Comstock Holding Companies, Inc. (NASDAQ:CHCI) provides asset management and real estate services in the Washington, D.C. metropolitan area for mixed-use development, residential apartment complexes, and parking developments. While these lines of business generate the majority of the company’s revenue, the company is also a minority owner in some of the properties it administers.

Surprisingly, the majority of the properties in which this company is involved are owned by companies owned by Comstock’s CEO, Chris Clemente. Clemente also holds almost one-third of Comstock’s stock. At first, I was skeptical of these linkages, but after more investigation, I am not concerned (more on this later).

Normally, in order to gain real estate investment exposure, one either invests directly in real estate or in funds that invest in real estate. Comstock has direct real estate investments, but they are unusual in that the majority of their value is derived from cash flows associated with managing real estate developments. Although the company touts this as an asset-light approach with no debt, an investment in Comstock is still very much related to the real estate market, for mixed-use, commercial, and apartment-style buildings. The key advantage of this approach is that I am better able to assess the firm because the value is dependent on cash flows rather than the value of the real estate or land.

Comstock, in my opinion, is an appealing investment for two key reasons. The first is that it is an investment in the increase of population and demand in a few important regions in the Washington, D.C. area, and the second is that it is selling at low earnings multiple while growing revenue at a good rate and providing strong returns on invested capital over the past few years. These factors lead me to assume that an investment in stock will yield very strong returns in the future.

Placement, Placement, Placement

Many of Comstock’s maintained buildings are located in locations that have been extensively developed over the last few decades. Rockville, MD, and Arlington, VA, both immediately outside of Washington, D.C., have seen particularly strong growth.

One cause for growth in places outside of D.C. is the increase of the Washington D.C. population, which has expanded at a rate of.75% per year since 2011, compared to a rate of.53% per year in the United States. While the difference isn’t substantial, it’s large enough to raise city rents and cause outward growth along the metro line. The Height of Construction Act of 1910, which limits construction heights in DC along residential streets to 90 feet and a maximum of 130 feet along commercial corridors, is what actually magnifies the city’s price growth.

This prohibits the development of taller structures, which generally precludes an increase in housing supply in the city and leads to higher rent costs as the population expands. Add to that the reality that many people in the D.C. area work for the government, which is a more recession-proof employer, and the demand for expansion into areas surrounding D.C. grows.

The structures in which Comstock has ownership are found in these nearby localities. The Hartford is an office building in Arlington, VA near the Clarendon metro station, and the BLVD Forty-Four and BLVD Ansel are near the Rockville metro station.

While these developments will continue to benefit from D.C. population growth, the majority of Comstock’s growth will come from the management of its Anchor Portfolio, which includes two massive mixed-use developments located along the Metro’s newly built silver line.

Some of the developments include the one that houses Google headquarters as well as SolarWinds (NYSE:SWI) and Rolls-Royce (OTCPK:RYCEY) offices.

Many significant organizations are drawn to these Anchor Portfolio buildings in Reston and Loudon.

These Anchor Portfolio developments are located near the Wiehle-Reston East and Loudon Gateway metro stops on the Silver Line’s east end. While they are somewhat remote from the city, the Silver Line runs directly through the heart of D.C. at the Metro Center stop, providing a direct connection. This makes these developments appealing since individuals in D.C. can commute to them and those nearby can commute to D.C.

Importantly, despite the pandemic’s skepticism about working from home and commercial real estate in general, these companies are securing leases. In early 2021, Google leased an extra level of the Comstock-managed property at the Wiehle-Reston East stop, much as SolarWinds did at the end of 2022.

All of this, to me, indicates a long-term trend of both commercial and residential demand for developments along the new Silver line, similar to how trends built up Arlington, VA, and Rockville, MD over the last few decades.

Finally, Comstock will manage a number of properties that are actively being developed or are in the pipeline. This pipeline, together with the long-term demand pattern I mentioned before, leads me to feel that Comstock has a long growth runway.

Valuation

Although Comstock is heavily reliant on the commercial and residential real estate markets, it can be valued primarily on profitability because revenue earned from property management is somewhat recurrent and consistent. Despite the periodic pattern of sales, earnings appear lumpy when broken down each quarter. For example, in the third quarter of 2022, operating income was $3.9 million on $12.8 million in revenue. Prior to that, in Q2 2022, operating income was $1.1 million on $8.5 million in revenue, and following that, in Q4 2022, operating income was $1.6 million on $9.3 million in revenue.

Why is this the case when the revenue stream from property management is recurring? The explanation is found in its agreement with Comstock Partners, LC, one of the firms managed by CEO Chris Clemente, not to be confused with Comstock Holding Companies, Inc., the company under consideration in this article. This agreement governs the management of the Anchor Portfolio, which includes the Reston and Loudon developments along the Silver line.

The fees Comstock receives under this arrangement are based on specific percentages of the Anchor Portfolio revenue as well as certain set amounts. These are the recurrent revenue streams. The lumpiness is caused by incentive fees based on the imputed profits of projects, which are determined by the fair market value of those properties. These payments are triggered when the uncertainties around the property’s valuation are settled. One of these fees was responsible for the significant increase in revenue and earnings in Q3 2022.

There isn’t much more information on these triggering events, but the Q3 2022 triggering event was the first of a series of triggering events scheduled each October 1 through 2024, according to the 2022 annual report.

Given my beliefs on the long-term demand trends I detailed above, I am fairly convinced that these triggering events will materialize. Comstock appears to be trading at a low valuation even without the triggering circumstances.

I consider the last two quarters to be relatively normal and free of the impact of the incentive fee. In these periods, operating income was $1.6 million and $1.30 million, respectively. Using the midpoint of these figures, I estimate a normalized operating income of $1.45 million per quarter, or $5.8 million on an annual basis. Comstock is trading at an EV/EBIT ratio of 6.4 based on this assessment and a market capitalization of $37 million. This appears to be a bargain to me, especially given Comstock’s recent revenue and profits growth, as well as the strong ROIC it is producing. In 2019, operating income was $2.2 million. ROIC is 40.6%, computed by dividing annualized operating income after taxes by net working capital + PPE.

Assuming a 20% increase in normalized operating income in 2023, normalized operating income for the entire year would be $6.7 million. If the EV/EBIT multiple increases to 9.2, the average peer-adjusted EV/EBITDA multiple calculated by Comstock in its investor presentation, the enterprise value by the end of 2023 would be $64m, representing a little less than 100% upside by the end of the year. This does not account for the possibility of incentive fees, which might boost earnings by $2 million in Q3 2023 as they did in Q3 2022, resulting in significantly more upside.

Risks

The largest risk is a crash in the commercial real estate sector. This has been a hotly debated topic in 2023. Despite the fact that the company has no debt and owns little real estate, it is nevertheless very much tied to the commercial real estate market because much of Comstock’s value is derived from its agreement to manage commercial real estate developments in the Anchor Portfolio. Comstock’s earnings would drop if this market crashed.

I have no ability to anticipate what will happen in any real estate market, so I will refrain from attempting to do so. I recognize that these dangers exist, as they always do, but I will not let them dissuade me from investing in businesses that I believe will provide significant returns owing to business fundamentals and a long runway for growth due to demographic trends in the Washington, D.C. area.

Position sizing is the best strategy to limit left tail risk while investing and considering projected values. A commercial real estate crash that causes Comstock’s equity to drop would subtract from my portfolio but would not wipe me out if I used proper position sizing. However, if the high ROIC increase continues, as I believe it will, I will make respectable but not life-changing gains.

Comstock’s capital structure includes approximately $7 million in operational lease liabilities, but the $9 million cash balance more than covers these liabilities. They’ve also been cash flow positive since 2017, thus I don’t think they’ll issue debt or issue stock to raise money because their present cash balance and cash generated from operations will be enough to pay all liabilities and capital expenditures. Although I believe this is the case, it is critical to monitor the capital structure in the future and evaluate whether it will ever be necessary to dilute shareholders.

I am not concerned about Comstock’s ties to firms owned by its CEO, Chris Clemente. When I saw this association, my immediate instinct was that it could lead to poor decision-making, especially given the company’s scale. However, after spending more time examining the organization and its structure, it appears to be nothing more than a mechanism for him to diversify his assets and real estate portfolio. He also owns roughly a third of Comstock’s stock, so his motivations are very certainly aligned with those of outside shareholders.

The investment by Schar Holdings, LLC, a corporation owned by Dwight Schar, the former CEO of NVR, Inc. (NVR), a prominent homebuilding company headquartered in Reston, VA, has put these fears to rest. Dwight Schar now controls one-third of Comstock’s equity as a result of this transaction. Clemente and Schar, I believe, have significant ownership shares because they believe in the long-term value of the firm and the growth in demand along the Metro’s silver line. However, when investing in small micro-cap businesses like Comstock, it’s always a good idea to be aware of these risks.

Finally, Comstock’s stock is highly illiquid, with approximately $80,000 worth of shares moved per day on average. This makes it difficult to sell the stock without causing the stock price to fall if the investor suddenly needs cash. This risk is best reduced by controlling position sizing and investing exclusively for the long run. If you need to sell your shares immediately, it is preferable not to invest in an illiquid stock at all.

Bottom Line

Based on the present low earnings multiple the company trades at, the strong ROIC gained from business operations, and the potential for long-term development owing to the demographics of the Washington D.C. metropolitan region, I believe an investment in Comstock could provide substantial returns in the future. These potential returns, however, must be weighed against the hazards of an investment that is heavily reliant on the commercial real estate market.

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