The fund provides investors with the flexibility to choose a property to invest in and not have
to depend on a fund manager’s choice. This unique proposition allows the investor to diversify and avoid higher exposure to a single asset at a relatively low cost. DCL’s platform facilitates fractional investing/crowdfunding through this fund and creates a niche for retail real estate investment. Apart from retail investors looking to build a real estate portfolio, the DCL platform and the fund provide a significant opportunity for SMSF investors.

Equity Release: Aimed at retirees with property holdings

In November 2018, DCL received regulatory approval for launching Equity Release, a new product involving on the one hand the elderly and on the other hand investors. People who own significant real estate holdings but have limited cash flow can monetise their properties by releasing a part of the equity in their home. This is similar to the reverse mortgage offered by financial institutions, with the difference being that the investors are crowdfunded and take an equity interest in the property rather than debt that accumulates and is owed to one institution.

With ~15% of the current Australian population aged over 65 years old, this product offers an ideal opportunity for elderly people to leverage their large real estate holdings. Also, with major banks withdrawing from the reverse mortgage market, there is a significant investment opportunity to be explored.

Business still highly undervalued

DCL is currently valued at only A$18m. One key reason for this low valuation
is the incremental costs the firm is undertaking as a result of platform innovation and educating investors. Fractional investing as an investment vehicle is still not being fully explored by retail investors and the concept is in the nascent stage. Similarly, Equity Release will be introduced to the
market shortly and will build traction over time.

In our opinion, investors do not yet fully acknowledge the potential of disruptive retail financial products based on crowdfunding. We seek a re-rating of DCL based on the company’s first-mover advantage in a disruptive niche sector; its consistent growth in Funds Under Management (FuM), resulting in higher fees; the launch of Equity Release; strong take-up by financial advisors; a white-label deal with the Big Four banks; and lowering of operating costs with the maturing of industry.

Ten reasons to look at DomaCom Limited

1) Rising property prices have made housing unaffordable. Exposure to property means investors with limited resources can rely on fractional
investing.

2) DCL has an experienced team that has been at the forefront of fractional
property investment for the past three to five years. Management has successfully traversed the initial phase and added over 50 properties to
its portfolio.

3) The Equity Release product is unique and DomaCom is the only company to get product approval from ASIC. Competitors will take three to four years to obtain approval due to regulatory hurdles. The product is well suited for older citizens who are asset rich but cash poor.

4) Once a property is purchased and a sub-fund is created, it is usually not
terminated until the term expires. The company earns a management fee as a percentage of FuM. This implies the revenue is recurring and provides good visibility to investors.

5) DCL targets end customers as well as financial advisors to sell its products. Most competitors only target end customers. It has products with the approved list of 44 Independent Financial Advisors (IFA), as of November 2018, which represents ~1200 advisors presenting DCL products to their clients.

6) Use of debt in the funding mix through the recent residential property
debt facility agreement with La Trobe Financial will be a game changer. Property purchases before March 2018 were mostly done without any debt. Availability of debt for residential property purchases will make DCL’s products more lucrative for financial planners as internal leverage will make the investment tax efficient for equity investors.

7) After a court ruling in August 2018, SMSFs are now allowed to invest in
DCL’s sub-funds (up to 50%) when the tenant of the underlying asset is a related party, such as a family member. The Australian Taxation Office (ATO) did not appeal against this ruling regarding the breach of the sole purpose test. It paves the way for inter-generational wealth management.

8) Banks have withdrawn lending to SMSFs, which means it will be harder
to purchase property now. SMSFs looking to leverage property transactions might look at DCL as an alternative.

9) If Labor win the upcoming election, as they are forecasted to do, their
stated policy is to ban borrowing within SMSFs which will leave DomaCom as one of the few remaining vehicles for SMSFs to invest in direct property .

10) We believe DCL is currently undervalued. We value the company at
A$0.32 per share in our base case scenario, using a long-term DCF calculation approach. We have applied realistic estimates on the increase in FuM across Fractional Investing and Equity Release products.

 

Fractional Investing: New era in property investment

Fractional investing is a method by which investors collectively raise capital to purchase a high-value asset, such as residential properties, residential developments, land banking, renewable energy assets and rural properties. This gives an individual investor exposure to an asset at a fraction of the total cost.

Fractional investment allows investors, who would otherwise not be able to purchase an entire property by themselves, to build exposure to property assets. It also allows investors to diversify their investment portfolio by giving them fractional exposure to different properties. Compared to traditional property investing, the barriers to entry for DCL’s investors are low, i.e. investors can sign up with DCL’s platform in a few simple steps.

Why fractional investing makes so much sense

Given that Australia has become the third-least affordable country for housing, fractional property investing is an ideal solution for investors looking to enter the market without having to purchase an entire property.
According to the 14th Annual Demographia International Housing Affordability Survey conducted in 2018, the average house priceto-household income ratio is 12.9x in Sydney. Consequently, it is extremely difficult for a person to invest in real estate in an individual capacity. As a result of this, the concept of crowdfunding property investments shows great promise.

A boon for financial advisors

We believe fractional investing will be a very welcome addition to financial
advisors’ investment advisory toolkits. Typically, financial advisors struggle
to allocate funds to property investments and diversify their clients’ portfolio through traditional investment vehicles, such as unlisted trusts, Australian Real Estate Investment Trusts (AREITs), and traditional syndicates, and have difficulty diversifying across property types and geographic locations. Also, property investors do not get to choose the properties they invest in and liquidity is typically low.

Fractional property investment overcomes all these problems as clients get
to choose the property in which they want to invest. DCL conducts due
diligence before purchasing a property, which assuages most concerns a
financial advisor might have. It reviews the purchase contract, provides legal oversight, conducts property valuation so that investors do not buy an over-priced property, and also carries out property and pest inspections to ensure that the property is in sound condition. Finally, DCL appoints a buyer’s agent to negotiate the best possible price and a property manager to ensure minimum vacancy.

Fractional investing is a new asset class

Since fractional property is a new asset class, it is a regulated product and
only Authorized Representatives (AR) under the Australian Financial Services
Licensee (AFSL) can recommend it to their clients. The financial advisor is
required to hire a property advisor to select the property based on the
investor’s requirement and risk profile. Hence, the advisor only recommends
the structure and not the underlying property to its clients. Fractional
property investing will benefit financial advisors as it will result in increased
revenue and client reach. It also protects investors from purchasing over-priced properties.

Equity Release: Ideal for ‘asset rich, cash poor’

A significant portion of real estate in Australia is held by people over 65
years of age (Figure 3). Thus, the possibility of utilising asset holdings for
sustainable and regular income for retirees is very substantial. Reverse
Mortgage, the best possible financial instrument which provides this
flexibility, accounts for only ~1% of total housing equity, until now. This
problem is exacerbated by the fact that the superannuation guarantee only
started in the early 1990s, which means that members of the older generations did not have the ability to accumulate their funds into a superannuation account in their early years and hence many do not have sufficient savings. Considering the significant gap in the potential and existing underlying assets, DCL is compensating by launching a parallel but better product – Equity Release.

Equity Release will match those looking to obtain cash by releasing equity in
their homes with individuals who wish to make investments that are underpinned by those properties. Recently approved by the regulators, DCL’s Equity Release product provides an attractive solution to ‘asset rich, cash poor’ retirees; it gives them control and at the same time unlocks the value of their homes, while allowing them to remain living in them.

With increasing life expectancy, people will need more capital for retirement

Looking at the current demographic situation in Australia, the need and the opportunity for Equity Release has become more apparent. Just like most developed countries, Australia’s population is ageing due to low fertility and increased life expectancy; therefore, there are fewer children below 15 and a proportionally larger number of those aged 65 and over.

Furthermore, the demographic that is worst hit by the continuously rising cost of living mostly comprises retirees, i.e. people who do not have an independent, growing source of income to support their expenditures, unlike their employed counterparts.

1. Australia’s ageing population

Over the last two decades, the median population of Australia has gone up by 2 years, from 35 years (as at June 30, 1998) to 37 years (as at June 30, 2018). The proportion of population above 65 years old increased from 11.8% in 1994 to 14.7% in 2014. It is projected that by 2061, 25% of the country’s population will be above 65.

As Australia’s population continues to age, a larger portion will be joining the retiree segment, thereby stimulating the demand for more funds to meet their rising expenditures. Add to that the currently prevailing tighter underwriting standards in the economy, and DCL has the perfect opportunity to leverage its Equity Release offering.

2. Increasing cost of living

The cost of living in Australia has risen, as evidenced by a 1.8% YoY increase in the CPI to 114.1, as of December 2018 (from 112.1 a year ago). Notably, the largest uptick in the Living Cost Indexes (LCI) was observed in the Self-Funded Retiree segment, which grew 2.2% YoY to 113.7. This was closely followed by a 2.1% YoY increase experienced by the Pensioner and Beneficiary Index (PBLCI), which includes the Age Pensioner and Other Government Transfer Recipient Household segments of the economy.

The segments that were worst hit by the continuously rising costs of living are mostly comprised of retirees and individuals who do not have an independent, growing source of income to support their expenditures. We believe that for these individuals, DCL’s Equity Release offering provides a great opportunity to tap into the part of their capital that has been locked up in their most prized asset, their house.

 

Equity Release is an ideal investment opportunity for retirees

1. Volatility in Superfunds PerformanceMembers of superfunds that are invested in the Median Balanced option experienced a negative return of 0.6% in November 2018 . History is witness to other such instances where returns on superfunds turned negative, such as the annual loss of 1.9% in 2011. Such instances bring to the forefront the fact that superfunds, which form the majority of the average Australian’s retirement source of income, are just like any other financial investment product and are prone to associated risks. This makes superannuation funds a risky short- to medium-term source of income.

2. Shrinking benefits paid to pensioners

Effective from January 2017, the Australian government increased the taper rate on assets (which determines how much of the pension payment is made on a fortnightly basis) from A$1.5 to A$3.0 on every $1,000 above the threshold limit. As a result of these sweeping changes made by the government in order to determine the eligibility of the pensioners, the reliance of retirees on pension transfers has reduced dramatically. In the same year, the age limit for a retiree to qualify to receive the pension payment was also increased to 65 years and six months of age. As the government plans on increasing this limit by six months every two years, the eligibility threshold for receiving the pension benefits is set to reach 67 years old by 2023. This will drive retirees to seek other sources of income to make up for the loss caused by the above mentioned changes in the legislature. It is expected that Equity Release will provide the required platform for retirees to earn higher yields from their property holdings.

3. Relatively superior products

Compared to some other financial products for retirees that allow them to benefit from real estate holdings, i.e. reverse mortgages and downsizing, Equity Release has inherent benefits. DCL’s product is not only well funded but progressive equity sale means that both the owner and investor have enough scope to judge the return before committing any more capital/holding. Comparatively, other options have fundamental complications:

a. Reverse mortgages: These are debt products, secured over a property, that release equity to the owners. The loan can be taken as a lump sum, an income stream, or a line of credit. There are no regular repayments in this case. In Australia, reverse mortgage includes a no-negative-equity guarantee. Although this protects against negative equity, there is no certainty regarding the value of the residual equity at the end of the contract.

b. Downsizing: This refers to selling the current house and moving to a smaller house, which frees up some cash from the transactions in consideration. However, it means a change in lifestyle and a significant transaction cost for the property owner.

Equity release deed

An equity release deed is an agreement between a property owner and a
custodian in which the property owner sells an interest in his/her property
to the custodian for an agreed amount. The supplementary Product
Disclosure Statement (PDS) will contain relevant information for investors,
such as the value of the property, the proposed interest DCL will acquire,
the notional rent, the associated expenses, a property description, and the
risks associated with the investment.

The deed allows investors to receive a fixed income from the service fee paid by the property owner. As this notional rent is disclosed in the supplementary PDS, investors are not subject to vacancy risk, and because the amounts are fixed in advance, there is certainty of yield. Generally, the base service fee rate is 5.4% of the payout amount, while 4% of the service fee goes to paying investors a notional rent.

The fixed fee is paid through releasing additional interest in the property,
usually every five years, to the DomaCom fund. This allows existing unit
holders to increase their holdings in the sub-fund. If the property owner’s
interests in the underlying property are extinguished over time, the Equity
Release Administrator (ERA) has to pay rent to the investors until the deed is
terminated. This payment is made from the longevity reserve that is built up
over the time of the investment.

The underlying asset in this case is still held in the name of the property
owner; however, as a co-owner of the property, investors will share certain
expenses with the owner – such as property maintenance and insurance
costs – in proportion to their share of the property; this will be deducted
from investor returns.

Valuation

Considering that DCL is one of the only listed companies present in the niche
crowdfunding property space, the underlying value of the business lies in its
ability to scale up business operations. Hence, the true value of its business
can best be gauged from a Discounted Cash Flow (DCF) calculation over a
long-term period. We have also refrained from using relative valuation,
given the limited relevant public peers and the fact that most of them are
making a loss operationally.

Some investors might make the mistake of comparing DCL with real estate
fund management companies, but DCL deserves premium valuation over
them as it offers a unique combination of fund management and a Software
as a Service (SaaS) platform.

Our DCF model yields a 9.8% Weighted Average Cost of Capital (WACC) for
DCL (with a risk-free rate of 2.7%, a beta of 1.1, and an equity risk premium
of 7.7%). Applying this discount rate to our free cash flow projections
through FY2028E, and using a terminal growth rate of 2.0%, DCL yields a
value of A$0.35 per share. Our bull case calculation results in a
valuation of A$0.46. This implies a substantial upside from the
current share price.

Even though there is execution risk associated with DCL’s strategy, as the
company matures and approaches EBITDA breakeven (by FY2022E), there
will be room for lower discount rates, which will translate into higher share
price values.

Re-rating DomaCom Limited

DCL’s stock is currently trading below our base case valuation. We have
outlined a number of factors that may result in a re-rating of DCL going
forward:

– DCL has approval for Equity Release, which provides it with a
competitive edge as there are regulatory hurdles in obtaining this
approval. Clients and financial advisors have a latent demand for this
product as it can be used for inter-generational wealth planning.

– The availability of leverage for property purchases will make DCL’s
products more lucrative to financial planners as internal leverage will
make the investment tax efficient. Property purchases prior to March
2018 were made without any debt.

– Banks have withdrawn lending to self-managed superfunds. This will
make it difficult to purchase property and give a boost to fractional
investing. DCL is a viable option for SMSFs looking to leverage property
transactions.

– Labor winning and delivering on their promise to ban SMSFs from
borrowing. This will position DCL as one of the few, if not only, ways for
SMSFs to invest in direct property.

Further, DCL has an experienced management team capable of
steering the company through to the growth stage. Grahame Evans, the
chairman, has over 30 years of experience in financial services. CEO Arthur
Naoumidis has over 20 years of experience in consulting and has worked in
financial services for several years. Ross Laidlaw, COO, has over 25 years of
experience in financial services operations.

Please note, the usual disclaimers apply – click here

Pitt Street Research work is commissioned by the listed companies it covers, and Pitt Street Research has received or will receive payment for the preparation of such work. Please refer to the bottom of the research notes as published on Pitt Street Research’s web site for risks related to the companies being covered, as well our General Advice Warning, disclaimer and full disclosures. Also, please be aware that the investment opinion in this report is current as at the date of publication but that the circumstances of the company may change over time, which may in turn affect our investment opinion.



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